(8th edition) (the pearson series in economics) robert pindyck, daniel rubinfeld microecon 326

CHAPTER 8 • Profit Maximization and Competitive Supply 301

Dollars per
unit of
output

LMC

SMC
$40
C

D

LAC

F IGURE 8.13

SAC
E

A

P = MR

B

G
$30

The firm maximizes its profit by

choosing the output at which
price equals long-run marginal
cost LMC. In the diagram, the firm
increases its profit from ABCD to
EFGD by increasing its output in
the long run.

F

q1

q2

q3

OUTPUT CHOICE IN THE
LONG RUN

Output

If the firm believes that the market price will remain at $40, it will want
to increase the size of its plant to produce at output q3, at which its long-run
marginal cost equals the $40 price. When this expansion is complete, the profit
margin will increase from AB to EF, and total profit will increase from ABCD to
EFGD. Output q3 is profit-maximizing because at any lower output (say, q2), the
marginal revenue from additional production is greater than the marginal cost.
Expansion is, therefore, desirable. But at any output greater than q3, marginal
cost is greater than marginal revenue. Additional production would therefore
reduce profit. In summary, the long-run output of a profit-maximizing competitive
firm is the point at which long-run marginal cost equals the price.

Note that the higher the market price, the higher the profit that the firm can
earn. Correspondingly, as the price of the product falls from $40 to $30, the profit
also falls. At a price of $30, the firm’s profit-maximizing output is q2, the point of
long-run minimum average cost. In this case, because P ϭ ATC, the firm earns
zero economic profit.

Long-Run Competitive Equilibrium
For an equilibrium to arise in the long run, certain economic conditions must
prevail. Firms in the market must have no desire to withdraw at the same time
that no firms outside the market wish to enter. But what is the exact relationship
between profitability, entry, and long-run competitive equilibrium? We can see
the answer by relating economic profit to the incentive to enter and exit a market.
ACCOUNTING PROFIT AND ECONOMIC PROFIT As we saw in Chapter 7,
it is important to distinguish between accounting profit and economic profit.
Accounting profit is measured by the difference between the firm’s revenues and
its cash flows for labor, raw materials, and interest plus depreciation expenses.
Economic profit takes into account opportunity costs. One such opportunity cost
is the return to the firm’s owners if their capital were used elsewhere. Suppose,