Chapter 8 Profit Maximization and Competitive Supply

Chapter 8Slide 2 Perfectly Competitive Markets Characteristics of Perfectly Competitive Markets 1)Price taking 2)Product homogeneity 3)Free entry and exit

Chapter 8Slide 3 Perfectly Competitive Markets Price Taking The individual firm sells a very small share of the total market output and, therefore, cannot influence market price. The individual consumer buys too small a share of industry output to have any impact on market price.

Chapter 8Slide 4 Perfectly Competitive Markets Product Homogeneity The products of all firms are perfect substitutes. Examples  Agricultural products, oil, copper, iron, lumber

Chapter 8Slide 5 Perfectly Competitive Markets Free Entry and Exit Buyers can easily switch from one supplier to another. Suppliers can easily enter or exit a market.

Chapter 8Slide 6 Profit Maximization Do firms maximize profits? Possibility of other objectives  Revenue maximization  Dividend maximization  Short-run profit maximization

Chapter 8Slide 7 Profit Maximization Do firms maximize profits? Implications of non-profit objective  Over the long-run investors would not support the company  Without profits, survival unlikely

Chapter 8Slide 8 Profit Maximization Do firms maximize profits? Long-run profit maximization is valid and does not exclude the possibility of altruistic behavior.

Chapter 8Slide 9 Marginal Revenue, Marginal Cost, and Profit Maximization Determining the profit maximizing level of output Profit ( ) = Total Revenue - Total Cost Total Revenue (R) = Pq Total Cost (C) = Cq Therefore:

Chapter 8Slide 10 Profit Maximization in the Short Run 0 Cost, Revenue, Profit ($s per year) Output (units per year) R(q) Total Revenue Slope of R(q) = MR

Chapter 8Slide 11 0 Cost, Revenue, Profit $ (per year) Output (units per year) Profit Maximization in the Short Run C(q) Total Cost Slope of C(q) = MC Why is cost positive when q is zero?

Chapter 8Slide 12 Comparing R(q) and C(q) Output levels: 0- q 0 :  C(q)> R(q) Negative profit  FC + VC > R(q)  MR > MC Indicates higher profit at higher output 0 Cost, Revenue, Profit ($s per year) Output (units per year) R(q) C(q) A B q0q0 q*q* Marginal Revenue, Marginal Cost, and Profit Maximization

Chapter 8Slide 13 Comparing R(q) and C(q) Output levels: q 0 - q *  R(q)> C(q)  MR > MC Indicates higher profit at higher output Profit is increasing 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

Chapter 8Slide 14 Comparing R(q) and C(q) Output level: q *  R(q)> C(q)  MR = MC  Profit is maximized 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

Chapter 8Slide 15 Comparing R(q) and C(q) Output levels beyond q * :  R(q)> C(q)  MC > MR  Profit is decreasing Marginal Revenue, Marginal Cost, and Profit Maximization R(q) 0 Cost, Revenue, Profit $ (per year) Output (units per year) C(q) A B q0q0 q*q*

Chapter 8Slide 16 Therefore, it can be said: Profits are maximized when MC = MR. Marginal Revenue, Marginal Cost, and Profit Maximization R(q) 0 Cost, Revenue, Profit $ (per year) Output (units per year) C(q) A B q0q0 q*q*

Chapter 8Slide 17 The Competitive Firm Price taker Market output (Q) and firm output (q) Market demand (D) and firm demand (d) R(q) is a straight line Marginal Revenue, Marginal Cost, and Profit Maximization

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

Chapter 8Slide 19 The Competitive Firm Profit Maximization  MC(q) = MR = P Marginal Revenue, Marginal Cost, and Profit Maximization

Chapter 8Slide 20 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

Chapter 8Slide 21 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

Chapter 8Slide 22 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.

Chapter 8Slide 23 A Competitive Firm’s Short-Run Supply Curve Price ($ per unit) Output MC AVC ATC P = AVC What happens if P < AVC? P2P2 q2q2 P1P1 q1q1 The firm chooses the output level where MR = MC, as long as the firm is able to cover its variable cost of production.

Chapter 8Slide 24 Price ($ per unit) MC Output AVC ATC P = AVC P1P1 P2P2 q1q1 q2q2 S = MC above AVC A Competitive Firm’s Short-Run Supply Curve Shut-down

Chapter 8Slide 25 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. A Competitive Firm’s Short-Run Supply Curve

Chapter 8Slide 26 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. A Competitive Firm’s Short-Run Supply Curve

Chapter 8Slide 27 MC 2 q2q2 Input cost increases and MC shifts to MC 2 and q falls to q 2. MC 1 q1q1 The Response of a Firm to a Change in Input Price Price ($ per unit) Output $5 Savings to the firm from reducing output

Chapter 8Slide 28 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?

Chapter 8Slide 29 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

Chapter 8Slide 30 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.

Chapter 8Slide 31 Producer Surplus in the Short-Run The Short-Run Market Supply Curve

Chapter 8Slide 32 D P*P*P*P* Q*Q*Q*Q* ProducerSurplus Market producer surplus is the difference between P* and S from 0 to Q *. Producer Surplus for a Market Price ($ per unit of output) OutputS

Chapter 8Slide 33 Choosing Output in the Long Run In the long run, a firm can alter all its inputs, including the size of the plant. We assume free entry and free exit.

Chapter 8Slide 34 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

Chapter 8Slide 35 q1q1 A B C D Output Choice in the Long Run Price ($ per unit of output) Output P = MR $40 SAC SMC Question: Is the producer making a profit after increased output lowers the price to $30? q3q3 q2q2 G F $30 LAC E LMC

Chapter 8Slide 36 Choosing Output in the Long Run Accounting Profit & Economic Profit Accounting profit = R - wL Economic profit = R - wL - rK  wL = labor cost  rK = opportunity cost of capital

Chapter 8Slide 37 Choosing Output in the Long Run Zero-Profit If R > wL + rK, economic profits are positive If R = wL + rK, zero economic profits, but the firm is earning a normal rate of return; indicating the industry is competitive If R < wL + rK, consider going out of business Long-Run Competitive Equilibrium

Chapter 8Slide 38 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

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

Chapter 8Slide 40 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

Chapter 8Slide 41 Choosing Output in the Long Run Economic Rent Economic rent is the difference between what firms are willing to pay for an input less the minimum amount necessary to obtain it.

Chapter 8Slide 42 Choosing Output in the Long Run An Example Two firms A & B Both own their land A is located on a river which lowers A’s shipping cost by $10,000 compared to B. The demand for A’s river location will increase the price of A’s land to $10,000

Chapter 8Slide 43 The shape of the long-run supply curve depends on the extent to which changes in industry output affect the prices the firms must pay for inputs. The Industry’s Long-Run Supply Curve

Chapter 8Slide 44 The Industry’s Long-Run Supply Curve To determine long-run supply, we assume: All firms have access to the available production technology. Output is increased by using more inputs, not by invention.

Chapter 8Slide 45 The Industry’s Long-Run Supply Curve To determine long-run supply, we assume: The market for inputs does not change with expansions and contractions of the industry.

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 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.

Chapter 8Slide 47 In a constant-cost industry, long-run supply is a horizontal line at a price that is equal to the minimum average cost of production. Long-Run Supply in a Constant-Cost Industry

Long-Run Supply in an Increasing-Cost Industry Output $ per unit of output $ per unit of output S1S1 D1D1 P1P1 AC 1 P1P1 MC 1 q1q1 Q1Q1 A SLSLSLSL P3P3 MC 2 Due to the increase in input prices, long-run equilibrium occurs at a higher price. AC 2 B S2S2 P3P3 Q3Q3 q2q2 P2P2 P2P2 D1D1 Q2Q2

S2S2 B SLSL P3P3 Q3Q3 MC 2 P3P3 AC 2 Due to the decrease in input prices, long-run equilibrium occurs at a lower price. Long-Run Supply in an Decreasing-Cost Industry Output $ per unit of output $ per unit of output P1P1 P1P1 MC 1 A D1D1 S1S1 Q1Q1 q1q1 AC 1 Q2Q2 q2q2 P2P2 P2P2 D2D2

Chapter 8Slide 50 Effect of an Output Tax on a Competitive Firm’s Output 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 firm’s marginal cost by the amount of the tax.

Chapter 8Slide 51 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.

Chapter 8Slide 52 Long-Run Elasticity of Supply 1)Constant-cost industry  Long-run supply is horizontal  Small increase in price will induce an extremely large output increase The Industry’s Long-Run Supply Curve

Chapter 8Slide 53 Long-Run Elasticity of Supply 1)Constant-cost industry  Long-run supply elasticity is infinitely large  Inputs would be readily available The Industry’s Long-Run Supply Curve

Chapter 8Slide 54 Long-Run Elasticity of Supply 2)Increasing-cost industry  Long-run supply is upward-sloping and elasticity is positive  The slope (elasticity) will depend on the rate of increase in input cost  Long-run elasticity will generally be greater than short-run elasticity of supply The Industry’s Long-Run Supply Curve

Chapter 8Slide 55 Question: Describe the long-run elasticity of supply in a decreasing-cost industry. The Industry’s Long-Run Supply Curve