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1
Profit Maximization
Chapter 8
2
PERFECTLY COMPETITIVE MARKETS
• The model of perfect competition rests on three basic assumptions:
(1) price taking,(2) product homogeneity, and (3) free entry and exit.
Price Taking
Because each individual firm sells a sufficiently small proportion of total market output, its decisions have no impact on market price.
price taker Firm that has no influence over market price
and thus takes the price as given.
3
Product Homogeneity
When the products of all of the firms in a market are perfectly substitutable with one another—that is, when they are homogeneous—no firm can raise the price of its product above the price of other firms without losing most or all of its business.
free entry (or exit) Condition under which there are no special costs that make it difficult for a firm to enter (or exit) an industry.When Is a Market Highly Competitive?
Because firms can implicitly or explicitly collude in setting prices, the presence of many firms is not sufficient for an industry to approximate perfect competition.
Conversely, the presence of only a few firms in a market does not rule out competitive behavior.
4
Profit Maximization
• Do firms maximize profits?– Managers in firms may be concerned with other
objectives• Revenue maximization• Revenue growth• Dividend maximization• Short-run profit maximization (due to bonus or
promotion incentive)– Could be at expense of long run profits
5
Marginal Revenue, Marginal Cost, and Profit Maximization
• We can study profit maximizing output for any firm whether perfectly competitive or not– Profit () = Total Revenue - Total Cost– If q is output of the firm, then total revenue is price of the
good times quantity– Total Revenue (R) = P*q
Costs of production depends on outputTotal Cost (C) = C*q
Profit for the firm, , is difference between revenue and costs
)()()( qCqRq
6
MARGINAL REVENUE, MARGINAL COST,AND PROFIT MAXIMIZATION
• Revenue is curved showing that a firm can only sell more if it lowers its price
• Slope in revenue curve is the marginal revenue– Change in revenue resulting from a one-unit increase in
output• Slope of total cost curve is marginal cost
– Additional cost of producing an additional unit of output
Δπ/Δq = ΔR/Δq − ΔC/Δq = 0
MR(q) = MC(q)
Profit Maximization by a Competitive Firm
MC(q) = MR = P
7
Profit Maximization – Short Run
Profits are maximized where MR (slope at A) and MC (slope at B) are equal
Profits are maximized where R(q) – C(q) is maximizedR(q)
C(q)
(q)
Cost,Revenue,
Profit($s per
year)
Output q*q0
A
B
8
Marginal Revenue, Marginal Cost, and Profit Maximization
• Profit is maximized at the point at which an additional increment to output leaves profit unchanged
MCMR
MCMR
q
C
q
R
q
CR
0
0
9
The Competitive Firm
• The Competitive Firm– Price taker – market price and output determined from
total market demand and supply– Market output (Q) and firm output (q)– Market demand (D) and firm demand (d)
• Demand curve faced by an individual firm is a horizontal line– Firm’s sales have no effect on market price
• Demand curve faced by whole market is downward sloping– Shows amount of good all consumers will purchase at
different prices
10
The Competitive Firm• Demand curve faced by an individual firm is a horizontal line
– Firm’s sales have no effect on market price• Demand curve faced by whole market is downward sloping
– Shows amount of good all consumers will purchase at different prices
The competitive firm’s demand
Individual producer sells all units for $4 regardless of that producer’s level of output.
MR = P with the horizontal demand curve
For a perfectly competitive firm, profit maximizing output occurs when
ARPMRqMC )(
11
A Competitive Firm
10
20
30
40
Price
50
0 1 2 3 4 5 6 7 8 9 10 11Output
AR=MR=P
MC
q*q1 q2
AVC
ATC
Lost Profit for q2>q*Lost Profit
for q2>q*
q1 : MR > MCq2: MC > MRq0: MC = MR
12
A Competitive Firm – Positive Profits
q2
MC
AVC
ATC
q*
AR=MR=PA
q1
10
20
30
40
Price
50
0 1 2 3 4 5 6 7 8 9 10 11Output
Total Profit = ABCD
Profits are determined by output per unit times
quantity
Profit per unit
= P-AC(q) = A to B
13
A Competitive Firm – Positive Profits
• A firm does not have to make profits• It is possible a firm will incur losses if the P < AC for
the profit maximizing quantity– Still measured by profit per unit times quantity– Profit per unit is negative (P – AC < 0)
Summary of Production Decisions
Profit is maximized when MC = MR
If P > ATC the firm is making profits.
If P < ATC the firm is making losses
14
A Competitive Firm – Losses
BC
AVC
ATCMC
P = MRD
q*
A
Output
Price
At q*: MR = MC and P <
ATCLosses =
(P- AC) x q* or ABCD
15
Competitive Firm – Short Run Supply
• When should the firm shut down?– If AVC < P < ATC the firm should continue producing in
the short run• Can cover some of its variable costs and all of its
fixed costs– If AVC > P < ATC the firm should shut-down.
• Can not cover even its fixed costs
Supply curve tells how much output will be produced at different pricesCompetitive firms determine quantity to produce where P = MC
Firm shuts down when P < AVCCompetitive firms supply curve is portion of the marginal cost curve above the AVC curve
16
A Competitive Firm’s Short-Run Supply Curve
AVC
ATC
S
P = AVC
P1
q1
P2
q2
MC
Price($ per
unit)
Output
Supply is MC above AVC
The firm chooses theoutput level where P = MR = MC,
as long as P > AVC.
17
Elasticity of Market Supply
• Elasticity of Market Supply– Measures the sensitivity of industry output to
market price– The percentage change in quantity supplied, Q, in
response to 1-percent change in price
)//()/( PPQQEs
18
Producer Surplus versus Profit
• Profit is revenue minus total cost (not just variable cost)
• When fixed cost is positive, producer surplus is greater than profit
VC- R PS Surplus Producer
FC - VC- R - Profit
19
Output Choice in the Short Run
q1
BC
AD
Output
SACSMC
q3q2
$30
LAC
LMC
P = MR$40
Price
20
Output Choice in the Long Run
Price
Outputq1
BC
ADP = MR$40
SACSMC
q3q2
$30
LAC
LMC
FG
In the long run, the plant size will be increased and output increased to q3.
Long-run profit, EFGD > short runprofit ABCD.
21
long-run competitive equilibrium• Accounting profit
– Difference between firm’s revenues and direct costs
• Economic profit– Difference between firm’s revenues and direct
and indirect costs– Takes into account opportunity costs
22
long-run competitive equilibrium• Firm uses labor (L) and capital (K) with purchased
capital• Accounting Profit & Economic Profit
– Accounting profit: = R - wL– Economic profit: = R = wL - rK
• wl = labor cost• rk = opportunity cost of capital
23
Long-Run Competitive Equilibrium
1. All firms in industry are maximizing profits– MR = MC
2. No firm has incentive to enter or exit industry– Earning zero economic profits
3. Market is in equilibrium– QD = QD
24
Firms Earn Zero Profit in Long-Run Equilibrium
$10$10
Economic Rent
$7.20$7.20A team with the samecost in a larger citysells tickets for $10.
Season TicketsSales (millions)
LACLMC
TicketPrice
1.31.3
25
The Industry’s Long-Run Supply Curve
• To analyze long-run industry supply, will need to distinguish between three different types of industries1.Constant-Cost2.Increasing-Cost3.Decreasing-Cost
26
Constant-Cost Industry
Industry whose long-run supply curve is horizontal
Assume a firm is initially in equilibrium
Demand increases causing price to increaseIndividual firms increase supply
Causes firms to earn positive profits in short-runSupply increases causing market price to decrease
Long run equilibrium – zero economic profits
27
Increasing-Cost Industry
• Prices of some or all inputs rises as production is expanded when demand of inputs increases
• When demand increases causing prices to increase and production to increase– Firms enter the market increasing demand for
inputs– Costs increase causing an upward shift in supply
curves– Market supply increases but not as much
28
Decreasing-Cost Industry
• Industry whose long-run supply curve is downward sloping
• Increase in demand causes production to increase– Increase in size allows firm to take advantage
of size to get inputs cheaper– Increased production may lead to better
efficiencies or quantity discounts– Costs shift down and market price falls