Profit Maximization, Supply, Market Structures, and Resource Allocation

Market Structure Firms are assumed to maximize economic profits Economic Profit = Revenue – Total Opportunity Costs = Explicit and Implicit Costs Costs are dependent on technology and input prices Revenue is dependent upon the market structure in which a firm operates Therefore, the profit maximization decision must be analyzed by market structures

Market Structures Competitive Markets Monopoly Oligopoly Monopolistic Competition

Quick Overview of Supply and Resource Allocation in Markets Marginal benefits from a firms perspective are marginal revenue from selling output Marginal revenue equal the extra revenue from selling another unit of output Assuming the firm produces (does not shutdown), the firm will maximize profit (or minimize losses) where MR=MC The level of output will determine the costs of production (measured by ATC) Comparing price to average costs show if the firm is making profits, losses or will shutdown production

All the buyers in the market combined form the market demand curve and all the sellers for the market supply curve Market demand and supply determine the price and along with firms’ costs determine economic profits (hereafter simply profits) Changes in demand and supply, cause market prices to change, and thus cause profits to rise or fall In the short-run, existing firms in an industry change production as price changes. In the transition to the long-run, firms enter or exit an industry depending on whether profits are greater than or less than zero. In the long-run, profits are driven to zero or to the level of NORMAL profits (accounting profits that just cover all opportunity costs).

Resource allocation is determined by: –Buyers and sellers follow their self-interest Buyers maximize utility Seller maximize profit –Market demand reflects buyer behavior (and thus each individual buyers behavior) and market supply reflect seller behaviors (and thus individual firm behavior) –Prices signal increases or decreases in quantity demand and supply and profits signal resources to enter or exit an industry causing market supply to change

–Long-run equilibrium occurs where: The price paid by the consumer, which is equal to the marginal benefit of another unit, is just equal to the marginal cost, which is equal to the opportunity cost of another unit to society. MB = MC

From the videos, –Resources dedicated to farming have decreased –If rents are not controlled, the supply of housing will respond to increased demand without shortages –The same is true of gasoline and water –Also, in class, DVDs versus VCRs

This is Adam Smith’s “Invisible Hand at work”. –Every individual necessarily labours to render the annual revenue of the society as great as he can. He generally neither intends to promote the public interest, nor knows how much he is promoting it...He intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for society that it was no part of his intention. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good. Wealth of Nations, 1776)

Marginal Revenue and Market Structure Competitive markets – sellers are price takers so MR = Market Price, MR =P Monopoly – the seller is a price maker and faces the entire market demand curve so MR < Price Oligopoly – the seller directly competes with a few firms so MR depends on the actions of competitors Monopolistic Competition – sellers possess some market power and can set their own prices in the short-run, so MR<P

Competitive Markets or Pure Competition Assumptions revisited –Many buyers and sellers Each buyer and seller is a price taker –Homogenous or identical products Competition is based only on the price –Perfect information or knowledge All firms have access to the same technology Competition is based upon price –Firms can freely enter or exit Profits will be eliminated in the long-run

Revenue in Competitive Markets The market demand and supply curves determine the equilibrium price and quantity and the price that buyers will pay and sellers receive As with producer surplus, sellers are price takers and the price they receive is their MR. The marginal revenue and the price remain the same no matter how much output is sold.

Table 1 Total, Average, and Marginal Revenue for a Competitive Firm Copyright©2004 South-Western

Competitive Firm in the Short-run Short-run – at least one fixed factor = fixed costs. Assume the plant size is fixed. Set MR=MC to find profit maximizing level of output. Use the average cost curves to determine whether one –Operates and earn profits –Operate and breakeven –Operates and make losses –Shutdowns and minimize losses

Table 2 Profit Maximization: A Numerical Example Copyright©2004 South-Western

Figure 1 Profit Maximization for a Competitive Firm Copyright © 2004 South-Western Quantity 0 Costs and Revenue MC ATC AVC MC 1 Q 1 2 Q 2 The firm maximizes profit by producing the quantity at which marginal cost equals marginal revenue. Q MAX P = MR 1 = 2 P = AR = MR

Conditions for Profits, Breakeven, Losses and Shutdown Profits –P > ATC Breakeven –P = ATC Losses but operate –P > AVC but P < ATC or –ATC < P < AVC Shutdown –P > AVC

Figure 5 Profit as the Area between Price and Average Total Cost Copyright © 2004 South-Western (a) A Firm with Profits Quantity 0 Price P=AR= MR ATCMC P ATC Q (profit-maximizing quantity) Profit

Figure 5 Profit as the Area between Price and Average Total Cost Copyright © 2004 South-Western (b) A Firm with Losses Quantity 0 Price ATCMC (loss-minimizing quantity) P=AR= MR P ATC Q Loss

Short-run Supply Individual Firm: The short-run supply curve is MC curve above minimum AVC. Market: The short-run supply curve is the horizontal sum of all of the individual firm’s MC curves above the minimum AVC.

Figure 3 The Competitive Firm’s Short Run Supply Curve Copyright © 2004 South-Western MC Quantity ATC AVC 0 Costs Firm shuts down if P < AVC Firm’s short-run supply curve If P > AVC, firm will continue to produce in the short run. If P > ATC, the firm will continue to produce at a profit.

Figure 6 Market Supply with a Fixed Number of Firms Copyright © 2004 South-Western (a) Individual Firm Supply Quantity (firm) 0 Price MC $ (b) Market Supply Quantity (market) 0 Price Supply ,000 $ ,000 Assume 100 firms with identical plant sizes and horizontally sum their marginal cost curves above minimum AVC

Price Determination in the Short-run Fixed plant sizes implies a fixed number of firms. Market supply and demand curve determine the price and the profit loss situations of existing firms. If demand increase, firms increase the quantity supplied by utilizing increasing capacity. The law of diminishing returns implies that supply is upward sloping at that prices will rise.

Long-run Supply and Price Determination Long-run – all factors are variable = no fixed costs and plant size can be changed, ALSO firms can enter and exit If economic profits are positive, new firms will enter. If economic profits are negative, existing firms will exit. Long-run equilibrium: –Firms must chose the plant that minimizes LRATC or they will suffer losses. –Economic profits are reduced to zero.

Figure 7 Market Supply with Entry and Exit Copyright © 2004 South-Western (a) Firm’s Zero-Profit Condition Quantity (firm) 0 Price (b) Market Supply Quantity (market) Price 0 P = minimum ATC Supply MC ATC LRMC LRATC

Figure 8 An Increase in Demand in the Short Run and Long Run Firm (a) Initial Condition Quantity (firm) 0 Price Market Quantity (market) Price 0 DDemand, 1 SShort-run supply, 1 P 1 ATC Long-run supply P 1 1 Q A MC

Figure 8 An Increase in Demand in the Short Run and Long Run Copyright © 2004 South-Western P 1 Firm (c) Long-Run Response Quantity (firm) 0 Price MC ATC Market Quantity (market) Price 0 P 1 P 2 Q 1 Q 2 Long-run supply B D 1 D 2 S 1 A S 2 Q 3 C

Long-run Supply Curve Constant cost industries – horizontal or perfectly elastic supply Increasing cost industries – upward sloping supply –Some resource may be available in limited quantities (farm land) –Some resources may increase in cost or be less productive (skilled labor) Decreasing cost industries – downward sloping supply –Increased output may stimulate increased productivity or technological change (computers)

Competitive Markets: Short-run and Long-run Short-run supply response to changes in demand are to increase or decrease the use of existing capacity. Long-run supply response is to build efficient plant size and increase or decrease capacity. In both the short-run and long-run, the profit maximizing behavior of firms leads to supply responses to accommodate changes in demand. In the short-run, prices act as signals and, in the long-run,prices and profits act as signals to increase or decrease output.

Efficiency Revisited Maximize human satisfaction from resources = maximize total surplus = maximize consumer surplus + producer surplus. Two conditions: –Produce what is most highly valued and the amount that maximizes total surplus –Produce it at the least possible cost.

In the absence of market failures, competitive markets are efficient in both the short-run and the long-run: –Supply responds to what consumers demand –Goods are produced at least possible cost Price and profits are extremely important as signals for the allocation of scarce resources. –Examples of when prices and profits no longer act as signal are rent controls and price supports