microeconomics lecture ----profit maximization and competitive supply

Chapter 8

Profit Maximization and

Competitive Supply

©2005 Pearson Education, Inc. Chapter 8 2

Topics to be Discussed

Perfectly Competitive Markets

Profit Maximization

Marginal Revenue, Marginal Cost, and

Profit Maximization

Choosing Output in the Short-Run


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


Perfectly Competitive Markets

Basic assumptions of Perfectly

Competitive Markets

1. Price taking

2. Product homogeneity

3. Free entry and exit


When are Markets Competitive

Very rarely markets are perfectlycompetitive, but many markets are (relatively) highly competitive.

They face relatively low entry and exit costs

Highly elastic demand curves

We do not always need many firms to have a highly competitive market an example …


Profit Maximization

Do firms maximize profits?

Managers in firms may be concerned with

other objectives, such as revenue

maximization, revenue growth, or others.

But, without profits, survival is unlikely in

competitive industries.

Thus, profit maximization assumption is

reasonable.


Marginal Revenue, Marginal

Cost, and Profit Maximization

We can study profit maximizing output for

any firm whether perfectly competitive or

not

Profit () = Total Revenue - Total Cost

If q is output of the firm, then total revenue is

price of the good times quantity

Total Revenue (R) = P.q




Costs of production depends on output

Total Cost (C) = C.q

Profit for the firm, , is the difference

between revenue and costs

)()()( qCqRq




Firm selects output to maximize the

difference between revenue and cost

We can graph the total revenue and total

cost curves to show maximizing profits

for the firm

Distance between revenues and costs

show profits




Slope of the revenue curve is the marginal revenue

Change in revenue resulting from a one-unit increase in output

Slope of the total cost curve is marginal cost

Additional cost of producing an additional unit of output

R q

q

C q

q


Profit Maximization – Short Run

0

Cost,

Revenue,

Profit

($s per

year)

Output

C(q)

R(q)A

B

(q)q0 q*

Profits are maximized where MR (slope

at A) and MC (slope at B) are equal

Profits are

maximized

where R(q) –

C(q) is

maximized

0

q

q




Profit is maximized at the point at which

an additional increment to output leaves

profit unchanged

0

0

R C

R C

q q q

MR MC

MR MC

2

2

*

max ( ) ( ) ( )

f.o.c. for max 0

check for the s.o.c. 0

solve for q

q

MR MC

q R q C q

q R q C q

q q q

q

q




The Competitive Firm

Price taker – market price and output

determined from total market demand and

supply

Market output (Q) and firm output (q)

Market demand (D) and firm demand (d)



Demand curve faced by an individual firm

is a horizontal line

Firm’s sales have no effect on market price

Demand curve faced by whole market is

downward sloping

Shows amount of good all consumers will

purchase at different prices



d$4

Output

(bushels)

Price

$ per

bushel

100 200

Firm Industry

D

$4

S

Price

$ per

bushel

Output

(millions

of bushels)

100



The competitive firm’s demand

Individual producer sells all units for $4

regardless of that producer’s level of output.

R=P.q P does not depend on q MR = P

and AR=P.q / q with the horizontal demand

curve

For a perfectly competitive firm, profit

maximizing output occurs when

ARPMRqMC )(


Choosing Output: Short Run

The point where MR = MC, the profit

maximizing output is chosen

MR=MC at quantity, q*, of 8

At a quantity less than 8, MR>MC so more

profit can be gained by increasing output

At a quantity greater than 8, MC>MR,

increasing output will decrease profits


q2

A Competitive Firm

10

20

30

40

Price

50

MC

AVC

ATC

0 1 2 3 4 5 6 7 8 9 10 11Outputq*

AR=MR=PA

q1 : MR > MC

q2: MC > MR

q0: MC = MR

q1

Lost Profit

for q2>q*Lost Profit

for q2>q*


A Competitive Firm – Positive

Profits

10

20

30

40

Price

50

0 1 2 3 4 5 6 7 8 9 10 11Outputq2

MC

AVC

ATC

q*

AR=MR=PA

q1

D

C BProfits are

determined

by output per

unit times

quantity

Profit per

unit = P-

AC(q) = A

to B

Total

Profit =

ABCD


A Competitive Firm – Losses

Price

Output

MC

AVC

ATC

P = MRD

At q*: MR =

MC and P <

ATC

Losses =

(P- AC) x q*

or ABCD

q*

A

BC


Short Run Production

Why would firm produce at a loss?

Might think price will increase in near future

Shutting down and starting up could be

costly

Firm has two choices in short run

Continue producing

Shut down temporarily

Will compare profitability of both choices


Short Run Production

When should the firm shut down?

If AVC < P < ATC the firm should continue

producing in the short run

Can cover some of its variable costs and all of

its fixed costs

If AVC > P < ATC the firm should shut-down.

Can not cover even its fixed costs


A Competitive Firm – Losses

Price

Output

P < ATC but

AVC so

firm will

continue to

produce in

short run

MC

AVC

ATC

P1= MR1D

q*

A

BC

Losses

EF P2= MR2

HG P3= MR3

Shut Down Point


Competitive Firm – Short Run

Supply

Supply curve tells how much output will

be produced at different prices

Competitive firms determine quantity to

produce where P = MC

Firm shuts down when P < AVC

Competitive firms supply curve is portion

of the marginal cost curve above the

AVC curve


A Competitive Firm’s

Short-Run Supply CurvePrice

($ per

unit)

Output

MC

AVC

ATC

P = AVC

P2

q2

The firm chooses the

output level where P = MR = MC,

as long as P > AVC.

P1

q1

S

Supply is MC

above AVC


Short-Run Market Supply Curve

Shows the amount of product the whole

market will produce at given prices

Is the sum of all the individual producers

in the market

We can show graphically how we can

sum the supply curves of individual

producers


Industry Supply in the Short

Run

$ per

unit

SThe short-run

industry supply curve

is the horizontal

summation of the supply

curves of the firms.

Q15 21

P1

P3

P2

1082 4 75


Elasticity of Market Supply


Measures the sensitivity of industry output to

market price

The percentage change in quantity supplied,

Q, in response to 1-percent change in price

)//()/( PPQQEs



When MC increase rapidly in response to increases in output, elasticity is low

When MC increase slowly, supply is relatively elastic

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.


Choosing Output in the Long

Run

In short run, one or more inputs are fixed

Depending on the time, it may limit the

flexibility of the firm

In the long run, a firm can alter all its

inputs, including the size of the plant.

We assume free entry and free exit.

No legal restrictions or extra costs


Choosing Output in the Long

Run

In the short run a firm faces a horizontal demand curveTake market price as given

The short-run average cost curve (SAC) and short run marginal cost curve (SMC) are low enough for firm to make positive profits (ABCD)

The long run average cost curve (LRAC)Economies of scale to q2

Diseconomies of scale after q2


q1

BC

AD

In the short run, the

firm is faced with fixed

inputs. P = $40 > ATC.

Profit is equal to ABCD.

Output Choice in the Long RunPrice

Output

P = MR$40

SAC

SMC

q3q2

$30

LAC

LMC


Output Choice in the Long Run

Price

Outputq1

BC

ADP = MR$40

SAC

SMC

q3q2

$30

LAC

LMC

In the long run, the plant size will be

increased and output increased to q3.

Long-run profit, EFGD > short run

profit ABCD.

FG

E


Long-run Competitive

Equilibrium

Entry and Exit

Profits will attract other producers.

More producers increase industry supply

which lowers the market price.

This continues until there are no more profits

to be gained in the market – zero economic

profits


Long-Run Competitive

Equilibrium – Profits

S1

Output Output

$ per

unit of

output

$ per

unit of

output

LAC

LMC

D

S2

$40 P1

Q1

Firm Industry

Q2

P2

q2

$30

•Profit attracts firms

•Supply increases until profit = 0



Equilibrium – Losses

S2

Output Output

$ per

unit of

output

$ per

unit of

output

LAC

LMC

D

S1

P2

Q2

Firm Industry

Q1

P1

q2

$20

$30

•Losses cause firms to leave

•Supply decreases until profit = 0

©2005 Pearson Education, Inc.

Long-run Competitive

Equilibrium

$/unit

Quantity

$/unit

Quantity

D1S1

Q

C

AC

MC

PCPC

(b) The Industry(a) The Firm With market demand D1

and market supply S1

equilibrium price is PC

and quantity is QC

With market price PC

the firm maximizes

profit by setting

MR (= PC) = MC and

producing quantity qc

qc

D2

Now assume that

demand

increases to

D2

Q1

P1P1

With market demand D2

and market supply S1

equilibrium price is P1

and quantity is Q1

q

1

Existing firms maximize

profits by increasing

output to q1

Excess profits induce

new firms to enter

the market

• The supply curve moves to the

right• Price falls

• Entry continues while profits

exist• Long-run equilibrium is restored

at price PC and supply curve S2

S2

Q´C



Equilibrium

1. All firms in industry are maximizing

profits

MR = MC

2. No firm has incentive to enter or exit

industry

Earning zero economic profits

3. Market is in equilibrium

Quantity supplied = Quantity demanded


The Industry’s Long-Run Supply

Curve

Assume

All firms have access to the available

production technology

Output is increased by using more inputs,

not by invention

The market for inputs does not change with

expansions and contractions of the industry.


The Industry’s Long-Run Supply

Curve

To analyze long-run industry supply, will

need to distinguish between three

different types of industries

1. Constant-Cost

2. Increasing-Cost

3. Decreasing-Cost


Constant-Cost Industry

ACMC

q1

D1

S1

Q1

P1

D2

P2P2

q2

S2

Q2Output Output

$$

P1SL

Q1 increases to Q2.

Long-run supply = SL = LRAC.

Change in output has no impact on

input cost.

Increase in demand increases

market price and firm output

Positive profits cause market

supply to increase and price to fall


Long-Run Supply in a

Constant-Cost Industry

Price of inputs does not change

additional inputs necessary to produce

higher outputs can be purchased without

an increase in per unit price.

Firms cost curves do not change

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.


Increasing-Cost Industry

Prices of some or all inputs rises as production is expanded when demand of inputs increases.

When demand increases causing prices to increase and production to increase

Firms enter the market increasing demand for inputs

Costs increase causing an upward shift in supply curves

Market supply increases but not as much


Long-run Supply in an


Output Output

$$

D1

S1

q1

P1

Q1

P1

SL

SMC1

LAC1

SMC2

LAC2

P3

S2

P3

Q3q2

P2

D2

Q2

P2

Due to the increase in input prices, long-

run equilibrium occurs at a higher price.Long Run Supply is

upward Sloping


Long-Run Supply in a


In a increasing-cost industry, long-run

supply curve is upward sloping.

More output is produced, but only at the

higher price needed to compete for the

increased input costs


Decreasing-Cost Industry

Industry whose long-run supply curve is

downward sloping

Increase in demand causes production to

increase

Increase in size allows firm to take

advantage of size to get inputs cheaper

Increased production may lead to better

efficiencies or quantity discounts

Costs shift down and market price falls


Long-run Supply in a

Decreasing-Cost Industry

S2

SL

P3

Q3

P3

SMC2

LAC2

Output Output

$$

P1

D1

S1

P1

Q1q1

SMC1

LAC1

q2

P2

D2

Q2

P2

Due to the decrease

in input prices, long-run

equilibrium occurs at

a lower price.

Long Run Supply is Downward

Sloping

microeconomics lecture ----profit maximization and competitive supply

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