Micro Ch 21

Presentation 2

Profit Maximization in the SR

• Because the purely competitive firm is a price taker, it can maximize its economic profit/minimize loss only by adjusting its output.

• With a fixed plant, the firm can only adjust its output through changes in the amount of variable resources it uses (materials, labor)

Methods to Determine Output

• 1. compare total revenue and total cost• 2. compare marginal revenue and marginal

cost• *both methods apply to all firms whether

pure competition, pure monopolies, monopolistic competition or oligopolies

1. Total Revenue-Total Cost Approach

• The firm must ask three questions:• 1. Should we produce the product?• 2. If so, how much?• 3. What economic profit (or loss) will we

realize?

Total Revenue Total Cost Approach

(1)Total Product(Output) (Q)

(2)Total FixedCost (TFC)

(3)Total Variable

Cost (TVC)

(4)Total Cost

(TC)

(5)Total Revenue

(TR)

(6)Profit (+)or Loss (-)

Price = $131

0123456789

10

$100100100100100100100100100100100

$090

170240300370450540650780930

$100190270340400470550640750880

1030

$0131262393524655786917

104811791310

$-100-59

-8+53

+124+185+236+277+298+299+280

Now Let’s Graph The Results…Do You See Profit Maximization?

Break Even Point

• Point(s) where total revenue and total cost are equal

• Total revenue covers all costs including a normal profit but not an economic profit

• **the firm achieves maximum profit where the vertical distance between the TR and TC curves is greatest

Total Revenue-Total Cost Approach

Profit Maximization in the Short Run

10 2 3 4 5 6 7 8 9 10 11 12 13 14

10 2 3 4 5 6 7 8 9 10 11 12 13 14

$180017001600150014001300120011001000

900800700600500400300200100

$500400300200100

Tota

l Rev

enue

and

Tot

al C

ost

Tota

l Eco

nom

icPr

ofit

Quantity Demanded (Sold)

Quantity Demanded (Sold)

Total Revenue, (TR)

Break-Even Point(Normal Profit)

Break-Even Point(Normal Profit)

MaximumEconomic

Profit$299

Total EconomicProfit

$299

P=$131

Total Cost,(TC)

W 21.1

G 21.1

2. Marginal Revenue-Marginal Cost Approach

• Compare the amounts that each additional unit of output would add to TR and TC

• The firm should produce any unit of output whose MR > or = MC

MR = MC Considerations

• Most often, MR = MC at a fractional amount of output---- the firm should complete the last complete unit of output where MR > MC

• Can be restated Price = MC for perfectly competitive market

• ****Rule applies only if MR is = or > AVC

Calculating Economic Profit

• Profit = (price – ATC) x Q• Per Unit Profit = price - ATC

Cost

and

Rev

enue

$200

150

100

50

01 2 3 4 5 6 7 8 9 10

Output

Economic Profit

Profit Maximization in the Short Run

MR = P

MCMR = MC

AVC

ATC

P=$131

A=$97.78

W 21.2

Loss Minimizing Case

The firm should produce at a loss @ MR = MC where price is greater than AVC but less than ATC

The loss must be less than the TFC

Lower the Price to $81 andObserve the Results!

Co

st a

nd

Rev

enu

e$200

150

100

50

01 2 3 4 5 6 7 8 9 10

Output

Loss

Marginal Revenue-Marginal Cost ApproachMR = MC Rule

Profit Maximization in the Short Run

MR = P

MC

AVCATC

Loss Minimizing Case

P=$81

V = $75

Shut Down Case

• A firm will Shut down at a price where Price is less than AVC

Lower the Price Further to $71 and Observe the Results!

Cost

and

Rev

enue

$200

150

100

50

01 2 3 4 5 6 7 8 9 10

Output

Marginal Revenue-Marginal Cost ApproachMR = MC Rule

Profit Maximization in the Short Run

MR = P

MC

AVC

ATC

Short-Run Shut Down Case

P=$71 Short-Run Shut Down Point

P < Minimum AVC$71 < $74

V = $74

Marginal Cost and Short-Run Supply

Generalizing the MR=MC Relationship and its Use

P1

0

Co

st a

nd

Rev

enu

es (

Do

llars

)

Quantity Supplied

MR1

P2 MR2

P3 MR3

P4 MR4

P5 MR5

MC

AVC

ATC

Q2 Q3 Q4 Q5

This Price is Below AVCAnd Will Not Be Produced

ab

c

d

e

MC Above AVC Becomesthe Short-Run Supply Curve S

Examine the MC for the Competitive Firm

Break-even(Normal Profit) Point

Shut-Down Point (If P is Below)

Single Firm MarketP

rice

Pri

ce

Quantity Quantity

0 0

Long-Run EquilibriumCompetitive Firm and Market

P MR

D

S

QeQf

ATC

Productive Efficiency: Price = Minimum ATCAllocative Efficiency: Price = MCPure Competition Has Both in

Its Long-Run Equilibrium

MCP=MC=MinimumATC (Normal Profit)

P