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8.c.

The Calculus of Profit-Maximization by a Competitive Firm


Any profit-maximizing firm chooses inputs and outputs to maximize economic profits. By
definition, maximization of economic profits entails maximization of the difference between the firm's total
revenue and its total cost.

A firm's total revenue is defined as the quantity, Q, sold at a price, P(q):


TR(q) = P(q) Q

A firm's total costs are defined as the quantity of capital, K, used multiplied by the price of capital,
v, plus the quantity of labor, L, used multiplied by the price of labor (wage rate), w.
TC = vK + wL

Therefore, economic profits (), are defined as the difference between total revenue and total cost:
(q) = TR(q) TC(q)

Maximization of this equation is found by applying the derivative with respect to q and setting equal to 0:
(d )/(dq) = (dTR)/(dq) (dTC)/(dq) = 0
(dTR)/(dq) (dTC)/(dq) = 0
moving things around we get
(dTR)/(dq) = (dTC)/(dq)
or the derivative of total revenue with respect to q is equal to the derivative of total cost with
respect to q. The derivative of total revenue is marginal revenue, and the derivative of total cost is
marginal cost.
And thus you come to the profit maximizing equation of
MR = MC
In the case of a competitive firm, the firm is free to sell all the q it wants at the market price without the
firm having a notable affect on the market price. This is true because the firm is only one of many firms,
and so its output will have no effect on market price.
The demand curve is horizontal at price P, and at this price the demand curve is infinitely elastic, if the firm
chooses a price higher than P, it will sell nothing, and a price lower than P will capture the entire market. So
D = P and in the case of a competitive market, MR = P. This is crucial to remember, as it changes the profit
maximization equation into the following:
The original profit maximization equation is as follows:
= TR TC or Pq TC(q)
This yields
(d) / (dq) = MR MC = 0
Remember though that MR = P, and so
3.

(d) / (dq) = P MC = 0

furthermore

4.

P = MC

Equations 3 and 4 are the new profit maximization equations for a competitive firm.
Equation 4 also serves as the supply curve for the competitive firm, where the firm will supply only those
points along the marginal cost curve where (1) the marginal cost curve is rising, and (2) the point above
where the marginal cost curve intersects the average variable cost curve. A point on the marginal cost
curve below the average variable cost curve implies that the firm's profits cannot cover its AVC, and thus it
is better off producing nothing and losing only its fixed costs instead of losing both; this point is the firm's
shutdown price. (for a geometric interpretation of this, refer to section 8.2)
Practice Problems: section 8.c.
1.Q) A competitive firm faces a price of $6 and a total cost function of TC = 10 +2q 0.2q2 + 0.01q3.
a) Find MC, AVC, ATC, FC
b) Find the optimal quantity produced and *
c) Find the shutdown price
1.A)

a)

MC = (dTC)/(dq)
MC = 2 0.4q + 0.03q2
AVC = (VC)/(q)
VC = 2q 0.2q2 + 0.01q3
AVC = (2q/q) (0.2q2 / q) + (0.01q3 / q)
AVC = 2 0.2q + 0.01q2
ATC = (TC)/(q)
ATC = (10/q) +(2q/q) (0.2q2 /q) + (0.01q3/q)
ATC = (10/q) + 2 0.2q + 0.01q2
TC = FC + VC
FC = 10

b)

Optimal quantity is found at profit maximization, or when MR = MC or P =MC


6 = 2 0.4q + 0.03q2
0 = 0.03q2 - 0.4q 4
100 (0 = 0.03q2 - 0.4q 4)
0 = 3q2 40q 400
0 = (3q + 20) (q-20)
q* = 20
* = 6(20) [10+2(20) 0.2(20) 2 + 0.01(20)3]= 70

c)

Shutdown price occurs where MC = AVC or when the MC curve intersects the AVC
curve at its lowest point. That is, when (AVC/q) = 0
(AVC/q) = -0.2 + 0.02q = 0
q = 10
When q=10, or the shutdown point, P=MC=AVC, and so plugging q=10 into the MC
equation, we get P = 1.

2.Q) Renee owns a small factory that produces golf balls. The market price for golf balls is P, and
Renee's total costs are TC = 261.6323 + 0.47q + 0.00021q2,
a) Find her MC, AC, AVC, and FC

b) Find her short-run supply curve


c) Find her shutdown price and quantity
2.A)

a)

MC = (dTC)/(dq)
MC = 0.47 + 0.00021q
AC = (TC/q)
AC = (261.6323/q) + (0.47q/q) + (0.00021q2/q)
AC = (261.6323/q) + 0.47 + 0.00021q
AVC = (VC)/(q)
AVC = 0.47 + 0.00021q
TC = FC + VC
FC = 261.6323

b)

The short-run supply curve for a competitive firm is P = MC, so P = 0.47 + 0.00021q.
This however, is the inverse supply, to find the supply curve, express the equation as a
function of q, and so the supply curve is, q = 2380.952P 1119.048. This is the short-run
supply curve only when MC>AVC or when P>0.47.

c)

At shutdown, MC = AVC or the MC curve intersects the AVC curve at its lowest point.
That is, when (AVC/q) = 0.
0.47 + 0.00021q = 0.47 + 0.00021q
q=0
At shutdown price, MC = AVC and = P, so plugging q=0 into the MC equation, we get
MC = P = 0.47.