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1 Profit Maximization 1

14.01 Principles of Microeconomics, Fall 2007

Chia-Hui Chen

October 19, 2007

Lecture 15
Short Run and Long Run Supply

Outline
1. Chap 8: Profit Maximization
2. Chap 8: Short Run Supply
3. Chap 8: Producer Surplus
4. Chap 8: Long Run Competitive Equilibrium

1 Profit Maximization
For perfect competition in a product market, we make some assumptions:
• Price taking: either individual firms or consumers cannot affect the price.
• Product homogeneity: product of all firms are perfect substitutes.
• Free entry and exit: no special cost to enter or exit the market.
Firms choose the level of output to maximize their profits. Profit equals
total revenue minus total cost, namely

π(q) = R(q) − C(q) = P (q)q − C(q).

To maximize the profit, the following condition must hold:


dπ(q) dR dC
= − = M R(q) − M C(q) = 0,
dq dq dq
and thus
M R(q) = M C(q).
Since
R(q) = P q,
we have
dR(q)
M R(q) = = P,
dq
and
M R = AR,

Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT
OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month
YYYY].
2 Short Run Supply 2

thus
M C(q) = P = M R = AR
is the maximization condition. Note that the condition is not sufficient. In
Figure 1), if the price is P2 , q2 and q3 both satisfy the condition, but only q3
maximizes the profit.

10

7 P1
6

MC
C

2
P 2
1
q q q1
2 3
0
0 1 2 3 4 5 6 7 8 9 10
q

Figure 1: Profit Maximization.

2 Short Run Supply


Assume the firm has production costs shown in Figure 2, let us discuss its
behavior under different prices.
• When P = P1 , the firm is making profits, so it will continue to produce;
• When P = P2 , the firm has losses but still continues to produce, because if
it shuts down, the profit is −F C, and if continuing to produce, the profit
is R − T V C − F C > −F C.
• Since R < SV C, when P = P3 , the profit if the firm shuts down, −F C, is
more than the profit if it continues, R − T V C − F C, so it will shut down.
When the firm produces, it chooses the output level where M C(q) = P . There­
fore, the firm’s supply curve when it produces is just the part of M C above
T V C. When P < AV C, the firm shuts down and q = 0.
We can derive market supply from an individual firm’s supply (see Figure 3).
Define elasticity of market supply as follows:

dQ/Q
ES = .
dP/P

Figure 4 and 5 stand for inelastic and elastic supply curves, respectively.

Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT
OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month
YYYY].
2 Short Run Supply 3

10

8 MC

P1
7

6 ATC

5
C

P2
3

2 AVC
P3

0
0 1 2 3 4 5 6 7 8 9 10
q

Figure 2: Individual Firm’s Supply in Short Run.

10

6 MC1

Market Supply
5 MC2
P

0
0 1 2 3 4 5 6 7 8 9 10
q

Figure 3: Market Supply in Short Run.

Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT
OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month
YYYY].
2 Short Run Supply 4

10

5 MC
P

0
0 1 2 3 4 5 6 7 8 9 10
q

Figure 4: Inelastic Market Supply Curve.

10

6 MC

5
P

0
0 1 2 3 4 5 6 7 8 9 10
q

Figure 5: Elastic Market Supply Curve.

Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT
OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month
YYYY].
2 Short Run Supply 5

10

6
P

0
0 1 2 3 4 5 6 7 8 9 10
q

Figure 6: Perfectly Inelastic Market Supply Curve.

10

6
P

0
0 1 2 3 4 5 6 7 8 9 10
q

Figure 7: Perfectly Elastic Market Supply Curve.

Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT
OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month
YYYY].
3 Producer Surplus 6

Similarly, we have perfectly inelastic market supply (see Figure 6) and perfectly
elastic market supply (see Figure 7).
Perfectly elastic market supply happens when

M C = const.

3 Producer Surplus
Producer Surplus is the difference between the firm’s revenue and the sum of
the total variable cost of producing q (see Figure 8):

P S = R − T V C = R − T V C − F C + F C = P rof it + F C.

Thus, producer surplus is the sum of profit and fixed cost.

6 MC

4
P

3 AVC

0
0 1 2 3 4 5 6 7 8
q

Figure 8: Producer Surplus.

Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT
OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month
YYYY].