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Chapter 8

Profit
Maximization and
Competitive
Supply
Topics to be Discussed
• Perfectly Competitive Markets
• Profit Maximization
• Marginal Revenue, Marginal Cost,
and Profit Maximization

• Choosing Output in the Short-Run

Chapter 1 2
Topics to be Discussed
• The Competitive Firm’s Short-Run
Supply Curve

• Short-Run Market Supply


• Choosing Output in the Long-Run
• The Industry’s Long-Run Supply
Curve
Chapter 1 3
Perfectly Competitive
Markets

• Characteristics of Perfectly
Competitive Markets

1) Price taking

2) Product homogeneity

3) Free entry and exit

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.

– The individual consumer buys too small


a share of industry output to have any
impact on market price.
Chapter 1 5
Perfectly Competitive
Markets

• Product Homogeneity
– The products of all firms are perfect
substitutes.

– Examples
• Agricultural products, oil, copper, iron,
lumber

Chapter 1 6
Perfectly Competitive
Markets

• Free Entry and Exit


– Buyers can easily switch from one
supplier to another.

– Suppliers can easily enter or exit a


market.

Chapter 1 7
Perfectly Competitive
Markets

• Discussion Questions
– What are some barriers to entry and
exit?

– Are all markets competitive?

– When is a market highly competitive?

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

• Determining the profit maximizing


level of output
– Profit ( )π= Total Revenue - Total Cost
– Total Revenue (R) = Pq
– Total Cost (C) = Cq
– Therefore:

π (q) = R(q) − C (q)


Chapter 1 12
Profit Maximization in the Short
Run

Cost, Total Revenue


Revenue, R(q)
Profit
($s per year)

Slope of R(q) = MR

Output (units per year)

Chapter 1 13
Profit Maximization in the Short
Run
C(q)
Cost,
Revenue,
Profit
$ (per year) Total Cost

Slope of C(q) = MC

Why is cost positive when q is zero?

Output (units per year)

Chapter 1 14
Marginal Revenue, Marginal Cost,
and Profit Maximization

• Marginal revenue is the additional


revenue from producing one more
unit of output.

• Marginal cost is the additional cost


from producing one more unit of
output.

Chapter 1 15
Marginal Revenue, Marginal Cost,
and Profit Maximization

• Comparing R(q) and Cost,


C(q) Revenue,
Profit
– Output levels: 0- q0: ($s per year) C(q)

• C(q)> R(q) A R(q)


– Negative profit
• FC + VC > R(q) B

• 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

• Comparing R(q) and Cost,


C(q) Revenue,
Profit
– Question: Why is profit $ (per year) C(q)
negative when output is
A R(q)
zero?

0 q0 q*
π (q )
Output (units per year)

Chapter 1 17
Marginal Revenue, Marginal Cost,
and Profit Maximization

• Comparing R(q) and Cost,


C(q) Revenue,
Profit
– Output levels: q0 - $ (per year) C(q)

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

• Comparing R(q) and Cost,


C(q) Revenue,
Profit
– Output level: q* $ (per year) C(q)

• R(q)= C(q) A R(q)

• 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

• Comparing R(q) and C(q) Cost,


– Output levels beyond Revenue,
Profit
q*: $ (per year) C(q)

• R(q)> C(q) A R(q)

• 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

• Therefore, it can be Cost,


said: Revenue,
Profit
$ (per year) C(q)
– Profits are A R(q)
maximized when
MC = MR. B

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

Profits are maximized when :


∆π ∆R ∆C
= − = 0 or
∆q ∆q ∆q

MR − MC = 0 so that
MR(q) = MC(q)

Chapter 1 24
Marginal Revenue, Marginal Cost,
and Profit Maximization

• The Competitive Firm


– Price taker

– Market output (Q) and firm output (q)

– Market demand (D) and firm demand


(d)

– R(q) is a straight line

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

• The Competitive Firm


– The competitive firm’s demand
• Individual producer sells all units for $4
regardless of the producer’s level of
output.
• If the producer tries to raise price, sales
are zero.

Chapter 1 27
Marginal Revenue, Marginal Cost,
and Profit Maximization

• The Competitive Firm


– The competitive firm’s demand
• If the producers tries to lower price he
cannot increase sales
• P = D = MR = AR

Chapter 1 28
Marginal Revenue, Marginal Cost,
and Profit Maximization

• The Competitive Firm


– Profit Maximization
• MC(q) = MR = P

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

q1 : MR > MC and At q*: MR = MC


and P > ATC
q2: MC > MR20 and
q0: MC = MR but π = (P - AC) x q*
10
MC falling or ABCD

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

• Three guidelines for estimating


marginal cost:

1) Average variable cost should not


be used as a substitute for
marginal cost.

Chapter 1 35
Some Cost Considerations for
Managers

• Three guidelines for estimating


marginal cost:

2) A single item on a firm’s


accounting ledger may have two
components, only one of
which involves marginal cost.

Chapter 1 36
Some Cost Considerations for
Managers

• Three guidelines for estimating


marginal cost:

3) All opportunity cost should be


included in determining
marginal cost.

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

• Supply is the amount of output for


every possible price. Therefore:
– If P = P1, then q = q1
– If P = P2, then q = q2
Chapter 1 39
A Competitive Firm’s
Short-Run Supply Curve

Price S = MC above AVC


($ per
unit)
MC
P2 ATC

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

• Firm’s Response to an Input Price


Change
– When the price of a firm’s product
changes, the firm changes its output
level, so that the marginal cost of
production remains equal to the price.

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

How much would


25 be produced if
P = $23?
P = $24-$25?
24

23 Output
(barrels/day)
8,000 9,000 10,000 11,000

Chapter 1 44
The Short-Run Production
of Petroleum Products

• Stepped SMC indicates a different


production (cost) process at various
capacity levels.
• Observation:
– With a stepped MC function, small
changes in price may not trigger a
change in output.

Chapter 1 45
The Short-Run Production
of Petroleum Products

• The short-run market supply curve


shows the amount of output that the
industry will produce in the short-run
for every possible price.

• Consider, for simplicity, a


competitive market with three firms:

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

• Elasticity of Market Supply

Es = (∆Q / Q) /(∆P / P )

Chapter 1 48
The Short-Run Market Supply
Curve

• Perfectly inelastic short-run supply


arises when the industry’s plant and
equipment are so fully utilized that
new plants must be built to achieve
greater output.

• Perfectly elastic short-run supply


arises when marginal costs are
constant.
Chapter 1 49
The Short-Run Market Supply
Curve

• Questions
1) Give an example of a perfectly
inelastic supply.

2) If MC rises rapidly, would the


supply be more or less elastic?

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

• Producer Surplus in the Short Run


– Firms earn a surplus on all but the last
unit of output.
– The producer surplus is the sum over all
units produced of the difference
between the market price of the good
and the marginal cost of production.

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 in the Short-Run

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)

Market producer surplus is


P* the difference between P*
and S from 0 to Q*.

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.

• We assume free entry and free exit.

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

• Entry and Exit


– The long-run response to short-run
profits is to increase output and profits.
– Profits will attract other producers.
– More producers increase industry supply
which lowers the market price.

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

3) Equilibrium Market Price


Chapter 1 65
Choosing Output in the Long Run
• Questions
1) Explain the market adjustment
when P < LAC and firms have
identical costs.
2) Explain the market adjustment
when firms have different costs.
3) What is the opportunity cost of
land? Chapter 1 66
Choosing Output in the Long Run
• Economic Rent
– Economic rent is the difference between
what firms are willing to pay for an input
less the minimum amount necessary to
obtain it.

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

Economic Rent LMC LAC

$10

$7 A team with the same


cost in a larger city
sells tickets for $10.

Season Tickets
Sales (millions)
1.3
Chapter 1 71
Firms Earn Zero Profit in
Long-Run Equilibrium

• With a fixed input such as a unique


location, the difference between the
cost of production (LAC = 7) and
price ($10) is the value or
opportunity cost of the input
(location) and represents the
economic rent from the input.

Chapter 1 72
Firms Earn Zero Profit in
Long-Run Equilibrium

• If the opportunity cost of the input


(rent) is not taken into consideration
it may appear that economic profits
exist in the long-run.

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.

– Output is increased by using more


inputs, not by invention.

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

• In a constant-cost industry, long-run


supply is a horizontal line at a price
that is equal to the minimum
average cost of production.

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

• In a increasing-cost industry, long-


run supply curve is upward sloping.

Chapter 1 80
The Industry’s
Long-Run Supply Curve

• Questions
1) Explain how decreasing-cost is
possible.

2) Illustrate a decreasing cost


industry.

3) What is the slope of the SL in a


decreasing-cost industry?
Chapter 1 81
Long-Run Supply in an
Decreasing-Cost Industry
Due to the decrease
in input prices, long-run
equilibrium occurs at
$ per $ per a lower price.
unit of unit of
output output S1 S2
SMC1
SMC2 LAC1
P2 P2
LAC2
P1 A
P1 B
P3 P3
SL

D1 D2

q1 q2 Output Q1 Q2 Q3 Output
Long-Run Supply in a
Increasing-Cost Industry

• In a decreasing-cost industry, long-


run supply curve is downward
sloping.

Chapter 1 83
The Industry’s
Long-Run Supply Curve

• The Effects of a Tax


– In an earlier chapter we studied how
firms respond to taxes on an input.
– Now, we will consider how a firm
responds to a tax on its output.

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

Tax shifts S1 to S2 and


P1 output falls to Q2. Price
increases to P2.

Q2 Q1 Output
Chapter 1 86
The Industry’s
Long-Run Supply Curve

• Long-Run Elasticity of Supply


1) Constant-cost industry
• Long-run supply is horizontal
• Small increase in price will induce an
extremely large output increase

Chapter 1 87
The Industry’s
Long-Run Supply Curve

• Long-Run Elasticity of Supply


1) Constant-cost industry
• Long-run supply elasticity is infinitely large
• Inputs would be readily available

Chapter 1 88
The Industry’s
Long-Run Supply Curve

• Long-Run Elasticity of Supply


2) Increasing-cost industry
• Long-run supply is upward-sloping and
elasticity is positive
• The slope (elasticity) will depend on the rate
of increase in input cost
• Long-run elasticity will generally be greater
than short-run elasticity of supply

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.

• A competitive market makes its


output choice under the assumption
that the demand for its own output is
horizontal.
Chapter 1 95
Summary
• In the short run, a competitive firm
maximizes its profit by choosing an
output at which price is equal to
(short-run) marginal cost.

• The short-run market supply curve is


the horizontal summation of the
supply curves of the firms in an
industry.
Chapter 1 96
Summary
• The producer surplus for a firm is the
difference between revenue of a firm
and the minimum cost that would be
necessary to produce the profit-
maximizing output.
• Economic rent is the payment for a
scarce resource of production less
the minimum amount necessary to
hire that factor.
Chapter 1 97
Summary
• In the long-run, profit-maximizing
competitive firms choose the output
at which price is equal to long-run
marginal cost.

• The long-run supply curve for a firm


can be horizontal, upward sloping, or
downward sloping.

Chapter 1 98
End of Chapter 8
Profit
Maximization and
Competitive
Supply

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