chapter 8 profit maximization and competitive supply

Chapter 8
Profit Maximization
and Competitive
Supply
Chapter 8 Slide 2
Topics to be Discussed

Perfectly Competitive Markets

Profit Maximization

Marginal Revenue, Marginal Cost, and
Profit Maximization

Choosing Output in the Short-Run
Chapter 8 Slide 3
Topics to be Discussed

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 4
Perfectly Competitive Markets

Characteristics of Perfectly Competitive
Markets

1) Price taking
2) Product homogeneity
3) Free entry and exit
Chapter 8 Slide 5
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 6
Perfectly Competitive Markets

Product Homogeneity

The products of all firms are perfect
substitutes.

Examples

Agricultural products, oil, copper, iron,
lumber
Chapter 8 Slide 7
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 8
Profit Maximization

Do firms maximize profits?

Possibility of other objectives

Revenue maximization

Dividend maximization
Chapter 8 Slide 9
Profit Maximization

Do firms maximize profits?

Implications of non-profit objective

Over the long-run investors would not
support the company

Without profits, survival unlikely

Long-run profit maximization is valid and does
not exclude the possibility of altruistic

behavior.
Chapter 8 Slide
10
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:
π
)()()( qCqRq −=
π
Chapter 8 Slide
11

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.
Marginal Revenue, Marginal Cost,
and Profit Maximization

Chapter 8 Slide
12

Comparing R(q) and C(q)

Output levels: 0- q
0
:

C(q)> R(q)

Negative profit

FC + VC > R(q)

MR > MC

Indicates higher
profit at higher
output
0
Cost,
Revenue,
Profit
($s per year)
Output (units per year)
R(q)
C(q)
A
B

q
0
q
*
)(q
π
Marginal Revenue, Marginal Cost,
and Profit Maximization
Chapter 8 Slide
13

Comparing R(q) and C(q)

Question: Why is profit
negative when output is
zero?
Marginal Revenue, Marginal Cost,
and Profit Maximization
R(q)
0
Cost,
Revenue,
Profit
$ (per year)
Output (units per year)
C(q)
A
B
q
0

q
*
)(q
π
Chapter 8 Slide
14

Comparing R(q) and C(q)

Output levels: q
0
-

q
*

R(q)> C(q)

MR > MC

Indicates higher
profit at higher
output

Profit is increasing
R(q)
0
Cost,
Revenue,
Profit

$ (per year)
Output (units per year)
C(q)
A
B
q
0
q
*
)(q
π
Marginal Revenue, Marginal Cost,
and Profit Maximization
Chapter 8 Slide
15

Comparing R(q) and C(q)

Output level: q
*

MR = MC

Profit is maximized
R(q)
0
Cost,
Revenue,
Profit
$ (per year)

Output (units per year)
C(q)
A
B
q
0
q
*
)(q
π
Marginal Revenue, Marginal Cost,
and Profit Maximization
Chapter 8 Slide
16

Comparing R(q) and C(q)

Output levels beyond q
*
:

MC > MR

Profit is decreasing
Marginal Revenue, Marginal Cost,
and Profit Maximization
R(q)
0
Cost,
Revenue,

Profit
$ (per year)
Output (units per year)
C(q)
A
B
q
0
q
*
)(q
π
Chapter 8 Slide
17
C - R =
π
Marginal Revenue, Marginal Cost,
and Profit Maximization
q
R
MR
∆
∆
=
q
C
MC
∆
∆
=

Chapter 8 Slide
18
or
q
C
q
R
0
q
: whenmaximized are Profits
=
∆
∆
−
∆
∆
=
∆
∆
π
MC(q)MR(q)
MCMR
=
=− thatso0
Marginal Revenue, Marginal Cost,
and Profit Maximization
Chapter 8 Slide
19

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
Marginal Revenue, Marginal Cost,
and Profit Maximization
Demand and Marginal Revenue Faced
by a Competitive Firm
Output
(bushels)
Price
$ per
bushel
Price
$ per
bushel
Output
(millions
of bushels)
d$4
100 200 100
Firm Industry
D
$4
Chapter 8 Slide
21


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.
Marginal Revenue, Marginal Cost,
and Profit Maximization
Chapter 8 Slide
22

The Competitive Firm

AR = MR = P

Profit Maximization

MC(q) = MR = P
Marginal Revenue, Marginal Cost,
and Profit Maximization
Chapter 8 Slide
23
Choosing Output in the Short Run

We will combine production and cost

analysis with demand to determine
output and profitability.
Chapter 8 Slide
24
q
0
Lost profit for
q1 < q
*
Lost profit for
q
2
> q
*
q
1
q
2
A Competitive Firm
Making a Positive Profit
10
20
30
40
Price
($ per
unit)
0 1 2 3 4 5 6 7 8 9 10 11
50
60

MC
AVC
ATC
AR=MR=P
Output
q
*
At q
*
: MR = MC
and P > ATC
ABCDor
qx ATC) -(P
*
=
π
D
A
B
C
q
1
: MR > MC and
q
2
: MC > MR and
q*: MC = MR but
MC falling
Chapter 8 Slide
25

Would this producer
continue to produce
with a loss?
A Competitive Firm
Incurring Losses
Price
($ per
unit)
Output
AVC
ATC
MC
q
*
P = MR
B
F
C
A
E
D
At q
*
: MR = MC
and P < ATC
Losses = (P- ATC) x
q
*
or ABCD