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Profit
Maximization and
Competitive
Supply
Topics to be Discussed
• Perfectly Competitive Markets
• Profit Maximization
• Marginal Revenue, Marginal Cost,
and Profit Maximization
Chapter 1 2
Topics to be Discussed
• The Competitive Firm’s Short-Run
Supply Curve
• Characteristics of Perfectly
Competitive Markets
1) Price taking
2) Product homogeneity
Chapter 1 4
Perfectly Competitive
Markets
• Price Taking
– The individual firm sells a very small
share of the total market output and,
therefore, cannot influence market
price.
• Product Homogeneity
– The products of all firms are perfect
substitutes.
– Examples
• Agricultural products, oil, copper, iron,
lumber
Chapter 1 6
Perfectly Competitive
Markets
Chapter 1 7
Perfectly Competitive
Markets
• Discussion Questions
– What are some barriers to entry and
exit?
Chapter 1 8
Profit Maximization
• Do firms maximize profits?
– Possibility of other objectives
• Revenue maximization
• Dividend maximization
• Short-run profit maximization
Chapter 1 9
Profit Maximization
• Do firms maximize profits?
– Implications of non-profit objective
• Over the long-run investors would not
support the company
• Without profits, survival unlikely
Chapter 1 10
Profit Maximization
• Do firms maximize profits?
– Long-run profit maximization is valid
and does not exclude the possibility of
altruistic behavior.
Chapter 1 11
Marginal Revenue, Marginal Cost,
and Profit Maximization
Slope of R(q) = MR
Chapter 1 13
Profit Maximization in the Short
Run
C(q)
Cost,
Revenue,
Profit
$ (per year) Total Cost
Slope of C(q) = MC
Chapter 1 14
Marginal Revenue, Marginal Cost,
and Profit Maximization
Chapter 1 15
Marginal Revenue, Marginal Cost,
and Profit Maximization
• MR > MC
– Indicates higher
profit at higher
output q0 q*
0
π (q )
Output (units per year)
Chapter 1 16
Marginal Revenue, Marginal Cost,
and Profit Maximization
0 q0 q*
π (q )
Output (units per year)
Chapter 1 17
Marginal Revenue, Marginal Cost,
and Profit Maximization
q* A R(q)
• R(q)> C(q)
• MR > MC B
– Indicates higher
profit at higher
output
– Profit is increasing
0 q0 q*
π (q )
Output (units per year)
Chapter 1 18
Marginal Revenue, Marginal Cost,
and Profit Maximization
• MR = MC
• Profit is maximized B
0 q0 q*
π (q )
Output (units per year)
Chapter 1 19
Marginal Revenue, Marginal Cost,
and Profit Maximization
• Question Cost,
Revenue,
– Why is profit Profit
$ (per year) C(q)
reduced when R(q)
A
producing more or
less than q*?
B
0 q0 q*
π (q )
Output (units per year)
Chapter 1 20
Marginal Revenue, Marginal Cost,
and Profit Maximization
• MC > MR
• Profit is decreasing B
0 q0 q*
π (q )
Output (units per year)
Chapter 1 21
Marginal Revenue, Marginal Cost,
and Profit Maximization
0 q0 q*
π (q )
Output (units per year)
Chapter 1 22
Marginal Revenue, Marginal Cost,
and Profit Maximization
∆R
MR =
∆q
π = R-C
∆C
MC =
∆q
Chapter 1 23
Marginal Revenue, Marginal Cost,
and Profit Maximization
MR − MC = 0 so that
MR(q) = MC(q)
Chapter 1 24
Marginal Revenue, Marginal Cost,
and Profit Maximization
Chapter 1 25
Demand and Marginal Revenue Faced
Price
by a Competitive Firm
Price
$ per Firm $ per Industry
bushel bushel
$4 d $4
Output Output
100 200 (bushels)
100 (millions
of bushels)
Marginal Revenue, Marginal Cost,
and Profit Maximization
Chapter 1 27
Marginal Revenue, Marginal Cost,
and Profit Maximization
Chapter 1 28
Marginal Revenue, Marginal Cost,
and Profit Maximization
Chapter 1 29
Choosing Output in the Short Run
• We will combine production and cost
analysis with demand to determine
output and profitability.
Chapter 1 30
A Competitive Firm
Making a Positive Profit
Price 60 MC
($ per
unit)
50 Lost profit for Lost profit for
qq < q* q 2 > q*
D A
40 AR=MR=P
ATC
C B
30 AVC
0 1 2 3 4 5 6 7 8 9 10 11
q0 q1 q q2
* Output
Chapter 1 31
A Competitive Firm
Incurring Losses
Price MC ATC
($ per
unit) B
C
D P = MR
At q*: MR = MC A
and P < ATC
Losses = P- AC) x q* AVC
or ABCD
F Would this producer
E continue to produce
with a loss?
q* Output
Chapter 1 32
Choosing Output in the Short Run
• Summary of Production Decisions
– Profit is maximized when MC = MR
– If P > ATC the firm is making profits.
– If AVC < P < ATC the firm should
produce at a loss.
– If P < AVC < ATC the firm should shut-
down.
Chapter 1 33
The Short-Run Output of
an Aluminum Smelting Plant
Observations
Cost •Price between $1140 & $1300: q = 600
(dollars per item) •Price > $1300: q = 900
•Price < $1140: q = 0
1400
P2
1300
P1
1200
Question
1140
Should the firm stay in business
1100 when P < $1140?
Output
0 300 600 900 (tons per day)
Chapter 1 34
Some Cost Considerations for
Managers
Chapter 1 35
Some Cost Considerations for
Managers
Chapter 1 36
Some Cost Considerations for
Managers
Chapter 1 37
A Competitive Firm’s
Short-Run Supply Curve
Price The firm chooses the
($ per output level where MR = MC,
unit) as long as the firm is able to
cover its variable cost of
production.
MC
P2 ATC
P1 AVC
What happens
P = AVC if P < AVC?
q1 q2 Output
Chapter 1 38
A Competitive Firm’s
Short-Run Supply Curve
• Observations:
– P = MR
– MR = MC
– P = MC
P1 AVC
P = AVC
Shut-down
Output
q1 q2
Chapter 1 40
A Competitive Firm’s
Short-Run Supply Curve
• Observations:
– Supply is upward sloping due to
diminishing returns.
– Higher price compensates the firm for
higher cost of additional output and
increases total profit because it applies
to all units.
Chapter 1 41
A Competitive Firm’s
Short-Run Supply Curve
Chapter 1 42
The Response of a Firm to
a Change in Input Price
Price
Input cost increases
($ per
and MC shifts to MC2
unit) MC2 and q falls to q2.
Savings to the firm
from reducing output
MC1
$5
q2 q1 Output
Chapter 1 43
The Short-Run Production
of Petroleum Products
Cost
The MC of producing
($ per a mix of petroleum products
barrel) 27 from crude oil increases SMC
sharply at several levels
of output as the refinery
shifts from one processing
unit to another.
26
23 Output
(barrels/day)
8,000 9,000 10,000 11,000
Chapter 1 44
The Short-Run Production
of Petroleum Products
Chapter 1 45
The Short-Run Production
of Petroleum Products
Chapter 1 46
Industry Supply in the Short Run
The short-run S
$ per MC1 MC2 MC3 industry supply curve
is the horizontal
unit
summation of the supply
curves of the firms.
P3
P2
P1 Question: If increasing
output raises input
costs, what impact
would it have on
market supply?
0 2 4 5 7 8 10 15 Quantity 21
Chapter 1 47
The Short-Run Market Supply
Curve
Es = (∆Q / Q) /(∆P / P )
Chapter 1 48
The Short-Run Market Supply
Curve
• Questions
1) Give an example of a perfectly
inelastic supply.
Chapter 1 50
The World Copper Industry
(1999)
Annual Production Marginal Cost
Country (thousand metric tons) (dollars/pound)
Australia 600 0.65
Canada 710 0.75
Chile 3660 0.50
Indonesia 750 0.55
Peru 450 0.70
Poland 420 0.80
Russia 450 0.50
United States 1850 0.70
Zambia 280 0.55
Chapter 1 51
The Short-Run World Supply of Copper
Price
($ per pound)
0.90
MCPo
0.80
MCCa
MCP,MCUS
0.70 MCA
0.60
MCJ,MCZ
MCC,MCR
0.50
0.40
0 2000 4000 6000 8000 10000
Production (thousand metric tons)
Chapter 1 52
The Short-Run Market Supply
Curve
Chapter 1 53
Producer Surplus for a Firm At q* MC = MR.
Between 0 and q ,
Price MR > MC for all units.
($ per Producer
unit of Surplus MC AVC
output)
B
A P
Alternatively, VC is the
sum of MC or ODCq* .
R is P x q* or OABq*.
D Producer surplus =
C
R - VC or ABCD.
0 q* Output
Chapter 1 54
The Short-Run Market Supply
Curve
Producer Surplus = PS = R - VC
Profit = π - R - VC - FC
Chapter 1 55
The Short-Run Market Supply
Curve
• Observation
– Short-run with positive fixed cost
PS > π
Chapter 1 56
Producer Surplus for a Market
Price S
($ per
unit of
output)
Producer
Surplus D
Q* Output
Chapter 1 57
Choosing Output in the Long Run
• In the long run, a firm can alter all its
inputs, including the size of the plant.
Chapter 1 58
Output Choice in the Long Run
Price In the long run, the plant size will be
($ per increased and output increased to q3.
Long-run profit, EFGD > short run
LMC
unit of
output) profit ABCD.
LAC
SMC
SAC
D A E
$40 P = MR
C
B
G F
$30
In the short run, the
firm is faced with fixed
inputs. P = $40 > ATC.
Profit is equal to ABCD.
q1 q2 q3 Output
Chapter 1 59
Output Choice in the Long Run
Price Question: Is the producer making
($ per a profit after increased output
lowers the price to $30? LMC
unit of
output) LAC
SMC
SAC
D A E
$40 P = MR
C
B
G F
$30
q1 q2 q3 Output
Chapter 1 60
Choosing Output in the Long Run
• Accounting Profit & Economic Profit
– Accounting profit (π )= R - wL
– Economic profit (π =
) R = wL - rK
• wl = labor cost
• rk = opportunity cost of capital
Chapter 1 61
Choosing Output in the Long Run
Long-Run Competitive Equilibrium
• Zero-Profit
– If R > wL + rk, economic profits are
positive
– If R = wL + rk, zero economic profits,
but the firms is earning a normal rate of
return; indicating the industry is
competitive
– If R < wl + rk, consider going out of
business Chapter 1 62
Choosing Output in the Long Run
Long-Run Competitive Equilibrium
Chapter 1 63
Long-Run Competitive Equilibrium
•Profit attracts firms
•Supply increases until profit = 0
$ per Firm $ per Industry
unit of unit of S1
output output
LMC
$40 P1
LAC S2
$30 P2
q2 Output Q1 Q2 Output
Choosing Output in the Long Run
• Long-Run Competitive Equilibrium
1) MC = MR
2) P = LAC
• No incentive to leave or enter
• Profit = 0
Chapter 1 67
Choosing Output in the Long Run
• An Example
– Two firms A & B
– Both own their land
– A is located on a river which lowers A’s
shipping cost by $10,000 compared to
B.
– The demand for A’s river location will
increase the price of A’s land to $10,000
Chapter 1 68
Choosing Output in the Long Run
• An Example
– Economic rent = $10,000
• $10,000 - zero cost for the land
– Economic rent increases
– Economic profit of A = 0
Chapter 1 69
Firms Earn Zero Profit in
Long-Run Equilibrium
A baseball team
Ticket in a moderate-sized city
Price sells enough
tickets so that price
is equal to marginal
LMC LAC and average cost
(profit = 0).
$7
Season Tickets
Sales (millions)
1.0
Chapter 1 70
Firms Earn Zero Profit in
Long-Run Equilibrium
Ticket
Price
$10
Season Tickets
Sales (millions)
1.3
Chapter 1 71
Firms Earn Zero Profit in
Long-Run Equilibrium
Chapter 1 72
Firms Earn Zero Profit in
Long-Run Equilibrium
Chapter 1 73
The Industry’s Long-Run Supply Curve
• The shape of the long-run supply
curve depends on the extent to
which changes in industry output
affect the prices the firms must pay
for inputs.
Chapter 1 74
The Industry’s Long-Run Supply Curve
• To determine long-run supply, we
assume:
– All firms have access to the available
production technology.
Chapter 1 75
The Industry’s Long-Run Supply Curve
• To determine long-run supply, we
assume:
– The market for inputs does not change
with expansions and contractions of the
industry.
Chapter 1 76
Long-Run Supply in a
Constant-Cost Industry
Economic profits attract new
firms. Supply increases to S2 and Q1 increase to Q2.
the market returns to long-run Long-run supply = SL = LRAC.
$ per equilibrium. $ per Change in output has no impact on
unit of unit of input cost.
output output
MC AC S1 S2
P2 P2 C
A B
P1 P1 SL
D1 D2
q1 q2 Output Q1 Q2 Output
Long-Run Supply in a
Constant-Cost Industry
Chapter 1 78
Long-Run Supply in an
Increasing-Cost Industry
Due to the increase
in input prices, long-run
equilibrium occurs at
$ per $ per a higher price.
unit of unit of
output LAC2 output S1 S2
SMC2 SL
SMC1
P2 LAC1 P2
P3 P3 B
P1 P1 A
D1 D1
q1 q2 Output Q1 Q2 Q3 Output
Long-Run Supply in a
Increasing-Cost Industry
Chapter 1 80
The Industry’s
Long-Run Supply Curve
• Questions
1) Explain how decreasing-cost is
possible.
D1 D2
q1 q2 Output Q1 Q2 Q3 Output
Long-Run Supply in a
Increasing-Cost Industry
Chapter 1 83
The Industry’s
Long-Run Supply Curve
Chapter 1 84
Effect of an Output Tax on a
Competitive Firm’s Output
Price MC2 = MC1 + tax The firm will
($ per MC1 reduce output to
unit of An output tax the point at which
output) raises the firm’s the marginal cost
marginal cost by the plus the tax equals
amount of the tax. the price.
t
P1
AVC2
AVC1
q2 q1 Output
Chapter 1 85
Effect of an Output
Tax on Industry Output
Price
($ per S2 = S 1 + t
unit of
output) S1
P2 t
Q2 Q1 Output
Chapter 1 86
The Industry’s
Long-Run Supply Curve
Chapter 1 87
The Industry’s
Long-Run Supply Curve
Chapter 1 88
The Industry’s
Long-Run Supply Curve
Chapter 1 89
The Industry’s
Long-Run Supply Curve
• Question:
– Describe the long-run elasticity of
supply in a decreasing -cost industry.
Chapter 1 90
The Long-Run Supply of Housing
• Scenario 1: Owner-occupied housing
– Suburban or rural areas
– National market for inputs
Chapter 1 91
The Long-Run Supply of Housing
• Questions
– Is this an increasing or a constant-cost
industry?
– What would you predict about the
elasticity of supply?
Chapter 1 92
The Long-Run Supply of Housing
• Scenario 2: Rental property
– Zoning restrictions apply
– Urban location
– High-rise construction cost
Chapter 1 93
The Long-Run Supply of Housing
• Questions
– Is this an increasing or a constant-cost
industry?
– What would you predict about the
elasticity of supply?
Chapter 1 94
Summary
• The managers of firms can operate in
accordance with a complex set of
objectives and under various
constraints.
Chapter 1 98
End of Chapter 8
Profit
Maximization and
Competitive
Supply