(8th edition) (the pearson series in economics) robert pindyck, daniel rubinfeld microecon 310

CHAPTER 8 • Profit Maximization and Competitive Supply 285

Cost,
revenue,
profit
(dollars per year)

C(q)
R(q)

A

F IGURE 8.1

PROFIT MAXIMIZATION IN THE
SHORT RUN

B

A firm chooses output q*, so that profit, the
difference AB between revenue R and cost
C, is maximized. At that output, marginal
revenue (the slope of the revenue curve) is
equal to marginal cost (the slope of the cost
curve).
0

q0

q*

q1
π (q)
Output (units per year)

For the firm illustrated in Figure 8.1, profit is negative at low levels of output because revenue is insufficient to cover fixed and variable costs. As output
increases, revenue rises more rapidly than cost, so that profit eventually becomes
positive. Profit continues to increase until output reaches the level q*. At this
point, marginal revenue and marginal cost are equal, and the vertical distance
between revenue and cost, AB, is greatest. q* is the profit-maximizing output
level. Note that at output levels above q*, cost rises more rapidly than revenue—
i.e., marginal revenue is less than marginal cost. Thus, profit declines from its
maximum when output increases above q*.
The rule that profit is maximized when marginal revenue is equal to marginal
cost holds for all firms, whether competitive or not. This important rule can also
be derived algebraically. Profit, p = R - C, is maximized at the point at which
an additional increment to output leaves profit unchanged (i.e., ⌬p/⌬q = 0):
⌬p/⌬q = ⌬R/⌬q - ⌬C/⌬q = 0
⌬R/⌬q is marginal revenue MR and ⌬C/⌬q is marginal cost MC. Thus we conclude that profit is maximized when MR - MC = 0, so that
MR(q) = MC(q)

Demand and Marginal Revenue for a Competitive Firm
Because each firm in a competitive industry sells only a small fraction of the
entire industry output, how much output the firm decides to sell will have no effect
on the market price of the product. The market price is determined by the industry
demand and supply curves. Therefore, the competitive firm is a price taker. Recall
that price taking is one of the fundamental assumptions of perfect competition.
The price-taking firm knows that its production decision will have no effect on
the price of the product. For example, when a farmer is deciding how many acres
of wheat to plant in a given year, he can take the market price of wheat—say, $4
per bushel—as given. That price will not be affected by his acreage decision.