Profit Maximization

Chapter 8
Profit Maximization and Competitive Supply
Topics to be Discussed

Perfectly Competitive Markets Profit Maximization Marginal Revenue, Marginal Cost, and Profit Maximization Choosing Output in the Short-Run
Chapter 8
Slide 2
Topics to be Discussed
The Competitive Firms Short-Run Supply Curve
Short-Run Market Supply

Choosing Output in the Long-Run The Industrys Long-Run Supply Curve
Chapter 8
Slide 3
Perfectly Competitive Markets
Characteristics of Perfectly Competitive Markets
1) Price taking
2) Product homogeneity 3) Free entry and exit
Chapter 8
Slide 4
Price Taking
The
individual firm sells a very small share of the total market output and, therefore, cannot influence market price. individual consumer buys too small a share of industry output to have any impact on market price.
The
Chapter 8
Slide 5
Product Homogeneity
The
products of all firms are perfect substitutes.
Examples
Agricultural products, oil, copper, iron, lumber
Chapter 8
Slide 6
Free Entry and Exit

Buyers
can easily switch from one supplier to another. can easily enter or exit a market.
Suppliers
Chapter 8
Slide 7
Discussion Questions
What Are
are some barriers to entry and exit?
all markets competitive? is a market highly competitive?
When
Chapter 8
Slide 8
Profit Maximization
Do firms maximize profits?

Possibility

of other objectives
Revenue maximization Dividend maximization
Short-run profit maximization
Chapter 8
Slide 9
Profit Maximization

Implications
of non-profit objective
Over the long-run investors would not support the company Without profits, survival unlikely
Chapter 8
Slide 10
Profit Maximization

Long-run
profit maximization is valid and does not exclude the possibility of altruistic behavior.
Chapter 8
Slide 11
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:
(q) R(q) C (q)

Chapter 8 Slide 12
Profit Maximization in the Short Run

Cost, Revenue, Profit ($s per year)
Total Revenue
R(q)
Slope of R(q) = MR
0
Output (units per year) Chapter 8 Slide 13
Profit Maximization in the Short Run

C(q)
Cost, Revenue, Profit $ (per year)
Total Cost
Slope of C(q) = MC
Why is cost positive when q is zero? 0

Output (units per year) Chapter 8 Slide 14
Marginal revenue is the additional revenue from producing one more unit of output. Marginal cost is the additional cost from producing one more unit of output.
Chapter 8
Slide 15
Comparing R(q) and C(q)
Output levels: 0- q0:
C(q)> R(q)
Cost, Revenue, Profit ($s per year)
C(q) A B R(q)
Negative profit
FC + VC > R(q)
MR > MC
Indicates higher profit at higher output
q0
q*
(q)
Output (units per year)
Chapter 8
Slide 16
Question: Why is profit negative when output is zero?
C(q) A B R(q)
q0
q*
(q)
Chapter 8
Slide 17
Output levels: q0 - q*

R(q)> C(q) MR > MC
C(q) A B R(q)
Indicates higher profit at higher output Profit is increasing 0 q0
q*
(q)
Chapter 8
Slide 18
Output level: q*

R(q)= C(q) MR = MC
C(q) A B R(q)
Profit is maximized
q0
q*
(q)
Chapter 8
Slide 19
Question
Why is profit reduced when producing more or less than q*?
C(q) A B R(q)
q0
q*
(q)
Chapter 8
Slide 20
Output levels beyond q*:

R(q)> C(q) MC > MR
C(q) A B R(q)
Profit is decreasing
q0
q*
(q)
Chapter 8
Slide 21
Therefore, it can be said:
C(q) A B R(q)
Profits are maximized when MC = MR.
q0
q*
(q)
Chapter 8
Slide 22
R-C
R MR q
C MC q
Chapter 8 Slide 23
Profits are maximized when : R C 0 or q q q
MR MC 0 so that MR(q) MC(q)

Chapter 8 Slide 24
The Competitive Firm

Price
taker
output (Q) and firm output (q)
Market
Market
R(q)
demand (D) and firm demand (d)
is a straight line
Chapter 8
Slide 25
Demand and Marginal Revenue Faced by a Competitive Firm

Price $ per bushel
Firm
Price $ per bushel
Industry
$4
$4
D 100 200
Output (bushels)
100
Output (millions of bushels)

The
competitive firms demand
Individual producer sells all units for $4 regardless of the producers level of output. If the producer tries to raise price, sales are zero.
Chapter 8
Slide 27

The
competitive firms demand
If the producers tries to lower price he cannot increase sales P = D = MR = AR
Chapter 8
Slide 28

Profit
Maximization
MC(q) = MR = P
Chapter 8
Slide 29
Choosing Output in the Short Run
We will combine production and cost analysis with demand to determine output and profitability.
Chapter 8
Slide 30
A Competitive Firm Making a Positive Profit

Price 60 ($ per unit)
50
MC
D
40
Lost profit for q q < q* A B
Lost profit for q 2 > q* ATC
AR=MR=P
C
30
q1 : MR > MC and q2: MC > MR20 and q0: MC = MR but MC falling 10 0
Chapter 8
AVC At q*: MR = MC and P > ATC
(P - AC) x q*
or ABCD
1 2 3 4 5 6 7 8 9 10 11
q0
q1
q*
q2
Output
Slide 31
A Competitive Firm Incurring Losses

Price ($ per unit) C D
At q*: MR = MC and P < ATC Losses = P- AC) x q* or ABCD
MC B
ATC
P = MR AVC
Would this producer continue to produce with a loss?
q*
Chapter 8
Output
Slide 32
Choosing Output in the Short Run
Summary of Production Decisions

Profit
is maximized when MC = MR
If
If
P > ATC the firm is making profits.
AVC < P < ATC the firm should produce at a loss. P < AVC < ATC the firm should shutdown.
Slide 33
If
Chapter 8
Some Cost Considerations for Managers
Three guidelines for estimating marginal cost:
1) Average variable cost should not be used as a substitute for marginal cost.
Chapter 8
Slide 34
2) A single item on a firms accounting ledger may have two components, only one of which involves marginal cost.
Chapter 8
Slide 35
3) All opportunity cost should be included in determining marginal cost.
Chapter 8
Slide 36
A Competitive Firms Short-Run Supply Curve

Price ($ per unit)
The firm chooses the output level where MR = MC, as long as the firm is able to cover its variable cost of production.
MC ATC AVC
P2 P1
P = AVC
What happens if P < AVC?
q1
Chapter 8
q2 Output
Slide 37
Observations:
P = MR
MR = MC
P = MC
Supply is the amount of output for every possible price. Therefore:

If P = P1, then q = q1
If P = P2, then q = q2
Slide 38
Chapter 8

Price ($ per unit)
S = MC above AVC
MC P2 P1 ATC AVC
P = AVC Shut-down q1
Chapter 8
q2
Output Slide 39
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.
Chapter 8
Slide 40
Firms Response to an Input Price Change
When the price of a firms product changes, the firm changes its output level, so that the marginal cost of production remains equal to the price.
Chapter 8
Slide 41
The Response of a Firm to a Change in Input Price

Price ($ per unit)
MC2
Savings to the firm from reducing output
Input cost increases and MC shifts to MC2 and q falls to q2.
MC1 $5
q2
Chapter 8
q1
Output
Slide 42
The Short-Run Production of Petroleum Products

Cost ($ per barrel) 27
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.
SMC
26 How much would be produced if P = $23? P = $24-$25?
25
24
23
8,000 Chapter 8 9,000 10,000 11,000
Output (barrels/day) Slide 43
Stepped SMC indicates a different production (cost) process at various capacity levels. Observation:
With a stepped MC function, small changes in price may not trigger a change in output.
Chapter 8
Slide 44
The short-run market supply curve shows the amount of output that the industry will produce in the short-run for every possible price. Consider, for simplicity, a competitive market with three firms:
Chapter 8
Slide 45
Industry Supply in the Short Run

$ per unit MC1 MC2 MC3
The short-run industry supply curve is the horizontal summation of the supply curves of the firms.
P3
P2 P1
Question: If increasing output raises input costs, what impact would it have on market supply?
0
Chapter 8
4 5
7 8
10
15
Quantity 21
Slide 46
The Short-Run Market Supply Curve
Elasticity of Market Supply
E s ( Q / Q ) /( P / P )
Chapter 8
Slide 47
Perfectly inelastic short-run supply arises when the industrys plant and equipment are so fully utilized that new plants must be built to achieve greater output.
Perfectly elastic short-run supply arises when marginal costs are constant.
Chapter 8
Slide 48
Questions 1) Give an example of a perfectly inelastic supply. 2) If MC rises rapidly, would the supply be more or less elastic?
Chapter 8
Slide 49
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.
Chapter 8
Slide 50
Producer Surplus for a Firm

Price ($ per unit of output)
At q* MC = MR. Between 0 and q , MR > MC for all units.
Producer Surplus
MC B
AVC
Alternatively, VC is the sum of MC or ODCq* . R is P x q* or OABq*. Producer surplus = R - VC or ABCD.
0
Chapter 8
q*
Output Slide 51
Producer Surplus in the Short-Run
Producer Surplus PS R - VC
Profit - R - VC - FC
Chapter 8 Slide 52
Observation
Short-run
with positive fixed cost
PS
Chapter 8
Slide 53
Producer Surplus for a Market

P*
Market producer surplus is the difference between P* and S from 0 to Q*.
Producer Surplus
D
Output
Slide 54
Q*
Chapter 8
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 8
Slide 55
Output Choice in the Long Run

In the long run, the plant size will be increased and output increased to q3. Long-run profit, EFGD > short run profit ABCD.
LMC
LAC
SMC D $40 C G $30

In the short run, the firm is faced with fixed inputs. P = $40 > ATC. Profit is equal to ABCD.
SAC A
E
B F
P = MR
q1
Chapter 8
q2
q3
Output Slide 56
Output Choice in the Long Run

Question: Is the producer making a profit after increased output lowers the price to $30?
LMC
LAC
SMC D $40 C G $30 B F SAC A
P = MR
q1
Chapter 8
q2
q3
Output Slide 57
Accounting Profit & Economic Profit

Accounting profit ( ) = R - wL Economic profit ( ) = R = wL - rK
wl
= labor cost opportunity cost of capital
rk =
Chapter 8
Slide 58

Long-Run Competitive Equilibrium
Zero-Profit

If R > wL + rk, economic profits are positive
If R = wL + rk, zero economic profits, but the firms is earning a normal rate of return; indicating the industry is competitive If R < wl + rk, consider going out of business
Slide 59
Chapter 8

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.
Chapter 8
Slide 60

Profit attracts firms Supply increases until profit = 0
$ per unit of output
Firm
Industry S1
LMC
$40
LAC
P1
S2
$30
P2
D q2
Output
Q1
Q2
Output
Long-Run Competitive Equilibrium 1) MC = MR 2) P = LAC

No incentive to leave or enter Profit = 0
3) Equilibrium Market Price

Chapter 8 Slide 62
Questions 1) Explain the market adjustment when P < LAC and firms have identical costs. 2) Explain the market adjustment when firms have different costs. 3) What is the opportunity cost of land?
Chapter 8
Slide 63
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 8
Slide 64
An Example
Two
firms A & B
Both
A
own their land
is located on a river which lowers As shipping cost by $10,000 compared to B. demand for As river location will increase the price of As land to $10,000
Slide 65
The
Chapter 8
An Example
Economic
rent = $10,000
$10,000 - zero cost for the land

rent increases
Economic
Economic
profit of A = 0
Chapter 8
Slide 66
Firms Earn Zero Profit in Long-Run Equilibrium

Ticket Price
A baseball team in a moderate-sized city sells enough tickets so that price is equal to marginal and average cost (profit = 0).
LMC
LAC
$7
1.0
Chapter 8
Season Tickets Sales (millions)
Slide 67

Ticket Price
Economic Rent
LMC
LAC
$10 $7
A team with the same cost in a larger city sells tickets for $10.
1.3
Chapter 8
Season Tickets Sales (millions)
Slide 68
With a fixed input such as a unique location, the difference between the cost of production (LAC = 7) and price ($10) is the value or opportunity cost of the input (location) and represents the economic rent from the input.
Chapter 8
Slide 69
If the opportunity cost of the input (rent) is not taken into consideration it may appear that economic profits exist in the long-run.
Chapter 8
Slide 70
The Industrys Long-Run Supply Curve
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.
Chapter 8
Slide 71
To determine long-run supply, we assume:

All
firms have access to the available production technology.

is increased by using more inputs, not by invention.
Output
Chapter 8
Slide 72
To determine long-run supply, we assume:

The
market for inputs does not change with expansions and contractions of the industry.
Chapter 8
Slide 73
Long-Run Supply in a Constant-Cost Industry

Economic profits attract new firms. Supply increases to S2 and the market returns to long-run equilibrium.
Q1 increase to Q2. Long-run supply = SL = LRAC. Change in output has no impact on input cost.
MC
AC
S1 C A B
S2
P2
P1
P2
P1
SL
D1 q1 q2
Output
D2
Output
Q1
Q2
Long-Run Supply in a Constant-Cost Industry
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.
Chapter 8
Slide 75
Long-Run Supply in an Increasing-Cost Industry

$ per unit of output $ per unit of output
Due to the increase in input prices, long-run equilibrium occurs at a higher price.
SMC2
LAC2 SMC1 LAC1
S1 S2
SL
P2 P3 P1
P2 P3 P1 A B
D1 q1 q2
Q1 Q2 Q3
D1
Output
Output
Long-Run Supply in a Increasing-Cost Industry
In a increasing-cost industry, long-run supply curve is upward sloping.
Chapter 8
Slide 77
Questions 1) Explain how decreasing-cost is possible. 2) Illustrate a decreasing cost industry. 3) What is the slope of the SL in a decreasing-cost industry?
Chapter 8
Slide 78
Long-Run Supply in an Decreasing-Cost Industry

$ per unit of output SMC1 SMC2 LAC1 $ per unit of output
Due to the decrease in input prices, long-run equilibrium occurs at a lower price.
S1
S2
P2
P1 P3
LAC2
P2
P1 P3 A B SL D1 q1 q2
Q1 Q2 Q3
D2
Output
Output
Long-Run Supply in a Increasing-Cost Industry
In a decreasing-cost industry, long-run supply curve is downward sloping.
Chapter 8
Slide 80
The Effects of a Tax
In an earlier chapter we studied how firms respond to taxes on an input. Now, we will consider how a firm responds to a tax on its output.
Chapter 8
Slide 81
Effect of an Output Tax on a Competitive Firms Output

MC2 = MC1 + tax

An output tax raises the firms marginal cost by the amount of the tax.
MC1
The firm will reduce output to the point at which the marginal cost plus the tax equals the price.
P1
AVC2
AVC1
q2
Chapter 8
q1
Output Slide 82
Effect of an Output Tax on Industry Output

S2 = S1 + t S1
P2
P1
t Tax shifts S1 to S2 and output falls to Q2. Price increases to P2.
D Q2
Chapter 8
Q1
Output Slide 83
Long-Run Elasticity of Supply 1) Constant-cost industry

Long-run Small
supply is horizontal
increase in price will induce an extremely large output increase
Chapter 8
Slide 84
Long-Run Elasticity of Supply 1) Constant-cost industry
Long-run supply elasticity is infinitely large Inputs would be readily available
Chapter 8
Slide 85
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
Slide 86
Chapter 8
Question:
Describe the long-run elasticity of supply in a decreasing -cost industry.
Chapter 8
Slide 87
Summary
The managers of firms can operate in accordance with a complex set of objectives and under various constraints. A competitive market makes its output choice under the assumption that the demand for its own output is horizontal.
Chapter 8
Slide 88
Summary
In the short run, a competitive firm maximizes its profit by choosing an output at which price is equal to (shortrun) marginal cost. The short-run market supply curve is the horizontal summation of the supply curves of the firms in an industry.
Chapter 8
Slide 89
Summary
The producer surplus for a firm is the difference between revenue of a firm and the minimum cost that would be necessary to produce the profitmaximizing output. Economic rent is the payment for a scarce resource of production less the minimum amount necessary to hire that factor.
Slide 90
Chapter 8
Summary
In the long-run, profit-maximizing competitive firms choose the output at which price is equal to long-run marginal cost. The long-run supply curve for a firm can be horizontal, upward sloping, or downward sloping.
Chapter 8
Slide 91
End of Chapter 8
Profit Maximization and Competitive Supply

Profit Maximization

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Chapter 8

Profit Maximization and Competitive Supply

The Competitive Firms Short-Run Supply Curve

Short-Run Market Supply

Perfectly Competitive Markets

Characteristics of Perfectly Competitive Markets

Perfectly Competitive Markets

Perfectly Competitive Markets

products of all firms are perfect substitutes.

Agricultural products, oil, copper, iron, lumber

Perfectly Competitive Markets

Free Entry and Exit

Perfectly Competitive Markets

are some barriers to entry and exit?

all markets competitive? is a market highly competitive?

Do firms maximize profits?

Revenue maximization Dividend maximization

Short-run profit maximization

Do firms maximize profits?

Do firms maximize profits?

Marginal Revenue, Marginal Cost, and Profit Maximization

Determining the profit maximizing level of output

Profit ( ) = Total Revenue - Total Cost

(q) R(q) C (q)

Profit Maximization in the Short Run

Profit Maximization in the Short Run

Why is cost positive when q is zero? 0

Marginal Revenue, Marginal Cost, and Profit Maximization

Marginal Revenue, Marginal Cost, and Profit Maximization

Comparing R(q) and C(q)

Output levels: 0- q0:

Cost, Revenue, Profit ($s per year)

Indicates higher profit at higher output

Output (units per year)

Marginal Revenue, Marginal Cost, and Profit Maximization

Comparing R(q) and C(q)

Question: Why is profit negative when output is zero?

Cost, Revenue, Profit $ (per year)

Output (units per year)

Marginal Revenue, Marginal Cost, and Profit Maximization

Comparing R(q) and C(q)

R(q)> C(q) MR > MC

Cost, Revenue, Profit $ (per year)

Indicates higher profit at higher output Profit is increasing 0 q0

Output (units per year)

Marginal Revenue, Marginal Cost, and Profit Maximization

Comparing R(q) and C(q)

Cost, Revenue, Profit $ (per year)

Output (units per year)

Marginal Revenue, Marginal Cost, and Profit Maximization

Why is profit reduced when producing more or less than q*?

Cost, Revenue, Profit $ (per year)

Output (units per year)

Marginal Revenue, Marginal Cost, and Profit Maximization

Comparing R(q) and C(q)

Output levels beyond q*:

R(q)> C(q) MC > MR

Cost, Revenue, Profit $ (per year)

Output (units per year)

Marginal Revenue, Marginal Cost, and Profit Maximization

Therefore, it can be said:

Cost, Revenue, Profit $ (per year)

Profits are maximized when MC = MR.

Output (units per year)