Microeconomics: Lecture 10

Profit Maximization and Competitive Supply

Roadmap
Perfectly Competitive Markets Profit Maximization Choosing Output in the Short Run The Competitive Firms Short-Run Supply
Curve

Short-Run Market Supply Entry-Exit Long-Run Equilibrium

What does Competitive Mean?

Competitive Swimming Team: A good

one

Competitive Race: A race in which

runners are evenly matched

Competitive Students: Students who

are trying to be better than others

Competitive Market?

I. Perfectly Competitive Markets

The model of perfect competition can be used

to study a variety of markets

Basic assumptions of Perfectly Competitive

Markets
1. Price taking (suppliers, consumers) 2. Product homogeneity (all products are the same) 3. Free entry and exit

When are Markets Competitive?

Few real products are perfectly competitive Many markets are, however, highly competitive They face relatively low entry and exit costs Highly elastic demand curves
No rule of thumb to determine whether a market is close to perfectly competitive, estimates of elasticity of demand are informative, however, and the number of firms in the market.

Profit Maximization

Do firms maximize profits? Managers in firms may be concerned with other objectives

Revenue maximization Revenue growth Dividend maximization Short-run profit maximization (due to bonus
or share options) could be at expense of long run profits

Profit Maximization

Implications of non-profit objective Over the long run, investors would

not support the company

Without profits, survival is unlikely

in competitive industries

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 Note: If the firm is not a price taker, then
(R)=P(q)*q

Marginal Revenue, Marginal Cost, and Profit Maximization

Costs of production depends on output

Total Cost (C) = C(q)

Profit for the firm, , is difference between revenue and costs

Marginal Revenue, Marginal Cost, and Profit Maximization

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

Profit Maximization Short Run

Cost, Revenue, Profit ($s per year)

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

Output

Marginal Revenue, Marginal Cost, and Profit Maximization

Revenue is a curve, showing that a firm can only sell more if it lowers its price
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 the marginal cost

Additional cost of producing an additional unit of

output

Marginal Revenue, Marginal Cost, and Profit Maximization

Profit is maximized at the point at which an

additional increment to output leaves profit unchanged

The Competitive Firm

Demand curve faced by an individual firm is a horizontal line

Firms sales have no effect on market price

Demand curve faced by whole market is downward sloping

Shows amount of goods all consumers will

purchase at different prices

The Competitive Firm

Price $ per bushel

Firm

Price $ per bushel

Industry

100

200

Output (bushels)

100

Output (millions of bushels)

The Competitive Firm

The competitive firms demand

Individual producer sells all units for $4 regardless

of that producers level of output

MR = P with the horizontal demand curve For a perfectly competitive firm, profit maximizing
output occurs when

A Competitive Firm
Price 50

40 30
20 10 0 1 2 3 4 5 6 7 8 9 10 11

Output

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

A Competitive Firm Positive Profits

Price 50
Total Profit = ABCD

MC

40

A
ATC

AR=MR=P
B AVC Profits are determined by output per unit times quantity

Profit per unit = PAC(q) = A to B

30 C
20 10 0 1 2 3 4 5 6 7 8

q1

q*

10

11

q2

Output

The Competitive Firm

A firm does not have to make profits It is possible a firm will incur losses if
the P < AC for the profit maximizing quantity

Still measured by profit per unit times

quantity

Profit per unit is negative (P AC < 0)

A Competitive Firm Losses

Price C D
At MR = MC and P < ATC Losses = (P- AC) x q* or ABCD q *:

MC
B

ATC

P = MR AVC

q*

Output

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 P < ATC the firm is making losses

Short-Run Production

Why would a 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

(1) Continue producing (2) 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 all of its variable costs and some

of its fixed costs

If AVC > P < ATC, the firm should shut down Cannot cover its variable costs or any of its
fixed costs

A Competitive Firm Losses

Price
Losses

MC
B

ATC

C D
P < ATC but AVC so firm will continue to produce in short run

P = MR AVC

q*

Output

Competitive Firm ShortRun 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 Firms Short-Run Supply Curve

Price ($ per unit) The firm chooses the output level where P = MR = MC, as long as P > AVC

Supply is MC above AVC

MC
P2 P1

S ATC AVC

P = AVC

q1

q2 Output

A Competitive Firms Short-Run Supply Curve

Supply is upward sloping due to

diminishing returns

Higher price compensates the firm for

the higher cost of additional output and increases total profit because it applies to all units

A Competitive Firms Short-Run Supply Curve

Over time, prices of product and inputs

can change

How does the firms output change in

response to a change in the price of an input?

We can show an increase in marginal

costs and the change in the firms output decisions

The Response of a Firm to a Change in Input Price

Price ($ per unit)

MC2
Savings to the firm from reducing output

Input cost increases and MC shifts to MC2 and q falls to q2.

MC1 $5

q2

q1

Output

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
The short-run industry supply curve is the horizontal summation of the supply curves of the firms.

P3

P2 P1

Q
2 4
5

7 8

10

15

21

Elasticity of Market Supply

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

E s ( Q / Q ) /( P / P )

Elasticity of Market Supply

When MC increases rapidly in response to increases in output, elasticity is low When MC increases slowly, supply is relatively elastic Perfectly inelastic short-run supply arises when the industrys 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

Producer Surplus in the Short Run

Price is greater than MC on all but the last unit of output
Therefore, surplus is earned on all but the last unit 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 Area above supply curve to the market price

Producer Surplus for a Firm

Price ($ per unit of output) Producer Surplus

MC B

AVC

P
At q* MC = MR. Between 0 and q, MR > MC for all units.

Producer surplus is area above MC to the price

q*

Output

Producer Surplus for a Market

Price ($ per unit of output)

P*

Market producer surplus is the difference between P* and S from 0 to Q*.

Producer Surplus

D
Output

Q*

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

This continues until there are no more profits to

be gained in the market zero economic profits

Long-Run Competitive Equilibrium Profits

Profit attracts firms Supply increases until profit = 0

$ per unit of output

Firm

$ per unit of output LMC

Industry S1

$40

LAC

P1

S2

$30

P2

D q2
Output

Q1

Q2

Output

Long-Run Competitive Equilibrium

1. All firms in industry are maximizing profits

MR = MC
2. Market is in equilibrium

QD = QS
3. No firm has incentive to enter or exit industry

zero economic profits: P=AC=MC

Summary

Perfect competition Profit maximizing firms Supply curve Elasticity of supply Producer surplus

Required Reading

Pindyck and Rubinfeld,

Microeconomics, 8th edition, Chapter 8, pp. 279-304