1. Profit Maximization Chapter 8

2. PERFECTLY COMPETITIVE MARKETS
The model of perfect competition rests on three basic assumptions:
(1) price taking,
(2) product homogeneity, and
(3) free entry and exit.
Price Taking
Because each individual firm sells a sufficiently small proportion of total market output, its decisions have no impact on market price.
price taker Firm that has no influence over market price
and thus takes the price as given.

3. When Is a Market Highly Competitive?
Product Homogeneity
When the products of all of the firms in a market are perfectly substitutable with one another—that is, when they are homogeneous—no firm can raise the price of its product above the price of other firms without losing most or all of its business.
free entry (or exit) Condition under which there are no special costs that make it difficult for a firm to enter (or exit) an industry.
When Is a Market Highly Competitive?
Because firms can implicitly or explicitly collude in setting prices, the presence of many firms is not sufficient for an industry to approximate perfect competition.
Conversely, the presence of only a few firms in a market does not rule out competitive behavior.

4. Profit Maximization Do firms maximize profits?
Managers in firms may be concerned with other objectives
Revenue maximization
Revenue growth
Dividend maximization
Short-run profit maximization (due to bonus or promotion incentive)
Could be at expense of long run profits

5. 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) = P*q
Costs of production depends on output
Total Cost (C) = C*q
Profit for the firm, , is difference between revenue and costs

6. MARGINAL REVENUE, MARGINAL COST, AND PROFIT MAXIMIZATION
Revenue is curved showing that a firm can only sell more if it lowers its price
Slope in revenue curve is the marginal revenue
Change in revenue resulting from a one-unit increase in output
Slope of total cost curve is marginal cost
Additional cost of producing an additional unit of output
Δπ/Δq = ΔR/Δq − ΔC/Δq = 0
MR(q) = MC(q)
Profit Maximization by a Competitive Firm
MC(q) = MR = P

7. Profit Maximization – Short Run
Profits are maximized where MR (slope at A) and MC (slope at B) are equal
Cost,
Revenue,
Profit
($s per year)
Profits are maximized where R(q) – C(q) is maximized
C(q) A
R(q) q* B q0
(q)
Output

8. Marginal Revenue, Marginal Cost, and Profit Maximization
Profit is maximized at the point at which an additional increment to output leaves profit unchanged

9. The Competitive Firm 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)
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 good all consumers will purchase at different prices

10. The Competitive Firm The competitive firm’s demand
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 good all consumers will purchase at different prices
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

11. A Competitive Firm MC q2 AR=MR=P q1 q* Output 10 20 30 40 Price 50 AVC
Lost Profit for q2>q*
Lost Profit for q2>q*
AVC
ATC
AR=MR=P q1 q*
q1 : MR > MC
q2: MC > MR
q0: MC = MR 1 2 3 4 5 6 7 8 9 10 11
Output

12. A Competitive Firm – Positive Profitsq2 MC
AVC
ATC q*
AR=MR=P A q1 10 20 30 40
Price 50
Total Profit = ABCD
Profits are determined by output per unit times quantity
Profit per unit = P-AC(q) = A to B 1 2 3 4 5 6 7 8 9 10 11
Output

13. A Competitive Firm – Positive Profits
A firm does not have to make profits
It 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)
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

14. A Competitive Firm – LossesMC
AVC
ATC
Price B C
P = MR D q* A
At q*: MR = MC and P < ATC
Losses = (P- AC) x q* or ABCD
Output

15. Competitive Firm – Short Run Supply
When should the firm shut down?
If AVC < P < ATC the firm should continue producing in the short run
Can cover some of its variable costs and all of its fixed costs
If AVC > P < ATC the firm should shut-down.
Can not cover even its fixed costs
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

16. A Competitive Firm’s Short-Run Supply Curve
Price
($ per
unit)
The firm chooses the
output level where P = MR = MC,
as long as P > AVC.
Supply is MC above AVC S MC P2 q2
AVC
ATC P1 q1
P = AVC
Output

17. Elasticity of Market Supply
Measures the sensitivity of industry output to market price
The percentage change in quantity supplied, Q, in response to 1-percent change in price

18. Producer Surplus versus Profit
Profit is revenue minus total cost (not just variable cost)
When fixed cost is positive, producer surplus is greater than profit

19. Output Choice in the Short Run
Price
$30
LAC
LMC
SAC
SMC A D
P = MR
$40 q1 q3 B C q2
Output

20. Output Choice in the Long Run
In the long run, the plant size will be
increased and output increased to q3.
Long-run profit, EFGD > short run
profit ABCD.
Price q1 B C A D
P = MR
$40
SAC
SMC q3 q2
$30
LAC
LMC F G
Output

21. long-run competitive equilibrium
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

22. long-run competitive equilibrium
Firm uses labor (L) and capital (K) with purchased capital
Accounting Profit & Economic Profit
Accounting profit:  = R - wL
Economic profit:  = R = wL - rK
wl = labor cost
rk = opportunity cost of capital

23. Long-Run Competitive Equilibrium
All firms in industry are maximizing profits
MR = MC
No firm has incentive to enter or exit industry
Earning zero economic profits
Market is in equilibrium
QD = QD

24. Firms Earn Zero Profit in Long-Run Equilibrium
Ticket
Price
Economic Rent
LAC
LMC
$10
1.3
$7.20
A team with the same
cost in a larger city
sells tickets for $10.
Season Tickets
Sales (millions)

25. The Industry’s Long-Run Supply Curve
To analyze long-run industry supply, will need to distinguish between three different types of industries
Constant-Cost
Increasing-Cost
Decreasing-Cost

26. Constant-Cost Industry
Industry whose long-run supply curve is horizontal
Assume a firm is initially in equilibrium
Demand increases causing price to increase
Individual firms increase supply
Causes firms to earn positive profits in short-run
Supply increases causing market price to decrease
Long run equilibrium – zero economic profits

27. Increasing-Cost Industry
Prices of some or all inputs rises as production is expanded when demand of inputs increases
When demand increases causing prices to increase and production to increase
Firms enter the market increasing demand for inputs
Costs increase causing an upward shift in supply curves
Market supply increases but not as much

28. Decreasing-Cost Industry
Industry whose long-run supply curve is downward sloping
Increase in demand causes production to increase
Increase in size allows firm to take advantage of size to get inputs cheaper
Increased production may lead to better efficiencies or quantity discounts
Costs shift down and market price falls