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
The Competitive Firm’s Short-Run Supply Curve
Short-Run Market Supply
Choosing Output in the Long-Run
The Industry’s Long-Run Supply Curve
Chapter 8 Slide 2
Perfectly Competitive Markets
Characteristics of Perfectly Competitive
Markets
1) Price taking
2) Product homogeneity
3) Free entry and exit
Chapter 8 Slide 3
Perfectly Competitive Markets
Price Taking
The individual firm sells a very small share
of the total market output and, therefore,
cannot influence market price.
The individual consumer buys too small a
share of industry output to have any impact
on market price.
Chapter 8 Slide 4
Perfectly Competitive Markets
Product Homogeneity
The products of all firms are perfect
substitutes.
Examples
Agricultural products, oil, copper, iron,
lumber
Chapter 8 Slide 5
Perfectly Competitive Markets
Free Entry and Exit
Buyers can easily switch from one supplier
to another.
Suppliers can easily enter or exit a market.
Chapter 8 Slide 6
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 7
Profit Maximization in the Short Run
Cost, Total Revenue
Revenue, R(q)
Profit
($s per year)
Slope of R(q) = MR
Output (units per year)
Chapter 8 Slide 8
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?
Output (units per year)
Chapter 8 Slide 9
Marginal Revenue, Marginal Cost,
and Profit Maximization
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 10
Marginal Revenue, Marginal Cost,
and Profit Maximization
Comparing R(q) and C(q)
Cost,
Output levels: 0- q0: Revenue,
Profit
($s per year) C(q)
C(q)> R(q) R(q)
A
Negative profit
FC + VC > R(q) B
MR > MC
Indicates higher
profit at higher
output 0 q0 q*
(q )
Output (units per year)
Chapter 8 Slide 11
Marginal Revenue, Marginal Cost,
and Profit Maximization
Comparing R(q) and C(q)
Cost,
Question: Why is profit Revenue,
Profit
negative when output is $ (per year) C(q)
zero? R(q)
A
0 q0 q*
(q )
Output (units per year)
Chapter 8 Slide 12
Marginal Revenue, Marginal Cost,
and Profit Maximization
Comparing R(q) and C(q)
Cost,
Output levels: q0 - q* Revenue,
Profit
$ (per year) C(q)
R(q)> C(q) R(q)
A
MR > MC
Indicates higher B
profit at higher
output
Profit is increasing
0 q0 q*
(q )
Output (units per year)
Chapter 8 Slide 13
Marginal Revenue, Marginal Cost,
and Profit Maximization
Comparing R(q) and C(q)
Cost,
Output level: q* Revenue,
Profit
$ (per year) C(q)
R(q)= C(q)
A R(q)
MR = MC
Profit is maximized B
0 q0 q*
(q )
Output (units per year)
Chapter 8 Slide 14
Marginal Revenue, Marginal Cost,
and Profit Maximization
Question Cost,
Revenue,
Why is profit reduced Profit
$ (per year) C(q)
when producing more R(q)
A
or less than q*?
B
0 q0 q*
(q )
Output (units per year)
Chapter 8 Slide 15
Marginal Revenue, Marginal Cost,
and Profit Maximization
Comparing R(q) and C(q)
Cost,
Output levels beyond q*: Revenue,
Profit
$ (per year) C(q)
R(q)> C(q)
A R(q)
MC > MR
Profit is decreasing B
0 q0 q*
(q )
Output (units per year)
Chapter 8 Slide 16
Marginal Revenue, Marginal Cost,
and Profit Maximization
Therefore, it can be Cost,
said: Revenue,
Profit
$ (per year) C(q)
Profits are maximized A R(q)
when MC = MR.
B
0 q0 q*
(q )
Output (units per year)
Chapter 8 Slide 17
Marginal Revenue, Marginal Cost,
and Profit Maximization
R
MR
q
R-C
C
MC
q
Chapter 8 Slide 18
Marginal Revenue, Marginal Cost,
and Profit Maximization
Profits are maximized when :
R C
0 or
q q q
MR MC 0 so that
MR(q) MC(q)
Chapter 8 Slide 19
Marginal Revenue, Marginal Cost,
and Profit Maximization
The Competitive Firm
Price taker
Market output (Q) and firm output (q)
Market demand (D) and firm demand (d)
R(q) is a straight line
Chapter 8 Slide 20
Demand and Marginal Revenue Faced
by a Competitive Firm
Price Price
$ per Firm $ per Industry
bushel bushel
$4 d $4
Output Output
100 200 (bushels)
100 (millions
of bushels)
Marginal Revenue, Marginal Cost,
and Profit Maximization
The Competitive Firm
The competitive firm’s demand
Individual producer sells all units for $4
regardless of the producer’s level of
output.
If the producer tries to raise price, sales
are zero.
Chapter 8 Slide 22
Marginal Revenue, Marginal Cost,
and Profit Maximization
The Competitive Firm
The competitive firm’s demand
If the producers tries to lower price he
cannot increase sales
P = D = MR = AR
Chapter 8 Slide 23
Marginal Revenue, Marginal Cost,
and Profit Maximization
The Competitive Firm
Profit Maximization
MC(q) = MR = P
Chapter 8 Slide 24
A Competitive Firm
Making a Positive Profit
Price 60 MC
($ per
unit)
50 Lost profit for Lost profit for
qq < q * q2 > q *
D A
40 AR=MR=P
ATC
C B
30 AVC
q1 : MR > MC and At q*: MR = MC
and P > ATC
q2: MC > MR20 and
q0: MC = MR but (P - AC) x q*
10
MC falling or ABCD
0 1 2 3 4 5 6 7 8 9 10 11
q0 q1 q q2 * Output
Chapter 8 Slide 25
A Competitive Firm
Incurring Losses
Price MC ATC
($ per
unit) B
C
D P = MR
At q*: MR = MC A
and P < ATC
Losses = P- AC) x q* AVC
or ABCD
F Would this producer
E continue to produce
with a loss?
q* Output
Chapter 8 Slide 26
Choosing Output in the Short Run
Summary of Production Decisions
Profit is maximized when MC = MR
If P > ATC the firm is making profits.
If AVC < P < ATC the firm should produce
at a loss.
If P < AVC < ATC the firm should shut-
down.
Chapter 8 Slide 27
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 28
Some Cost Considerations for Managers
Three guidelines for estimating marginal
cost:
2) A single item on a firm’s
accounting ledger may have two
components, only one of which
involves marginal cost.
Chapter 8 Slide 29
Some Cost Considerations for Managers
Three guidelines for estimating marginal
cost:
3) All opportunity cost should be
included in determining
marginal cost.
Chapter 8 Slide 30
A Competitive Firm’s
Short-Run Supply Curve
Price The firm chooses the
($ per output level where MR = MC,
unit) as long as the firm is able to
cover its variable cost of
production.
MC
P2 ATC
P1 AVC
What happens
P = AVC if P < AVC?
q1 q2 Output
Chapter 8 Slide 31
A Competitive Firm’s
Short-Run Supply Curve
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
Chapter 8 Slide 32
A Competitive Firm’s
Short-Run Supply Curve
Price S = MC above AVC
($ per
unit)
MC
P2 ATC
P1 AVC
P = AVC
Shut-down
Output
q1 q2
Chapter 8 Slide 33
A Competitive Firm’s
Short-Run Supply Curve
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 34
Producer Surplus for a Firm
At q* MC = MR.
Between 0 and q ,
Price MR > MC for all units.
($ per Producer
unit of Surplus MC AVC
output)
B
A P
Alternatively, VC is the
sum of MC or ODCq* .
R is P x q* or OABq*.
D Producer surplus =
C
R - VC or ABCD.
0 q* Output
Chapter 8 Slide 35
The Short-Run Market Supply Curve
Producer Surplus in the Short-Run
Producer Surplus PS R - VC
Profit - R - VC - FC
Chapter 8 Slide 36
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 37
Output Choice in the Long Run
Price In the long run, the plant size will be
($ per increased and output increased to q3.
Long-run profit, EFGD > short run
LMC
unit of
output) profit ABCD.
LAC
SMC
SAC
D A E
$40 P = MR
C
B
G F
$30
In the short run, the
firm is faced with fixed
inputs. P = $40 > ATC.
Profit is equal to ABCD.
q1 q2 q3 Output
Chapter 8 Slide 38
Output Choice in the Long Run
Price Question: Is the producer making
($ per a profit after increased output
lowers the price to $30? LMC
unit of
output) LAC
SMC
SAC
D A E
$40 P = MR
C
B
G F
$30
q1 q2 q3 Output
Chapter 8 Slide 39
Choosing Output in the Long Run
Accounting Profit & Economic Profit
Accounting profit ( ) = R - wL
Economic profit ( ) = R = wL - rK
wl = labor cost
rk = opportunity cost of capital
Chapter 8 Slide 40
Choosing Output in the Long Run
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
Chapter 8 Slide 41
Choosing Output in the Long Run
Long-Run Competitive Equilibrium
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 42
Long-Run Competitive Equilibrium
•Profit attracts firms
•Supply increases until profit = 0
$ per Firm $ per Industry
unit of unit of S1
output output
LMC
$40 P1
LAC S2
$30 P2
q2 Output Q1 Q2 Output
Choosing Output in the Long Run
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 44
Choosing Output in the Long Run
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 45
Choosing Output in the Long Run
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 46
Choosing Output in the Long Run
An Example
Two firms A & B
Both own their land
A is located on a river which lowers A’s
shipping cost by $10,000 compared to B.
The demand for A’s river location will
increase the price of A’s land to $10,000
Chapter 8 Slide 47
Choosing Output in the Long Run
An Example
Economic rent = $10,000
$10,000 - zero cost for the land
Economic rent increases
Economic profit of A = 0
Chapter 8 Slide 48
Firms Earn Zero Profit in
Long-Run Equilibrium
A baseball team
Ticket in a moderate-sized city
Price sells enough
tickets so that price
is equal to marginal
LMC LAC and average cost
(profit = 0).
$7
Season Tickets
Sales (millions)
1.0
Chapter 8 Slide 49
Firms Earn Zero Profit in
Long-Run Equilibrium
Ticket
Price
Economic Rent LMC LAC
$10
$7 A team with the same
cost in a larger city
sells tickets for $10.
Season Tickets
Sales (millions)
1.3
Chapter 8 Slide 50
Firms Earn Zero Profit in
Long-Run Equilibrium
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 51
Firms Earn Zero Profit in
Long-Run Equilibrium
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 52
The Industry’s 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 53
The Industry’s Long-Run Supply Curve
To determine long-run supply, we assume:
Allfirms have access to the available production
technology.
Output is increased by using more inputs, not by
invention.
The market for inputs does not change with
expansions and contractions of the industry.
Chapter 8 Slide 54
Long-Run Supply in a
Constant-Cost Industry
Economic profits attract new
firms. Supply increases to S2 and Q1 increase to Q2.
the market returns to long-run Long-run supply = SL = LRAC.
$ per equilibrium. $ per Change in output has no impact on
unit of unit of input cost.
output output
MC AC S1 S2
P2 P2 C
A B
P1 P1 SL
D1 D2
q1 q2 Output Q1 Q2 Output
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 56
Long-Run Supply in an
Increasing-Cost Industry
Due to the increase
in input prices, long-run
equilibrium occurs at
$ per $ per a higher price.
unit of unit of
output LAC2 output S1 S2
SMC2 SL
SMC1
P2 LAC1 P2
P3 P3 B
P1 P1 A
D1 D1
q1 q2 Output Q1 Q2 Q3 Output
Long-Run Supply in a
Increasing-Cost Industry
In a increasing-cost industry, long-run
supply curve is upward sloping.
Chapter 8 Slide 58
Long-Run Supply in an
Decreasing-Cost Industry
Due to the decrease
in input prices, long-run
equilibrium occurs at
$ per $ per a lower price.
unit of unit of
output output S1 S2
SMC1
SMC2 LAC1
P2 P2
LAC2
P1 A
P1 B
P3 P3
SL
D1 D2
q1 q2 Output Q1 Q2 Q3 Output
Long-Run Supply in a
Increasing-Cost Industry
In a decreasing-cost industry, long-run
supply curve is downward sloping.
Chapter 8 Slide 60