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

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 Firm’s Short-Run Supply Curve
Short-Run Market Supply
Choosing Output in the Long-Run
The Industry’s Long-Run Supply Curve – Can it be less elastic? 2

3. MODELS OF MARKET STRUCTURE
Atomistic Competition
Non-Atomistic Competition
Perfect Competition
Monopolistic Competition
Oligopoly
Duopoly
Monopoly
Conjectural Variation = 0
Conjectural Variation

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

5. Marginal Revenue, Marginal Cost, and Profit Maximization
Question
Why is profit reduced when producing more or less than q*?
Cost,
Revenue,
Profit
$ (per year)
Output (units per year)
C(q) A B q0 q*
R(q) 20

6. Demand and Marginal Revenue Faced by a Competitive Firm
Price
$ per
bushel
Price
$ per
bushel
Firm
Industry D $4 d $4
100
200
Output
(bushels)
100
Output
(millions
of bushels) 27

7. A Competitive Firm Making a Positive ProfitMC
Price
($ per
unit) 60 q0
Lost profit for
qq < q*
q2 > q* q1 q2 50
AVC
ATC
At q*: MR = MC
and P > ATC D A B C
q1 : MR > MC and
q2: MC > MR and
q0: MC = MR but
MC falling 40
AR=MR=P q* 30 20 10 1 2 3 4 5 6 7 8 9 10 11
Output 36

8. A Competitive Firm Incurring Losses
AVC
ATC MC q*
P = MR
Price
($ per
unit) B F C A E D
At q*: MR = MC
and P < ATC
Losses = (P- AC) x q* or ABCD
Would this producer
continue to produce with a loss?
Output 39

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. 40

10. A Competitive Firm’s Short-Run Supply Curve
Price
($ per
unit)
S = MC above AVC MC
ATC P2
AVC P1
P = AVC
Shut-down
Output q1 q2 49

11. A Competitive Firm’s Short-Run Supply Curve
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.
Firm’s response to an input price change
When the price of a firm’s input changes, the firm changes its output level, so that the marginal cost of production remains equal to the price. 50

12. The Short-Run Production of Petroleum Products
Cost
($ per
barrel)
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. 27
SMC 26 25 24
Output
(barrels/day) 23
8,000
9,000
10,000
11,000 57

13. Industry Supply in the Short Run
industry supply curve
is the horizontal
summation of the supply
curves of the firms.
MC1
MC2
$ per
unit
MC3 P1 P3 P2
Question: If increasing
output raises input
costs, what impact
would it have on
market supply? 2 4 5 7 8 10 15
Quantity 21 64

14. The Short-Run Market Supply Curve
Perfectly inelastic (vertical) 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 (horizontal) short- run supply arises when marginal costs are constant. 67

15. The Short-Run Market Supply Curve
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. 69

16. Producer Surplus for a Firmq*
At q* MC = MR.
Between 0 and q ,
MR > MC for all units.
Price
($ per
unit of
output) A D B C
Producer
Surplus
Alternatively, VC is the
sum of MC or ODCq* .
R is P x q* or OABq*.
Producer surplus =
R - VC or ABCD. MC
AVC
Output 73

17. The Short-Run Market Supply Curve
Producer Surplus in the Short-Run
Observation
Short-run with positive fixed cost 69

18. Output Choice in the Long Run
Can this firm stay indefinitely at E?
Price
($ per
unit of
output)
In the long run, the plant size will be
increased and output increased to q3.
Long-run profit, EFGD > short run
profit ABCD. q3 q2 G F
$30
LAC E
LMC
SAC
SMC q1 A B C D
In the short run, the
firm is faced with fixed
inputs. P = $40 > ATC.
Profit is equal to ABCD.
P = MR
$40
Output 84

19. Choosing Output in the Long Run
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. 89

20. Long-Run Competitive Equilibrium
$30 Q2 P2
Profit attracts firms
Supply increases until profit = 0
$ per
unit of
output
Firm
$ per
unit of
output
Industry S1 D
LAC
LMC
$40 P1 Q1 S2 q2
Output
Output 92

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 93

22. Long-Run Supply in a Constant-Cost Industry is a horizontal lineB S2 Q2
Economic profits attract new
firms. Supply increases to S2 and
the market returns to long-run
equilibrium. SL
Q1 increase to Q2.
Long-run supply = SL = LRAC.
Change in output has no impact on
input cost.
$ per
unit of
output
$ per
unit of
output A P1 AC MC q1 D1 S1 Q1 2 2 C D2 P2 q2 1 1 3
Sequence of events
shown by numbers
In both diagrams
Output
Output
106

23. Long-Run Supply in an Increasing-Cost Industry is upward sloping
SMC2
Due to the increase
in input prices, long-run
equilibrium occurs at
a higher price.
LAC2
$ per
unit of
output
$ per
unit of
output S1 D1 P1
LAC1
SMC1 q1 Q1 A B S2 P3 Q3 2 q2 P2 D1 Q2 2 3 1 1
Sequence of events
shown by numbers
In both diagrams
Output
Output
111

24. Long-Run Supply in an Decreasing-Cost Industry is downward slopingB SL P3 Q3
SMC2
LAC2
Due to the decrease
in input prices, long-run
equilibrium occurs at
a lower price.
$ per
unit of
output
$ per
unit of
output P1
SMC1 A D1 S1 Q1 q1
LAC1 Q2 q2 P2 D2 2 2 1 1 3
Sequence of events
shown by numbers
In both diagrams
Output
Output
117

25. Effect of an Output Tax on a Competitive Firm’s Output (Is the drawing perfectly correct?)
Price
($ per
unit of
output) t
MC2 = MC1 + tax
AVC2
An output tax
raises the firm’s
marginal cost by the
amount of the tax.
The firm will
reduce output to
the point at which
the marginal cost
plus the tax equals
the price. q2
AVC1
MC1 P1 q1
Output
121

26. Effect of an Output Tax on Industry Output
Price
($ per
unit of
output)
S2 = S1 + t t
Tax shifts S1 to S2 and
output falls to Q2. Price
increases to P2. P1 S1 Q1 D P2 Q2
Note how the burden of tax is generally borne by both parties
Output
124