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PROFIT MAXIMIZATION UNDER COMPETITIVE MARKET CONDITIONS EA SESSION 8 18th July 2005 Prof. Samar K. Datta EA SESSION 8 18th July 2005 Prof. Samar K. Datta.

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Presentation on theme: "PROFIT MAXIMIZATION UNDER COMPETITIVE MARKET CONDITIONS EA SESSION 8 18th July 2005 Prof. Samar K. Datta EA SESSION 8 18th July 2005 Prof. Samar K. Datta."— Presentation transcript:

1 PROFIT MAXIMIZATION UNDER COMPETITIVE MARKET CONDITIONS EA SESSION 8 18th July 2005 Prof. Samar K. Datta EA SESSION 8 18th July 2005 Prof. Samar K. Datta

2 2 Sub-topics to be covered Perfectly Competitive Markets Profit Maximization Marginal Revenue, Marginal Cost, and Profit Maximization Choosing Output in the Short-Run The Competitive Firms Short-Run Supply Curve Short-Run Market Supply Choosing Output in the Long-Run The Industrys Long-Run Supply Curve – Can it be less elastic?

3 3 MODELS OF MARKET STRUCTURE Market Structure Atomistic Competition Non-Atomistic Competition Perfect Competition Monopolistic Competition OligopolyDuopoly Monopoly Conjectural Variation = 0 Conjectural Variation 0

4 4 Perfectly Competitive Markets Characteristics of Perfectly Competitive Markets 1)Price taking 2)Product homogeneity 3)Free entry and exit

5 5 Question –Why is profit reduced when producing more or less than q*? R(q) 0 Cost, Revenue, Profit $ (per year) Output (units per year) C(q) A B q0q0 q*q* Marginal Revenue, Marginal Cost, and Profit Maximization

6 Demand and Marginal Revenue Faced by a Competitive Firm Output (bushels) Price $ per bushel Price $ per bushel Output (millions of bushels) d$ FirmIndustry D $4

7 7 q0q0 Lost profit for q q < q * Lost profit for q 2 > q * q1q1 q2q2 A Competitive Firm Making a Positive Profit Price ($ per unit) MC AVC ATC AR=MR=P Output q*q* At q * : MR = MC and P > ATC D A B C q 1 : MR > MC and q 2 : MC > MR and q 0 : MC = MR but MC falling

8 8 Would this producer continue to produce with a loss? A Competitive Firm Incurring Losses Price ($ per unit) Output AVC ATC MC q*q* P = MR B F C A E D At q * : MR = MC and P < ATC Losses = (P- AC) x q * or ABCD

9 9 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.

10 10 Price ($ per unit) MC Output AVC ATC P = AVC P1P1 P2P2 q1q1 q2q2 S = MC above AVC A Competitive Firms Short-Run Supply Curve Shut-down

11 11 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. –Firms response to an input price change When the price of a firms input changes, the firm changes its output level, so that the marginal cost of production remains equal to the price. A Competitive Firms Short-Run Supply Curve

12 12 The Short-Run Production of Petroleum Products Cost ($ per barrel) Output (barrels/day) 8,0009,00010,00011, SMC How much would be produced if P = $23? P = $24-$25? The MC of producing a mix of petroleum products from crude oil increases sharply at several levels of output as the refinery shifts from one processing unit to another.

13 13 MC 3 Industry Supply in the Short Run $ per unit MC 1 S The short-run industry supply curve is the horizontal summation of the supply curves of the firms. Quantity MC 2 P1P1 P3P3 P2P2 Question: If increasing output raises input costs, what impact would it have on market supply?

14 14 Perfectly inelastic (vertical) 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 (horizontal) short- run supply arises when marginal costs are constant. The Short-Run Market Supply Curve

15 15 Producer Surplus in the Short Run – Firms 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. The Short-Run Market Supply Curve

16 16 A D B CProducerSurplus Alternatively, VC is the sum 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 of output) OutputAVCMC0 P q*q*q*q* At q * MC = MR. Between 0 and q, MR > MC for all units.

17 17 Producer Surplus in the Short-Run Observation –Short-run with positive fixed cost The Short-Run Market Supply Curve

18 18 q1q1 A B C D In the short run, the firm is faced with fixed inputs. P = $40 > ATC. Profit is equal to ABCD. Output Choice in the Long Run Price ($ per unit of output) Output P = MR $40 SAC SMC In the long run, the plant size will be increased and output increased to q 3. Long-run profit, EFGD > short run profit ABCD. q3q3 q2q2 G F $30 LAC E LMC Can this firm stay indefinitely at E?

19 19 Choosing Output in the Long Run 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. Long-Run Competitive Equilibrium

20 S1S1 Output $ per unit of output $ per unit of output $40 LAC LMC D S2S2 P1P1 Q1Q1 q2q2 FirmIndustry $30 Q2Q2 P2P2 Profit attracts firms Supply increases until profit = 0

21 21 Choosing Output in the Long Run Long-Run Competitive Equilibrium 1) MC = MR 2)P = LAC No incentive to leave or enter Profit = 0 3) Equilibrium Market Price

22 A P1P1 AC P1P1 MC q1q1 D1D1 S1S1 Q1Q1 C D2D2 P2P2 P2P2 q2q2 B S2S2 Q2Q2 Economic profits attract new firms. Supply increases to S 2 and the market returns to long-run equilibrium. Long-Run Supply in a Constant-Cost Industry is a horizontal line Output $ per unit of output $ per unit of output SLSL Q 1 increase to Q 2. Long-run supply = S L = LRAC. Change in output has no impact on input cost Sequence of events shown by numbers In both diagrams

23 Long-Run Supply in an Increasing-Cost Industry is upward sloping Output $ per unit of output $ per unit of output S1S1 D1D1 P1P1 LAC 1 P1P1 SMC 1 q1q1 Q1Q1 A SLSLSLSL P3P3 SMC 2 Due to the increase in input prices, long-run equilibrium occurs at a higher price. LAC 2 B S2S2 P3P3 Q3Q3 q2q2 P2P2 P2P2 D1D1 Q2Q Sequence of events shown by numbers In both diagrams

24 S2S2 B SLSL P3P3 Q3Q3 SMC 2 P3P3 LAC 2 Due to the decrease in input prices, long-run equilibrium occurs at a lower price. Long-Run Supply in an Decreasing-Cost Industry is downward sloping Output $ per unit of output $ per unit of output P1P1 P1P1 SMC 1 A D1D1 S1S1 Q1Q1 q1q1 LAC 1 Q2Q2 q2q2 P2P2 P2P2 D2D2 Sequence of events shown by numbers In both diagrams

25 25 Effect of an Output Tax on a Competitive Firms Output (Is the drawing perfectly correct?) Price ($ per unit of output) Output AVC 1 MC 1 P1P1 q1q1 The firm will reduce output to the point at which the marginal cost plus the tax equals the price. q2q2 t MC 2 = MC 1 + tax AVC 2 An output tax raises the firms marginal cost by the amount of the tax.

26 26 Effect of an Output Tax on Industry Output Price ($ per unit of output) Output D P1P1 SS1SS1 Q1Q1 P2P2 Q2Q2 S S 2 = S 1 + t t Tax shifts S 1 to S 2 and output falls to Q 2. Price increases to P 2. Note how the burden of tax is generally borne by both parties


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