Chapter 8

Chapter 8Profit Maximization

and Competitive Supply

Profit Maximization and Competitive

Supply

Chapter 8 Slide 2

Topics to be Discussed

Perfectly Competitive Markets

Profit Maximization

Marginal Revenue, Marginal Cost, and Profit Maximization

Choosing Output in the Short-Run

Chapter 8 Slide 3

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

Chapter 8 Slide 4


Characteristics of Perfectly Competitive Markets

1) Price taking

2) Product homogeneity

3) Free entry and exit

Chapter 8 Slide 5


Price Taking

The individual firm sells a very small share of the total market output and, therefore, cannot influence market price.

The individual consumer buys too small a share of industry output to have any impact on market price.

Chapter 8 Slide 6


Product Homogeneity

The products of all firms are perfect substitutes.

Examples

Agricultural products, oil, copper, iron, lumber

Chapter 8 Slide 7


Free Entry and Exit

Buyers can easily switch from one supplier to another.

Suppliers can easily enter or exit a market.

Chapter 8 Slide 8


Discussion Questions

What are some barriers to entry and exit?

Are all markets competitive?

When is a market highly competitive?

Chapter 8 Slide 9

Profit Maximization

Do firms maximize profits?

Possibility of other objectivesRevenue maximizationDividend maximizationShort-run profit maximization

Chapter 8 Slide 10

Profit Maximization


Implications of non-profit objectiveOver the long-run investors would not

support the companyWithout profits, survival unlikely

Chapter 8 Slide 11

Profit Maximization


Long-run profit maximization is valid and does not exclude the possibility of altruistic behavior.

Chapter 8 Slide 12

Marginal Revenue, Marginal Cost,and Profit Maximization

Determining the profit maximizing level of outputProfit ( ) = Total Revenue - Total Cost

Total Revenue (R) = Pq

Total Cost (C) = Cq

Therefore:

)()()( qCqRq

Chapter 8 Slide 13

Profit Maximization in the Short Run

0

Cost,Revenue,

Profit($s per year)

Output (units per year)

R(q)Total Revenue

Slope of R(q) = MR

Chapter 8 Slide 14

0

Cost,Revenue,

Profit$ (per year)


Profit Maximization in the Short Run

C(q)

Total Cost

Slope of C(q) = MC

Why is cost positive when q is zero?

Chapter 8 Slide 15

Marginal revenue is the additional revenue from producing one more unit of output.

Marginal cost is the additional cost from producing one more unit of output.


Chapter 8 Slide 16

Comparing R(q) and C(q)

Output levels: 0- q0:

C(q)> R(q) Negative profit

FC + VC > R(q) MR > MC

Indicates higher profit at higher output 0

Cost,Revenue,

Profit($s per year)


R(q)

C(q)

A

B

q0 q*

)(q


Chapter 8 Slide 17

Comparing R(q) and C(q) Question: Why is profit

negative when output is zero?


R(q)

0

Cost,Revenue,

Profit$ (per year)


C(q)

A

B

q0 q*

)(q

Chapter 8 Slide 18


Output levels: q0 - q*

R(q)> C(q) MR > MC

Indicates higher profit at higher output

Profit is increasing

R(q)

0

Cost,Revenue,

Profit$ (per year)


C(q)

A

B

q0 q*

)(q


Chapter 8 Slide 19


Output level: q*

R(q)= C(q) MR = MC Profit is maximized

R(q)

0

Cost,Revenue,

Profit$ (per year)


C(q)

A

B

q0 q*

)(q


Chapter 8 Slide 20

Question

Why is profit reduced when producing more or less than q*?

R(q)

0

Cost,Revenue,

Profit$ (per year)


C(q)

A

B

q0 q*

)(q


Chapter 8 Slide 21


Output levels beyond q*: R(q)> C(q) MC > MR Profit is decreasing


R(q)

0

Cost,Revenue,

Profit$ (per year)


C(q)

A

B

q0 q*

)(q

Chapter 8 Slide 22

Therefore, it can be said:

Profits are maximized when MC = MR.


R(q)

0

Cost,Revenue,

Profit$ (per year)


C(q)

A

B

q0 q*

)(q

Chapter 8 Slide 23

C - R


q

R MR

q

CMC

Chapter 8 Slide 24

orq

C

q

R 0

q

: whenmaximized are Profits

MC(q)MR(q)

MCMR

thatso0


Chapter 8 Slide 25

The Competitive Firm

Price taker

Market output (Q) and firm output (q)

Market demand (D) and firm demand (d)

R(q) is a straight line


Demand and Marginal Revenue Facedby a Competitive Firm

Output (bushels)

Price$ per bushel

Price$ per bushel

Output (millions of bushels)

d$4

100 200 100

Firm Industry

D

$4

Chapter 8 Slide 27


The competitive firm’s demand Individual producer sells all units for $4

regardless of the producer’s level of output.

If the producer tries to raise price, sales are zero.


Chapter 8 Slide 28


The competitive firm’s demand If the producers tries to lower price he

cannot increase salesP = D = MR = AR


Chapter 8 Slide 29


Profit MaximizationMC(q) = MR = P


Chapter 8 Slide 30

Choosing Output in the Short Run

We will combine production and cost analysis with demand to determine output and profitability.

Chapter 8 Slide 31

q0

Lost profit forqq < q*

Lost profit forq2 > q*

q1 q2

A Competitive FirmMaking a Positive Profit

10

20

30

40

Price($ per

unit)

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

50

60MC

AVC

ATCAR=MR=P

Outputq*

At q*: MR = MCand P > ATC

ABCDor

qx AC) -(P *

D A

BC

q1 : MR > MC andq2: MC > MR andq0: MC = MR but

MC falling

Chapter 8 Slide 32

Would this producercontinue to produce with a loss?

A Competitive FirmIncurring Losses

Price($ per

unit)

Output

AVC

ATCMC

q*

P = MR

B

F

C

A

E

DAt q*: MR = MCand P < ATCLosses = P- AC) x q* or ABCD

Chapter 8 Slide 33

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 AVC < P < ATC the firm should produce at a loss.

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

Chapter 8 Slide 34

The Short-Run Output ofan Aluminum Smelting Plant

Output (tons per day)

Cost(dollars per item)

300 600 9000

1100

1200

1300

1400

1140

P1

P2

Observations•Price between $1140 & $1300: q = 600•Price > $1300: q = 900•Price < $1140: q = 0

QuestionShould the firm stay in businesswhen P < $1140?

Chapter 8 Slide 35

Some Cost Considerations for Managers

Three guidelines for estimating marginal cost:

1) Average variable cost should not be used as a substitute for marginal

cost.

Chapter 8 Slide 36



2) A single item on a firm’s accounting ledger may have two components, only one of which involves marginal cost.

Chapter 8 Slide 37


3) All opportunity cost should be included in determining

marginal cost.


Chapter 8 Slide 38

A Competitive Firm’sShort-Run Supply Curve

Price($ per

unit)

Output

MC

AVC

ATC

P = AVCWhat happens

if P < AVC?

P2

q2

P1

q1

The firm chooses theoutput level where MR = MC,as long as the firm is able to

cover its variable cost of production.

Chapter 8 Slide 39

Observations:P = MRMR = MCP = MC

Supply is the amount of output for every possible price. Therefore:If P = P1, then q = q1

If P = P2, then q = q2


Chapter 8 Slide 40

Price($ per

unit)

MC

Output

AVC

ATC

P = AVC

P1

P2

q1 q2

S = MC above AVC


Shut-down

Chapter 8 Slide 41

Observations:Supply is upward sloping due to

diminishing returns.

Higher price compensates the firm for higher cost of additional output and increases total profit because it applies to all units.


Chapter 8 Slide 42

Firm’s Response to an Input Price ChangeWhen the price of a firm’s product

changes, the firm changes its output level, so that the marginal cost of production remains equal to the price.


Chapter 8 Slide 43

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

Chapter 8 Slide 44

The Short-Run Productionof Petroleum Products

Cost($ per

barrel)

Output(barrels/day)

8,000 9,000 10,000 11,000

23

24

25

26

27 SMC

How much wouldbe produced if

P = $23? P = $24-$25?

The MC of producinga mix of petroleum products

from crude oil increasessharply at several levelsof output as the refinery

shifts from one processingunit to another.

Chapter 8 Slide 45

Stepped SMC indicates a different production (cost) process at various capacity levels.

Observation:With a stepped MC function, small

changes in price may not trigger a change in output.


Chapter 8 Slide 46

The short-run market supply curve shows the amount of output that the industry will produce in the short-run for every possible price.

Consider, for simplicity, a competitive market with three firms:


Chapter 8 Slide 47

MC3

Industry Supply in the Short Run

$ perunit

0 2 4 8 105 7 15 21

MC1

SSThe short-runindustry supply curve

is the horizontalsummation of the supply

curves of the firms.

Quantity

MC2

P1

P3

P2

Question: If increasingoutput raises inputcosts, what impactwould it have on market supply?

Chapter 8 Slide 48

The Short-Run Market Supply Curve

Elasticity of Market Supply

)//()/( PPQQEs

Chapter 8 Slide 49

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.


Chapter 8 Slide 50

Questions

1) Give an example of a perfectly inelastic supply.

2) If MC rises rapidly, would the supply be more or less elastic?


Chapter 8 Slide 51

The World Copper Industry (1999)

Annual Production Marginal CostCountry (thousand metric tons) (dollars/pound)

Australia 600 0.65Canada 710 0.75Chile 3660 0.50Indonesia 750 0.55Peru 450 0.70Poland 420 0.80Russia 450 0.50United States 1850 0.70Zambia 280 0.55

Chapter 8 Slide 52

The Short-Run World Supply of Copper

Production (thousand metric tons)

Price($ per pound)

0 2000 4000 6000 8000 100000.40

0.50

0.60

0.70

0.80

0.90

MCC,MCR

MCJ,MCZ

MCA

MCP,MCUS

MCCa

MCPo

Chapter 8 Slide 53

Producer Surplus in the Short RunFirms earn a surplus on all but the last unit

of output.

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.


Chapter 8 Slide 54

AA

DD

BB

CC

ProducerProducerSurplusSurplus

Alternatively, VC is thesum of MC or ODCq* .R is P x q* or OABq*.Producer surplus =

R - VC or ABCD.

Producer Surplus for a Firm

Price($ per

unit ofoutput)

Output

AVCAVCMCMC

00

PP

qq**

At q* MC = MR.Between 0 and q ,

MR > MC for all units.

Chapter 8 Slide 55

Producer Surplus in the Short-Run


VC- R PS Surplus Producer

FC - VC- R - Profit

Chapter 8 Slide 56

Observation

Short-run with positive fixed cost


PS

Chapter 8 Slide 57

DD

PP**

QQ**

ProducerProducerSurplusSurplus

Market producer surplus isthe difference between P*

and S from 0 to Q*.

Producer Surplus for a Market

Price($ per

unit ofoutput)

Output

SS

Chapter 8 Slide 58

Choosing Output in the Long Run

In the long run, a firm can alter all its inputs, including the size of the plant.

We assume free entry and free exit.

Chapter 8 Slide 59

q1

A

BC

D

In the short run, thefirm is faced with fixedinputs. P = $40 > ATC.Profit is equal to ABCD.

Output Choice in the Long Run

Price($ per

unit ofoutput)

Output

P = MR$40

SACSMC

In the long run, the plant size will be increased and output increased to q3.

Long-run profit, EFGD > short runprofit ABCD.

q3q2

G F$30

LAC

E

LMC

Chapter 8 Slide 60

q1

A

BC

D

Output Choice in the Long Run

Price($ per

unit ofoutput)

Output

P = MR$40

SACSMC

Question: Is the producer makinga profit after increased output

lowers the price to $30?

q3q2

G F$30

LAC

E

LMC

Chapter 8 Slide 61


Accounting Profit & Economic ProfitAccounting profit = R - wL

Economic profit = R = wL - rKwl = labor cost

rk = opportunity cost of capital

)()(

Chapter 8 Slide 62


Zero-ProfitIf R > wL + rk, economic profits are positive

If R = wL + rk, zero economic profits, but the firms is earning a normal rate of return; indicating the industry is competitive

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

Long-Run Competitive EquilibriumLong-Run Competitive Equilibrium

Chapter 8 Slide 63


Entry and ExitThe 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.

Long-Run Competitive EquilibriumLong-Run Competitive Equilibrium

S1

Long-Run Competitive Equilibrium

Output Output

$ per unit ofoutput

$ per unit ofoutput

$40LAC

LMC

D

S2

P1

Q1q2

Firm Industry

$30

Q2

P2

•Profit attracts firms•Supply increases until profit = 0

Chapter 8 Slide 65


Long-Run Competitive Equilibrium

1) MC = MR

2) P = LAC

No incentive to leave or enter

Profit = 0

3) Equilibrium Market Price

Chapter 8 Slide 66


Questions

1) Explain the market adjustment when P < LAC and firms have identical costs.

2) Explain the market adjustment when firms have different costs.

3) What is the opportunity cost of land?

Chapter 8 Slide 67


Economic RentEconomic rent is the difference between

what firms are willing to pay for an input less the minimum amount necessary to obtain it.

Chapter 8 Slide 68


An Example

Two firms A & B

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

Chapter 8 Slide 69


An Example

Economic rent = $10,000

$10,000 - zero cost for the land

Economic rent increases

Economic profit of A = 0

Chapter 8 Slide 70

Firms Earn Zero Profit inLong-Run Equilibrium

TicketPrice

Season TicketsSales (millions)

LAC

$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).

LMC

Chapter 8 Slide 71

1.31.3

$10$10

Economic Rent

TicketPrice

$7$7

LAC

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


Season TicketsSales (millions)

LMC

Chapter 8 Slide 72

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.


Chapter 8 Slide 73

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


Chapter 8 Slide 74

The shape of the long-run supply curve depends on the extent to which changes in industry output affect the prices the firms must pay for inputs.


Chapter 8 Slide 75


To determine long-run supply, we assume:

All firms have access to the available production technology.

Output is increased by using more inputs, not by invention.

Chapter 8 Slide 76


To determine long-run supply, we assume:

The market for inputs does not change with expansions and contractions of the industry.

AP1

AC

P1

MC

q1

D1

S1

Q1

C

D2

P2P2

q2

B

S2

Q2

Economic profits attract newfirms. Supply increases to S2 and

the market returns to long-run equilibrium.

Long-Run Supply in aConstant-Cost Industry

Output Output

$ per unit ofoutput

$ per unit ofoutput

SL

Q1 increase to Q2.Long-run supply = SL = LRAC.

Change in output has no impact on input cost.

Chapter 8 Slide 78

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.

Long-Run Supply in aConstant-Cost Industry

Long-Run Supply in anIncreasing-Cost Industry

Output Output

$ per unit ofoutput

$ per unit ofoutput S1

D1

P1

LAC1

P1

SMC1

q1 Q1

A

SSLL

P3

SMC2

Due to the increasein input prices, long-runequilibrium occurs at

a higher price.

LAC2

B

S2

P3

Q3q2

P2 P2

D1

Q2

Chapter 8 Slide 80

In a increasing-cost industry, long-run supply curve is upward sloping.

Long-Run Supply in aIncreasing-Cost Industry

Chapter 8 Slide 81

The Industry’sLong-Run Supply Curve

Questions

1) Explain how decreasing-cost is possible.

2) Illustrate a decreasing cost industry.

3) What is the slope of the SL in a decreasing-cost industry?

S2

B

SL

P3

Q3

SMC2

P3

LAC2

Due to the decreasein input prices, long-runequilibrium occurs at

a lower price.

Long-Run Supply in anDecreasing-Cost Industry

Output Output

$ per unit ofoutput

$ per unit ofoutput

P1P1

SMC1

A

D1

S1

Q1q1

LAC1

Q2q2

P2 P2

D2

Chapter 8 Slide 83

In a decreasing-cost industry, long-run supply curve is downward sloping.

Long-Run Supply in aIncreasing-Cost Industry

Chapter 8 Slide 84

The Effects of a TaxIn an earlier chapter we studied how firms

respond to taxes on an input.

Now, we will consider how a firm responds to a tax on its output.


Chapter 8 Slide 85

Effect of an Output Tax on a Competitive Firm’s Output

Price($ per

unit ofoutput)

Output

AVC1

MC1

P1

q1

The firm willreduce output to

the point at whichthe marginal cost

plus the tax equalsthe price.

q2

tt

MC2 = MC1 + tax

AVC2

An output taxraises the firm’s

marginal cost by theamount of the tax.

Chapter 8 Slide 86

Effect of an OutputTax on Industry Output

Price($ per

unit ofoutput)

Output

DD

P1

SS1

Q1

P2

Q2

SS2 = S1 + t

t

Tax shifts S1 to S2 andoutput falls to Q2. Price

increases to P2.

Chapter 8 Slide 87

Long-Run Elasticity of Supply

1) Constant-cost industryLong-run supply is horizontalSmall increase in price will induce an

extremely large output increase


Chapter 8 Slide 88


1) Constant-cost industryLong-run supply elasticity is infinitely

large Inputs would be readily available


Chapter 8 Slide 89


2) Increasing-cost industryLong-run supply is upward-sloping and

elasticity is positiveThe slope (elasticity) will depend on the

rate of increase in input costLong-run elasticity will generally be

greater than short-run elasticity of supply


Chapter 8 Slide 90

Question:Describe the long-run elasticity of supply in

a decreasing -cost industry.


Chapter 8 Slide 91

The Long-Run Supply of Housing

Scenario 1: Owner-occupied housingSuburban or rural areas

National market for inputs

Chapter 8 Slide 92


QuestionsIs this an increasing or a constant-cost

industry?

What would you predict about the elasticity of supply?

Chapter 8 Slide 93

Scenario 2: Rental propertyZoning restrictions applyUrban locationHigh-rise construction cost


Chapter 8 Slide 94

QuestionsIs this an increasing or a constant-cost

industry?What would you predict about the elasticity

of supply?


Chapter 8 Slide 95

Summary

The managers of firms can operate in accordance with a complex set of objectives and under various constraints.

A competitive market makes its output choice under the assumption that the demand for its own output is horizontal.

Chapter 8 Slide 96

Summary

In the short run, a competitive firm maximizes its profit by choosing an output at which price is equal to (short-run) marginal cost.

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

Chapter 8 Slide 97

Summary

The producer surplus for a firm is the difference between revenue of a firm and the minimum cost that would be necessary to produce the profit-maximizing output.

Economic rent is the payment for a scarce resource of production less the minimum amount necessary to hire that factor.

Chapter 8 Slide 98

Summary

In the long-run, profit-maximizing competitive firms choose the output at which price is equal to long-run marginal cost.

The long-run supply curve for a firm can be horizontal, upward sloping, or downward sloping.

End of Chapter 8Profit Maximization

and Competitive Supply

Profit Maximization and Competitive

Supply

Chapter 8

Documents

Transcript of Chapter 8