Profit, Loss & Perfect Competition

Market Types Maximizing Profit/Minimizing Loss The Marginal Revenue Curve Perfect Competition Short-Run vs Long-Run Questions for Next Time

Market Types

Each firms goal is to maximize profits But Different competitive scenarios place unique decision making requirements on business managers Purpose of the next several chapters -- describe various competitive scenarios -- examine how business managers make decisions -- rational choice, balancing costs and benefits at the margin, and responding to incentives

Market Types

Perfect Competition
Monopoly Monopolistic Competition Oligopoly

Maximizing Profit/Minimizing Loss

Total Revenue = Price x Total Revenue Marginal Revenue = the increase in total revenue when output increases by one unit, or MR = Change in Total Revenue Change in Output

As long as MR > MC, the addition to Total Profit is increasing

and production should be increased As soon as MR < MC, the addition to Total Profit is decreased and production should be decreased Therefore Profit is Maximized (Losses Minimized) where MR = MC

Graphing Demand & Marginal Revenue

Marginal revenue is the increase in total revenue when output sold goes up by one unit
Output 1 Price $5 Total Revenue $ 5 Marginal Revenue $5

2
3 4 5 6

5
5 5 5 5

10
15 20 25 30

5
5 5 5 5

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

21-3

Graphing Demand & Marginal Revenue

Output

Price

Total Revenue

Marginal Revenue

1
2 3 4

$5
5 5 5

$ 5
10 15 20

$5
5 5 5

6 5 4 3 2 1 0 0 1 2 3 4 Output 5 6 D,MR

5
6

5
5

25
30

5
5

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

21-4

Profit Maximization and Loss Minimization

Output 1 1 1 2 1 3 1 4 1 5 1 6 7 Price $200 200 200 200 200 200 200 TR $200 400 600 800 1000 1200 1400 MR $200 200 200 200 200 200 200 TC $500 550 610 700 830 1000 1205 ATC $500 275 203 175 166 167 172 MC Total Profits $100 - $300 50 - 150 60 10 90 100 130 170 170 200 205 195

Profit Maximization Point: MC = MR

This occurs somewhere between 6 and 7 units.

We are assuming output can be produced in tenths of a unit
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

21-6

Profit Maximization and Loss Minimization

Output MR MC 1 $200 $100 2 200 50 3 200 60 4 200 90 5 200 130 6 200 170 7 200 205
Profit Maximization Point: MC = MR

500

400

300

200

D,MR

MC ATC

100

Most efficient Production Point: MC = ATC

4 Output

The most profitable output is where the MC curve crosses the D, MR curve. This occurs at an output of 6.7 units
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

21-7

Market Types

Perfect Competition -- many firms sell an identical product to many buyers -- no restrictions on entry to or exit from the market -- established firms have no advantage over new firms -- sellers and buyers are well informed about prices

Example: commodities, especially farming

Perfect Competition

The firm has no control over its price set by forces of market demand and supply The firm can sell all of its production at the going price The primary decision the firm must make is how much to produce It makes no sense to produce a single unit where what you receive (revenue/price) is less than the units cost (ATC/MC) So, problem is to determine the profit maximizing level of output (TR-TC = Max Profit)

Short Run Production Decisions

How much the firm chooses to produce is becomes a question of production cost vs revenue The firm will logically choose to produce at a level that maximizes profit Two methods of computing that level of production 1. The point where Total Revenue Total Cost = Max Profit, or where TR-TC = Max P 2. The point where Marginal Cost = Marginal Revenue, or where MC=MR

The Perfect Competitors Demand Curve

Firm 9 8 7 6 5 4 3 2 1 D,MR 6 5 4 3 2 1 D Industry S

10

15

20 25 Output

30

3 4 5 6 Output (in millions)

The intersection of the industry supply and demand curve set the price that is taken by the individual firm, in this case $6
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

22-6

The Perfect Competitor in the Short Run

20 MC 18 16 14 12 10 8 6 4 2 0 0 2 4 6 8 10 12 Output 14 16 18 20 D,MR ATC

In the short run the perfect competitor may make a profit or lose money 22-10 Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

The Perfect Competitor in the Short Run

20 MC 18 16 14 12 10 8 6 4 2 0 0 2 4 6 8 10 12 Output 14 16 18 20 ATC D,MR

Is this firm making a profit or losing money? Answer: Making a profit because the D,MR curve is above the ATC curve
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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Exit & Temporary Shutdown Decisions

When Total Costs exceed Total Revenue, what does the firm do? In the long run, the firm may choose to exit the market if it feels the imbalance is permanent In the short run, the firm must analyze its revenue & costs -- If Revenue exceeds Variable Cost, then some revenue is contributing toward covering part of fixed cost and the firm should continue to operate -- If Revenue is less than Variable Cost, then the firm is incurring all its fixed costs plus some of the Variable Cost and the firm should consider a temporary shutdown

Long Run- Output, Price & Profit

In the long run the firm in perfect competition earns zero economic profit. Means firm earns the normal profit only Economic Profit brings in other firms which increases competition Industry Supply Curve shifts to the right = more product and lower prices Economic Loss induces higher cost firms to exit the industry Industry Supply Curve shifts to the left = less product and higher prices for firms that are left

Long Run Permanent Change in Demand

A permanent increase in demand creates short term economic profits, but encourage new firms to enter the market
A permanent decrease in demand triggers a similar response except in the opposite direction incurring economic losses encourages firms to exit the industry

Going from Taking a Loss in the Short Run to Breaking Even in the Long Run
Firm 20 MC 18 16 14 12 10 8 6 4 2 0 0 2 4 6 8 10 12 Output 14 16 18 20 D2,MR2 D1,MR1 ATC 18 16 14 12 10 8 6 4 2 0 0 1 2 3 Output (in millions) D S2 S1 20 Market

This pushes the industry price up to $8. At this price the firm breaks even.
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

22-18

Going from Making a Profit in the Short Run to Breaking Even in the Long Run
Firm 20 MC 18 16 14 12 10 8 6 4 2 0 0 2 4 6 8 10 Output 12 14 16 18 20 ATC D1,MR1 D2,MR2 18 16 14 12 10 8 6 4 2 0 0 1 2 Output (in millions) 3 D 20 S1 S2 Market

New firms are attracted into the industry. This increases supply moving the supply curve from S1 to S2
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

22-20

The Perfect Competitor in the Long Run

24 MC 23 22 21 20 ATC

Price = ATC

19 D,MR 18 17

The most profitable level of output is 11.1

16 15

10 Output

15

20

In the long run the firm breaks even

The ATC curve is tangent to the demand curve at the point where MC = MR. ATC will equal price at the break-even point (the minimum point on the ATC curve) 22-22
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

External Economies & Diseconomies

External Economies Factors beyond a firms control that will lower its costs as the market output increases -- improvement in farm inputs (seed, fertilizer) -- technological change External Diseconomies Factors beyond a firms control that will increase its costs as market output increases -- Congestion (Airline Industry)

Market Types

Monopoly -- one firm sells a good or service with no close substitutes -- a barrier blocks the entry of new firms

Example: Utility companies/DeBeers in diamonds

Market Types

Monopolistic Competition -- Large number of firms making similar but slightly different products -- Each producer is a sole producer of a particular version of the product (Branding) -- Although each firm has a monopoly on its brand, they still compete with one another

Example: Nike/Reebok

Market Types

Oligopoly -- Small number of firms compete and dominate the industry -- Products might be very similar, or they may have brand differentiation

Example: Kodak/Fuji or Coke/Pepsi