Chapter 8 profit maximizaton to students

 In competitive market, average revenue equals the price of the good.. Profit Maximization in Competitive Markets Quantity 0 ATC AVC P1 Q1 P2 Q2 This section of the firm’s MC curve is a

Chapter 8:

PROFIT MAXIMIZATION

IN COMPETITIVE MARKETS

3 Dealing with Losses

2 Profit Maximization

1 The Competitive Market

CONTENTS

4 Measuring Profit in Graph

5 The Supply Curve

A competitive market (a perfectly

competitive market) has 04 characteristics:

 The industry is fragmented.

Sellers and buyers act as price takers.

 Firms produce undifferentiated products.

 Consumers have perfect information

about prices all sellers in the market charge

 The industry is characterized by equal

1 What is a Competitive Market?

2.1 TR and TC Approach

 Total revenue (TR) is the total inflow of

receipts from selling output

 Average revenue (AR) total revenue

divided by the quantity sold

 In competitive market, average revenue

equals the price of the good

TR = AR x Q = P x Q

2 Profit Maximization in Competitive Markets

2.1 TR and TC Approach

 In the total revenue and total cost

approach, we see the firm’s profit as the

difference between TC and TR at each

output level The firm chooses the output

level where profit is greatest

Max(Profit) = Max(TR – TC)

2 Profit Maximization in Competitive Markets

2.2 MR and MC Approach

 In the competitive market, the price line

is horizontal because the firm is a price

taker

 The firm’s price equals both its average

revenue (AR) and its marginal revenue

(MR)

2 Profit Maximization in Competitive Markets

2.3 MC & The Competitive Supply Curve

2 Profit Maximization in Competitive Markets

Quantity

0

ATC AVC P1

Q1

P2

Q2

This section of the firm’s MC curve is

also the firm’s supply curve.

3.1 Short-Run Decision to Shut Down

 A shutdown refers to a short-run decision

not to produce anything during a specific period

of time because of current market conditions

 Exit refers to a long-run decision to leave

the market

 The short-run and long-run decisions differ

because most firms cannot avoid their fixed

costs in the short run but can do so in the long

run

3 Dealing with Losses

3.1 Short-Run Decision to Shut Down

 The firm shuts down if the revenue that

it would earn from producing is less than its

variable costs of production

Shut down if TR < VC

Dividing both sides of this inequality by Q:

Shut down if P < AVC

3 Dealing with Losses

3.2 Long-Run Decision

 The firm exits the market if the revenue

it would get from producing is less than its

total costs

Exit if TR < TC or Exit if P < ATC

 The firm will enter the market if the

price of the good exceeds the average total

cost of production

Enter if P > ATC

3 Dealing with Losses

Quantity

0

Price

P = AR =MR

ATC MC P

ATC

Q

Profit

4 Measuring Profit in Graph

4.1 A firm with profits

4.2 A firm with losses

Price

ATC MC

P = AR =MR P

ATC

Loss

4 Measuring Profit in Graph

5.1 The Short Run: Market Supply with

a Fixed Number of Firms

5 Supply Curve in a Competitive Market

(a) Individual Firm Supply

Quantity (A firm)

0

Price

MC

$1

100

$2

200

(b) Market Supply

Quantity (Market)

0

Price

Supply

$1

100,000

$2

200,000

5.2 The Long Run: Market Supply with

Entry and Exit

5 Supply Curve in a Competitive Market

(a)

(a) Firm’s zero profit condition (b) Market Supply

Quantity (firm)

0

Price

Quantity (market)

Price

0

MC ATC

5.3 A Shift in Demand in the Short Run

and Long Run

5 Supply Curve in a Competitive Market

Firm

(a) Initial Condition

Demand

Short-run supply

P1

ATC

Long-run supply

P1

A

MC

5.3 A Shift in Demand in the Short Run

and Long Run

5 Supply Curve in a Competitive Market

(b) Short-run response

Quantity (firm)

0

Price

MC ATC

Profit

P1

Quantity (market)

Long-run supply

Price

0

P1

S1 P2

Q1

A

Q2

5.3 A Shift in Demand in the Short Run

and Long Run

5 Supply Curve in a Competitive Market

(b) Long-run response

P1

Quantity (firm)

0

Price

Quantity (market)

Price

0

P1 P2

Q1 Q2

Long-run supply B

S1

Q3

C

When profits induce entry, supply increases and the price falls,…

5.4 Why the Long-Run Supply Curve

Might Slope Upward

 Some resources used in production may be

available only in limited quantities An increase in

demand induce a rise in costs

 Firms may have different costs The marginal

firm is the firm that would exit the market if the

5 Supply Curve in a Competitive Market

 Because a competitive firm is a price taker,

its revenue is proportional to the amount of

output it produces

 The price of the good equals both the firm’s

average revenue and its marginal revenue

 To maximize profit, a firm chooses the

quantity of output such that MR = MC

 This is also the quantity at which P = MC

 Therefore, the firm’s marginal cost curve is

its supply curve

Summary

 In the short run, when a firm cannot

recover its fixed costs, the firm will choose to

shut down temporarily if the price of the good

is less than average variable cost

 In the long run, when the firm can recover

both fixed and variable costs, it will choose to

exit if the price is less than average total cost

Summary

 In a market with free entry and exit,

profits are driven to zero in the long run and

all firms produce at the efficient scale

 Changes in demand have different effects

over different time horizons

 In the long run, the number of firms

adjusts to drive the market back to the

zero-profit equilibrium

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