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Economic Principles I

Lecture 11:

Profit Maximisation in Conditions ofPerfect Competition

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Perfect Competition

A (perfectly) competitive market

Many buyers and sellers

Goods are largely the same(homogeneous)

So no one buyer or seller can influence

price, and must take the market price asgiven

Free entry and exit

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What does the Firm Earn?

Revenue

Total Revenue = Price times Quantity of Output

TR = P.Q

Average Revenue = Total Revenue divided by

Output

AR = TR/Q= (P.Q)/Q = P Marginal Revenue is the extra revenue from

selling another unit of output

MR = TR/Q

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The Soft Drinks Example again

No of Soft

Drinks Price

Total

Revenue

Average

Revenue

Marginal

Revenue

Q P TR=P.Q AR=TR/Q MR=TR/Q1 2 2 2

2 2 4 2 2

3 2 6 2 2

4 2 8 2 2

5 2 10 2 26 2 12 2 2

7 2 14 2 2

8 2 16 2 2

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Putting these Ideas together:

Because price doesnt change with output,

average and marginal revenue are constant

For a competitive firm marginal revenue

equals the price of the good

The firms objective is to maximise profits,

so we need to match together this revenueinformation with cost information

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Where Profit is Maximised

No of Soft

Drinks

Total

Revenue Total Cost Profit

Marginal

Revenue

Marginal

Cost

Q TR TC TR-TC MR=TR/Q MC=TC/Q1 2 3 -1

2 4 3.5 0.5 2 0.5

3 6 4.5 1.5 2 1

4 8 6 2 2 1.5

5 10 8 2 2 26 12 10.5 1.5 2 2.5

7 14 13.5 0.5 2 3

8 16 18 -2 2 4.5

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Changes at the Margin (1)

Why does profit fall at 6 units of output and

above?

The 6thdrink sold brings in extra(marginal)revenue of 2

But it incurs extra(marginal) cost of 2.50

So total profit must fall as it has cost more toproduce than it raises when sold

Rational people think at the margin!

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Changes at the Margin (2)

Why does profit rise up to 4 units of output?

The 3rddrink sold brings in marginal revenue of

2 But it only incurs marginal cost of 1.50

So total profit must rise as it has cost less toproduce than it raises when sold

Conclusion: the competitive firm maximisesprofits at the quantity of output wherepriceequals marginal cost

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Putting the Curves

Together At Q1P is

greater than

MC and soprofits rise if

output

increases

At Q2

MC is

greater than P

and so profits

rise if output

decreases

Qmaxis where

profits are

maximised

P=AR=MR

Costs and

Revenue

Quantity

0

MC1

MC2

Q1 Q2Qmax

MC ATC

AVC

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Market Equilibrium

We can now see how the competitive firmdecides how much to supply to the market

At any given price the profit maximising output isfound at the intersection of price and MC

So if the price the firm faces goes up, the chosenlevel of output rises in line with the MC curve

So the marginal cost curve is the competitive

firms supply curve

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Price Rises for

the Firm

Costs and

Revenue

Quantity

0

P1

P2

Q1 Q2

MC ATC

AVC

Increase in Pleads toincrease in

profitmaximisingoutput

MC curveshows quantity

supplied at anygiven price

MC curve is thefirms supplycurve

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Conclusion

We have looked at the competitive firm and

where it maximises profits

Profits are maximised at the level of outputwhere price equals marginal cost

The competitive firms supply curve is its

marginal cost curve

Lecture 13 will examine the firms decisions to

enter and to exit a market

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Economic Principles I

Lecture 11:

Profit Maximisation in Conditions ofPerfect Competition