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

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

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

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

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

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

A Competitive Firm Making a Positive Profit MC 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

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

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

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

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

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

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

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

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

Producer Surplus for a Firm q* 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

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

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

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

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

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

Long-Run Supply in a Constant-Cost Industry is a horizontal line B 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

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

Long-Run Supply in an Decreasing-Cost Industry is downward sloping B 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

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

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