©2005 pearson education, inc. chapter 81 0 5 10 15 20 25 101520253035404550 distribution of grades...

Chapter 8 1©2005 Pearson Education, Inc.

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Distribution of GradesMidterm #2

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Chapter 8

Profit Maximization and Competitive Supply


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

2. Product homogeneity

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 Depends on how they behave in situations


Profit Maximization

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

other objectivesRevenue maximizationRevenue growthDividend maximizationShort-run profit maximization (due to bonus or

promotion incentive) 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

Managers have constrained freedom to pursue goals other than long-run profit maximization


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) = Pq



Costs of production depends on output Total Cost (C) = C(q)

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

)()()( qCqRq


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



Profit is maximized at the point at which an additional increment to output leaves profit unchanged

MCMR

MCMR

q

C

q

R

q

CR

0

0



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)


The Competitive Firm

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 goods 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 MR = P with the horizontal demand curve For a perfectly competitive firm, profit

maximizing output occurs when

ARPMRqMC )(


Choosing Output: Short Run

In the short run, capital is fixed and firm must choose levels of variable inputs to maximize profits

We can look at the graph of MR, MC, ATC and AVC to determine profits

The point where MR = MC, the profit maximizing output is chosen


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 > MCq2: MC > MRq*: MC = MR

q1

Lost Profit for q2>q*Lost Profit

for q1 < 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 B Profits are determined

by output per unit times quantity

Profit per unit = P-AC(q) = A to B

Total Profit = ABCD



A firm does not have to make profitsIt 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

Output

MC

AVC

ATC

P = MRD

At q*: MR = MC and P < ATCLosses = (P- AC) x q* or ABCD

q*

A

BC


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 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 runCan 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

Output

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

MC

AVC

ATC

P = MRD

q*

A

BC

Losses

EF


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’sShort-Run Supply Curve

Price($ per

unit)

Output

MC

AVC

ATC

P = AVC

P2

q2

The firm chooses theoutput level where P = MR = MC,

as long as P > AVC.

P1

q1

S

Supply is MC above AVC


MC2

q2

Input cost increases and MC shifts to MC2

and q falls to q2.

MC1

q1

The Response of a Firm toa Change in Input Price

Price($ per

unit)

Output

$5

Savings to the firmfrom reducing 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


MC3

Industry Supply in the Short Run$ perunit

MC1

SSThe short-runindustry supply curve

is the horizontalsummation of the supply

curves of the firms.

Q

MC2

15 21

P1

P3

P2

1082 4 75


Long-Run Competitive Equilibrium

For long run equilibrium, firms must have no desire to enter or leave the industry

Relate economic profit to the incentive to enter and exit the market

Relate accounting profit to economic profit



Accounting profit Difference between firm’s revenues and

direct costs

Economic profit Difference between firm’s revenues and

direct and indirect costs Takes into account opportunity costs



Firm uses labor (L) and capital (K) with purchased capital

Accounting Profit and Economic Profit Accounting profit: = R - wL Economic profit: = R = wL - rK

wl = labor costrk = opportunity cost of capital



Zero-Profit A firm is earning a normal return on its

investment Doing as well as it could by investing its

money elsewhere Normal return is firm’s opportunity cost of

using money to buy capital instead of investing elsewhere

Competitive market long run equilibrium



Zero Economic Profits If R > wL + rk, economic profits are positive If R = wL + rk, zero economic profits, but the

firm is earning a normal rate of return, indicating the industry is competitive

If R < wl + rk, consider going out of business



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

S1

Output Output

$ per unit ofoutput

$ per unit ofoutput

LAC

LMC

D

S2

$40 P1

Q1

Firm Industry

Q2

P2

q2

$30

•Profit attracts firms•Supply increases until profit = 0


Long-Run Competitive Equilibrium – Losses

S2

Output Output

$ per unit ofoutput

$ per unit ofoutput

LAC

LMC

D

S1

P2

Q2

Firm Industry

Q1

P1

q2

$20

$30

•Losses cause firms to leave•Supply decreases until profit = 0



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 QD = QS


Choosing Output in the Long Run

Economic Rent The difference between what firms are willing

to pay for an input less the minimum amount necessary to obtain it

When some have accounting profits that are larger than others, they still earn zero economic profits because of the willingness of other firms to use the factors of production that are in limited supply


Choosing Output in the Long Run

An Example Two firms A & B that both own their land A is located on a river which lowers A’s

shipping cost by $10,000 compared to B The demand for A’s river location will

increase the price of A’s land to $10,000 = economic rent

Although economic rent has increased, economic profit has become zero


Firms Earn Zero Profit inLong-Run EquilibriumTicketPrice

Season TicketsSales (millions)

$7$7

1.01.0

A baseball teamin a moderate-sized city

sells enough tickets so that price is equal to marginal

and average cost(profit = 0).

LACLMC


1.31.3

$10$10

Economic Rent

TicketPrice

$7.20$7.20A team with the samecost in a larger citysells tickets for $10.

Firms Earn Zero Profit inLong-Run Equilibrium

Season TicketsSales (millions)

LACLMC



With a fixed input such as a unique location, the difference between the cost of production (LAC = 7) and price ($10) is the value or opportunity cost of the input (location) and represents the economic rent from the input



If the opportunity cost of the input (rent) is not taken into consideration, it may appear that economic profits exist in the long run (positive accounting profits)

©2005 pearson education, inc. chapter 81 0 5 10 15 20 25 101520253035404550 distribution of grades...

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