Topic 6 Profit Maximization and Equilibrium in

Perfectly Competitive Markets

Outline:
I) Motivation
II) Short Run Profit Maximization
III) Short Run Competitive Equilibrium
IV) Lon Run Profit Maximization
V) Lon Run Competitive Equilibrium
I) Motivation ! Intro"u#tion
$%o &oal':
() )erive rule' for maximizin profit'
*) +n"er'tan" ho% #ompetitive mar,et' operate
$he me#hani#' of profit maximization "epen" on the
'tru#ture of the mar,et in %hi#h the firm operate'
-e../ #ompetitive/ monopoli'ti#/ et#.).
0ere %e 'tu"1 the 'imple't of mar,et' 2 perfe#tl1
#ompetitive mar,et'.
Criteria for a Mar,et to be Perfe#tl1 Competitive
() 3irm' 'ell a homoenou' pro"u#t 2 #on'umer' "o
not per#eive an1 "ifferen#e bet%een the pro"u#t'
'ol" b1 rival firm'.
*) 3irm' are pri#e ta,er' 2 no firm i' lare enouh to
influen#e the mar,et pri#e throuh it' output
"e#i'ion' firm' ta,e pri#e a' iven in their
"e#i'ion ma,in.
4) 3ree entr1 an" exit 2 there are no barrier' to
enterin or exitin the in"u'tr1 -e.. reulator1
barrier' or patent').
5) 3irm' an" #on'umer' have perfe#t information 2
- firm' ,no% their #o't' an" %hat opportunitie'
exi't in other mar,et'.
- #on'umer' ,no% the pri#e #hare" b1 ever1
'eller.
Perfe#tl1 #ompetitive mar,et' are rarel1 en#ountere"
in pra#ti#e -althouh ari#ultural mar,et' are prett1
#lo'e).
0o%ever/ the1 'erve a' a rea'onable approximation
in man1 #a'e' an" provi"e a ben#hmar, aain't
%hi#h other mar,et 'tru#ture' #an be 6u"e".
Corre'pon"' to the 7fri#tionle'' %orl"8 'tu"ie" b1
ph1'i#i't'.
Con"ition' for profit maximization "iffer in the 'hort
run an" lon run/ 'o %e %ill loo, at ea#h in turn.
II) Short9Run Profit Maximization
- Sin#e firm' ta,e pri#e a' iven/ the onl1 "e#i'ion
the1 have to ma,e i' ho% mu#h output to pro"u#e
-if an1).
- Choo'e output 7:8 to maximize economic profit'
TFC Q TVC PQ
Q TC Q TR Q
) -
) - ) - ) -


;ote: TC(Q) alrea"1 in#orporate' the firm<' #o't9
minimizin input #hoi#e' for ea#h Q.
;ote: E#onomi# profit' in#lu"e all relevant
opportunit1 #o't' -in#lu"in the opportunit1 #o't of
the o%ner<' inve'tment)/ 'o an e#onomi# profit of
zero a#tuall1 #orre'pon"' to a 7normal8 rate of return
on one<' inve'tment.
- $%o #omponent' to firm<' "e#i'ion:
-Part () Shoul" the1 pro"u#e an1 output at all=
-Part *) If 'o/ ho% mu#h=
-Part () Shoul" the firm pro"u#e : > ? or 'hut "o%n
-pro"u#e : @ ?)=
$he firm 'houl" 'ta1 open if there exi't' a po'itive
output level : 'u#h that
) ? - ) - > Q Q

TFC TFC Q TVC Q TR > ) - ) -

) - ) - Q TVC Q TR >
Alternativel1/ %e #an re%rite thi' a':

:
) - ) - Q TVC
Q
Q TR
>

:
) -Q TVC
Q
PQ
>

? 'ome for AVC-:) P > > Q

-or)
AVC-:) min P >
Intuition:
3ixe" #o't' are irrelevant for the 'hut "o%n "e#i'ion
'in#e the1 mu't be pai" %hether the firm remain'
open or not.
0o%ever/ a' lon a' $R > $VC for 'ome : > ?
-alternativel1/ P > min AVC)/ the firm #an in#rea'e
profit' b1 pro"u#in : > ? -'in#e a""itional revenue
earne" on the'e unit' ex#ee"' the #o't of pro"u#in
them).
Conver'el1/ if $R B $VC for all : > ? -alternativel1/
P B min AVC)/ then the firm lo'e' mone1 on ea#h
unit it pro"u#e' 'o it i' better off not pro"u#in an1
output.
Ob'ervation: In the 'hort run/ it ma1 %ell be in the
firm<' intere't to remain open even if their profits are
negative.
$hi' i' be#au'e
? ) - ) - ) - < TFC Q TVC Q TR q
even if
? ) - ) - > Q TVC Q TR
-Part *) &iven that it i' in the firm<' intere't to
pro"u#e : > ?/ ho% mu#h output 'houl" the firm
pro"u#e in or"er to maximize profit'=
- Ea'ie't to 'ee raphi#all1C-'ee "iaram)
- Ob'erve that profit' are maximize" -the "ifferen#e
bet%een $R an" $C i' the reate't) at the point
%here
'lope of $R @ 'lope of $C

P @ MC
-in reion %here MC -'lope of $C) i' in#rea'inD)
- ;oti#e that the 'lope of the $R #urve miht al'o
equal the 'lope of the $C #urve in the reion %here
MC -'lope of $C) i' "e#rea'in.
- $hi' %oul" not be the profit9maximizin level of
output -in fa#t/ thi' i' the level of output %here
losses are maximize".)
Eoth #omponent' of the firm<' output "e#i'ion #an be
'ummarize" in the follo%in raph':
Ca'e () Profit > ? -'ee "iaram)
- 3ir't/ noti#e that there are man1 level' of : for
%hi#h P > AVC pro"u#e : > ?.
- Se#on"/ iven : > ? i' optimal/ #hoo'e output
level %here P @ MC -in reion %here MC i'
in#rea'in).
- Profit' at the optimal output level :
F
are iven b1
the area of the 'ha"e" re#tanle
)
F
- )
F
-
)
F
-
F

F
F
)
F
-

F
)
F
- ) -
Q TC Q TR
Q TC PQ
Q
Q
Q TC
P
Q Q ATC P Q

,
_

,
_

Ca'e *) Profit B ?G but remain open in 'hort run -'ee

"iaram)
- 0ere/ P > AVC for man1 value' of :/ 'o the firm
'houl" pro"u#e : > ?.
- Profit9maximizin : i' %here P @ MC -in reion
of in#rea'in MC).
- At :
F
/ P B A$C
?
F
)
F
- )
F
- <

,
_

Q Q ATC P Q
Ca'e 4) Profit' B ?G firm 'houl" 'hut "o%n -'ee
"iaram)
- 0ere there i' no : for %hi#h P > AVC
-i.e./ P B min AVC)/ 'o firm 'houl" 'hut "o%n.
;umeri#al Example:
H? I
*
*
(??

+
P
Q MC
Q TC
() Shoul" the firm 'ta1 open -pro"u#e : > ?)=
Q
Q
Q
AVC Q TVC
*

*
Clearl1/ P > AVC for 'ome : > ?/ 'o pro"u#e : > ?.
*) Jhat i' the profit9maximizin level of :=
Set P @ MC in reion %here MC i' in#rea'in.
MC @ *:/ 'o MC i' al%a1' in#rea'in.
4?
F
* H? Q Q MC P
4) Jhat are the firm<' e#onomi# profit'=
)
F
-
F

)
F
- )
F
- )
F
-
Q TC PQ
Q TC Q TR Q

K?? I
L?? (?? (K??
*
) 4? - (?? ) 4? - H? ) 4? -

Appli#ation: $%o Mi'#on#eption' about Short9Run
Profit Maximization
a) Man1 #ompanie' have a #ulture that en#ourae'
manaer' to maximize profit margins -'ee
"iaram).
b) A##ountin "epartment' often a"vi'e aain't
pro6e#t' if the1 #an<t 7pa1 their 'hare/8 i.e. earn
enouh revenue to #over 'ome portion of exi'tin
fixe" #o't'.
Example: Meat pa#,in #ompan1 m1 father %or,e"
for.
Current Pro"u#tion:
$R @ I4?/???/???
$VC @ I(?/???/???
$3C @ I(M/???/???
Propo'e" Pro6e#t -to be hou'e" in unu'e" ba'ement):
$R @ I*/???/???
$VC @ I(/???/???
Re6e#te" be#au'e it %a' a''ine" a (?N 'hare of the
exi'tin fixe" #o't' -I(/M??/???).
$he 3irm<' Short9Run Suppl1 Curve
$he t%o #on"ition' for profit maximization "efine the
firm<' 'hort9run 'uppl1 #urve -'ee "iaram)

'

<

AVC P if Q MC
AVC P if
Q
min ) -
min ?
%here MC "enote' the up%ar"9'lopin portion of the
marinal #o't #urve.
$hu'/ the firm<' 'hort9run 'uppl1 #urve i' the portion
of it' MC #urve above min AVC.
;ote: 3irm<' 'hort9run 'uppl1 #urve i' up%ar"
'lopin be#au'e it i' equal to the up%ar"9'lopin
portion of the MC #urve.
Short9Run In"u'tr1 Suppl1
Short-rn !n"str# Sppl# Crve 2 $he hori$ontal
'um of the 'hort9run 'uppl1 #urve' of all firm' in the
in"u'tr1.
Example: I"enti#al firm'
Suppo'e an in"u'tr1 ha' *?? i"enti#al firm'/ ea#h
%ith the 'hort9run 'uppl1 #urve
i
Q P (??? (?? +
:ue'tion: Jhat i' the 'hort9run in"u'tr1 'uppl1
#urve=
- Mu't 'um firm 'uppl1 #urve' hori$ontall#/ i.e.
mu't 'um quantitie' at ea#h pri#e.
Rearrane 'uppl1 #urve' 'o : i' on the left9han"
'i"e.

(?
(
(???

P
i
Q
Jith *?? firm'/ 'ummin the above 'uppl1 #urve i'
equivalent to multipl1in it b1 *??/ i.e.
*?
M

(?
(
(???
*??
*??

1
1
]
1

P
P
i
Q Q
3inall1/ rearrane 'o P i' on the left9han" 'i"e
Q P M (?? +
-III) Short9Run Competitive Equilibrium
A' 1ou ,no% from 1our earlier e#onomi#' #our'e'/
equilibrium in a iven mar,et o##ur' %here the
mar,et 'uppl1 #urve inter'e#t' the mar,et "eman"
#urve.
Re#all that the mar,et "eman" #urve i' 6u't the 'um
of the in"ivi"ual #on'umer "eman" #urve'.
Similarl1/ the mar,et 'uppl1 #urve i' the 'um of the
in"ivi"ual firm 'uppl1 #urve' -MC #urve above min
AVC).
Example: Cal#ulation of Short9Run Equilibrium
Con'i"er a mar,et #ompo'e" of (? i"enti#al firm'/
ea#h %ith the #o't #urve' iven belo%
Q MC
Q TC
*
*
(??

+
A''ume the mar,et "eman" #urve ta,e' the form
P
"
Q *? (??
:ue'tion: Jhat i' the equilibrium pri#e an" quantit1
in thi' mar,et=
Step () Cal#ulate ea#h firm<' 'hort9run 'uppl1 #urve.
Sin#e $VC @ :
*
/ AVC @ : an" min AVC @ ?.
$hu'/ ea#h firm<' 'hort run 'uppl1 #urve i' their MC
above ?: P @ *:.
Step *) Cal#ulate the mar,et 'uppl1 #urve.
$o et the mar,et 'uppl1 #urve/ %e nee" to 'um the
'uppl1 #urve' of the (? firm' in the in"u'tr1.
Sin#e %e are 'ummin quantitie' at ea#h pri#e/
re%rite the firm 'uppl1 #urve' %ith : on the left9
han" 'i"e: : @ O P
Jith (? i"enti#al firm'/ mar,et 'uppl1 i' iven b1:
:
S
@ (?: @ (? -O P) @ MP
Step 4) Cal#ulate the equilibrium pri#e an" quantit1
b1 'imultaneou'l1 'olvin the mar,et 'uppl1 an"
"eman" #urve' for : an" P.
$hi' 1iel"' P
F
@ 5 an" :
F
@ *?.
:ue'tion: Jhat quantit1 "oe' ea#h firm pro"u#e=
$here are (? i"enti#al firm'/ 'o ea#h pro"u#e : @ *.
:ue'tion: Jhat are profit' for a repre'entative firm=
LH
5 (?? K
*
) * - (?? ) * - 5
) - ) -



Q TC PQ Q
:ue'tion: Jhat %oul" profit' be if a repre'entative
firm 'hut "o%n=
(??
*
) ? - (?? ) ? - 5
) - ) -


Q TC PQ Q
better off to 'ta1 open an" pro"u#e : @ *.
Effi#ien#1 of 'hort9run #ompetitive equilibrium
Pareto %fficienc# 2 A #on"ition in %hi#h all po''ible
ain' from ex#hane are realize".
Re'ult: A 'hort9run #ompetitive equilibrium i' Pareto
effi#ient.
Rea'on:
- Suppl1 #urve mea'ure' marinal #o't to 'o#iet1 of
pro"u#in ea#h unit of output.
- )eman" #urve mea'ure' the marinal value
-marinal benefit) to 'o#iet1 of pro"u#in ea#h unit
of output -a' mea'ure" b1 the pri#e #on'umer' are
%illin to pa1).
- In a #ompetitive equilibrium/ all unit' of output for
%hi#h the marinal value ex#ee"' the marinal #o't
are pro"u#e" -'ee "iaram).
- $hu'/ re"u#in output b1 one unit %oul" #reate an
unrealize" ain for 'o#iet1 an" in#rea'in output
b1 one unit %oul" #reate a net lo'' for 'o#iet1.
IV) Lon9Run Profit Maximization
In the lon run/ firm' #an a"6u't fixe" input' -#apital)
to minimize the #o't' of pro"u#in the "e'ire" level
of output.
3irm' operate on their long-rn averae an"
marinal #o't #urve'
In the lon run/ all #o't' are variable.
A$C @ AVC @ LRAC -lon9run averae #o't)
Still t%o #omponent' to #hoo'in the profit9
maximizin level of output:
() Shoul" %e pro"u#e an1 output at all -i.e. remain in
the in"u'tr1)=
*) If %e remain in the in"u'tr1/ ho% mu#h output
'houl" %e pro"u#e=
() Shoul" %e remain in the in"u'tr1=
If there exi't' 'ome : > ? 'u#h that e#onomi# profit'
are reater than or equal to zero/ i.e. if
? ) - ) -
,
_

Q Q &RAC P Q
then the firm 'houl" remain in the in"u'tr1.
If not -if e#onomi# profit' are neative)/ it mean' that
at lea't one of the input' i' more hihl1 value" in
another in"u'tr1.
*) If %e remain in the in"u'tr1/ ho% mu#h output
'houl" %e pro"u#e=
$he rule i' the 'ame a' before:
Choo'e the level of output 'u#h that P @ LRMC -in
the reion %here LRMC i' in#rea'in)
-'ee "iaram)
V) Lon9Run Competitive Equilibrium
3a#t (: Entr1 an" exit b1 firm' uarantee' that in
lon9run #ompetitive equilibrium e#onomi# profit'
mu't be zero.
3a#t *: 3irm' operate on their lon9run #o't #urve'.
3a#t' ( an" * impl1 that in a lon9run #ompetitive
equilibrium/ firm' pro"u#e %here
P @ LRMC @ min LRAC
-'ee "iaram)
Rea'on: -'ee "iaram)
If P > min LRAC/ e#onomi# profit' %oul" be
po'itive an" firm' %oul" enter/ thereb1 "rivin "o%n
the pri#e.
If P B min LRAC/ e#onomi# profit' %oul" be
neative an" firm' %oul" exit/ thereb1 "rivin up the
pri#e.
Appli#ation 2 Reparation' for Slaver1
:: Jho 'houl" pa1= -Robert 3oel<' arument).
Example: Cal#ulation of Lon9Run Equilibrium
Con'i"er 5 i"enti#al firm'/ ea#h %ith the #o't #urve'
'ho%n belo%
( at o##ur' min
*
* 5
*
H K
4
*
*
5

Q &RAC
Q Q &RAC
Q Q &RMC
Q Q &RTC
;ote: Ob'erve that %e "on<t require an1 information
on the "eman" 'i"e of the mar,etD
:ue'tion: Jhat i' the lon9run equilibrium pri#e an"
quantit1 in thi' mar,et=
It help' to "ra% the pi#ture for a repre'entative firm
-'ee "iaram).
Sin#e there are 5 i"enti#al firm'/ ea#h pro"u#in (
unit of output/ the equilibrium quantit1 i' 5.
$o fin" the equilibrium pri#e/ u'e the fa#t that/ for
ea#h firm/ P @ LRMC @ LRAC at the profit9
maximizin output level : @ (.
$hu'/ 'ub'titute : @ ( into either LRMC or LRAC to
et P
F
@ *.
:ue'tion: Jhat are profit' for a repre'entative firm=
?
* 5 *
*
) ( - *
*
) ( - 5 ) ( - *
) - ) -

+
+
Q TC PQ Q
a' mu't be true in lon9run #ompetitive equilibrium.
Effi#ien#1 Propertie' of Lon9Run Competitive
Equilibrium
() Pareto Effi#ien#1 2 all ain' from tra"e are
realize" -'in#e ME @ P @ LRMC).
*) Pro"u#tive Effi#ien#1 2 output i' pro"u#e" at the
lo%e't po''ible unit #o't -'in#e ea#h firm pro"u#e'
at the min of LRAC).