Profit Maximization and Competitive Supply

1
Chapter 8

• Profit Maximization and Competitive Supply

2
Topics to be Discussed

• Perfectly Competitive Markets
• Profit Maximization
• Marginal Revenue, Marginal Cost, and Profit
  Maximization
• Choosing Output in the Short-Run

3
Topics to be Discussed

• The Competitive Firms Short-Run Supply Curve
• Short-Run Market Supply
• Choosing Output in the Long-Run
• The Industrys Long-Run Supply Curve

4
Perfectly Competitive Markets

• Characteristics of Perfectly Competitive Markets
• 1) Price taking
• 2) Product homogeneity
• 3) Free entry and exit

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.

6
Perfectly Competitive Markets

• Product Homogeneity
• The products of all firms are perfect
  substitutes.
• Examples
• Agricultural products, oil, copper, iron, lumber

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.

8
Perfectly Competitive Markets

• Discussion Questions
• What are some barriers to entry and exit?
• Are all markets competitive?
• When is a market highly competitive?

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Profit Maximization

• Do firms maximize profits?
• Possibility of other objectives
• Revenue maximization
• Dividend maximization
• Short-run profit maximization

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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

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Profit Maximization

• Do firms maximize profits?
• Long-run profit maximization is valid and does
  not exclude the possibility of altruistic
  behavior.

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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

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Profit Maximization in the Short Run
Cost, Revenue, Profit (s per year)
0
Output (units per year)
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Profit Maximization in the Short Run
Cost, Revenue, Profit (per year)
0
Output (units per year)
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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.

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Marginal Revenue, Marginal Cost,and Profit
Maximization

• Comparing R(q) and C(q)
• Output levels 0- q0
• C(q)gt R(q)
• Negative profit
• FC VC gt R(q)
• MR gt MC
• Indicates higher profit at higher output

Cost, Revenue, Profit (s per year)
0
Output (units per year)
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Marginal Revenue, Marginal Cost,and Profit
Maximization

• Comparing R(q) and C(q)
• Question Why is profit negative when output is
  zero?

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Marginal Revenue, Marginal Cost,and Profit
Maximization

• Comparing R(q) and C(q)
• Output levels q0 - q
• R(q)gt C(q)
• MR gt MC
• Indicates higher profit at higher output
• Profit is increasing

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Marginal Revenue, Marginal Cost,and Profit
Maximization

• Comparing R(q) and C(q)
• Output level q
• R(q) C(q)
• MR MC
• Profit is maximized

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Marginal Revenue, Marginal Cost,and Profit
Maximization

• Question
• Why is profit reduced when producing more or less
  than q?

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Marginal Revenue, Marginal Cost,and Profit
Maximization

• Comparing R(q) and C(q)
• Output levels beyond q
• R(q)gt C(q)
• MC gt MR
• Profit is decreasing

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Marginal Revenue, Marginal Cost,and Profit
Maximization

• Therefore, it can be said
• Profits are maximized when MC MR.

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Marginal Revenue, Marginal Cost,and Profit
Maximization
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Marginal Revenue, Marginal Cost,and Profit
Maximization
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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

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Demand and Marginal Revenue Facedby a
Competitive Firm
Price per bushel
Price per bushel
Firm
Industry
Output (bushels)
Output (millions of bushels)
100
200
100
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Marginal Revenue, Marginal Cost,and Profit
Maximization

• The Competitive Firm
• The competitive firms demand
• Individual producer sells all units for 4
  regardless of the producers level of output.
• If the producer tries to raise price, sales are
  zero.

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Marginal Revenue, Marginal Cost,and Profit
Maximization

• The Competitive Firm
• The competitive firms demand
• If the producers tries to lower price he cannot
  increase sales
• P D MR AR

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Marginal Revenue, Marginal Cost,and Profit
Maximization

• The Competitive Firm
• Profit Maximization
• MC(q) MR P

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Choosing Output in the Short Run

• We will combine production and cost analysis with
  demand to determine output and profitability.

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A Competitive FirmMaking a Positive Profit
Price ( per unit)
60
50
40
30
20
10
0
1
2
3
4
5
6
7
8
9
10
11
Output
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A Competitive FirmIncurring Losses
Price ( per unit)
Would this producer continue to produce with a
loss?
Output
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Choosing Output in the Short Run

• Summary of Production Decisions
• Profit is maximized when MC MR
• If P gt ATC the firm is making profits.
• If AVC lt P lt ATC the firm should produce at a
  loss.
• If P lt AVC lt ATC the firm should shut-down.

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The Short-Run Output ofan Aluminum Smelting Plant
Cost (dollars per item)
1400
1300
1200
1140
1100
Output (tons per day)
300
600
900
0
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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.

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Some Cost Considerations for Managers

• Three guidelines for estimating marginal cost
• 2) A single item on a firms accounting ledger
  may have two components, only one of which
  involves marginal cost.

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Some Cost Considerations for Managers

• Three guidelines for estimating marginal cost
• 3) All opportunity cost should be included in
  determining marginal cost.

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A Competitive FirmsShort-Run Supply Curve
Price ( per unit)
Output
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A Competitive FirmsShort-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

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A Competitive FirmsShort-Run Supply Curve
S MC above AVC
Price ( per unit)
MC
ATC
P2
AVC
P1
P AVC
Shut-down
Output
q1
q2
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A Competitive FirmsShort-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.

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A Competitive FirmsShort-Run Supply Curve

• Firms Response to an Input Price Change
• When the price of a firms product changes, the
  firm changes its output level, so that the
  marginal cost of production remains equal to the
  price.

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The Response of a Firm toa Change in Input Price
Price ( per unit)
Output
44
The Short-Run Productionof Petroleum Products
Cost ( per barrel)
27
26
25
24
Output (barrels/day)
23
8,000
9,000
10,000
11,000
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The Short-Run Productionof Petroleum Products

• Stepped SMC indicates a different production
  (cost) process at various capacity levels.
• Observation
• With a stepped MC function, small changes in
  price may not trigger a change in output.

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The Short-Run Productionof Petroleum Products

• The short-run market supply curve shows the
  amount of output that the industry will produce
  in the short-run for every possible price.
• Consider, for simplicity, a competitive market
  with three firms

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Industry Supply in the Short Run
per unit
Question If increasing output raises
input costs, what impact would it have on market
supply?
Quantity
0
2
4
8
10
5
7
15
21
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The Short-Run Market Supply Curve

• Elasticity of Market Supply

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The Short-Run Market Supply Curve

• Perfectly inelastic short-run supply arises when
  the industrys plant and equipment are so fully
  utilized that new plants must be built to achieve
  greater output.
• Perfectly elastic short-run supply arises when
  marginal costs are constant.

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The Short-Run Market Supply Curve

• Questions
• 1) Give an example of a perfectly inelastic
  supply.
• 2) If MC rises rapidly, would the supply be
  more or less elastic?

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The World Copper Industry (1999)
Annual Production Marginal Cost Country (thousand
metric tons) (dollars/pound)
Australia 600 0.65 Canada 710 0.75 Chile 3660 0.50
Indonesia 750 0.55 Peru 450 0.70 Poland 420 0.80
Russia 450 0.50 United States 1850 0.70 Zambia 280
0.55
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The Short-Run World Supply of Copper
Price ( per pound)
0.90
0.80
0.70
0.60
0.50
0.40
0
2000
4000
6000
8000
10000
Production (thousand metric tons)
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The Short-Run Market Supply Curve

• Producer Surplus in the Short Run
• Firms earn a surplus on all but the last unit of
  output.
• The producer surplus is the sum over all units
  produced of the difference between the market
  price of the good and the marginal cost of
  production.

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Producer Surplus for a Firm
Price ( per unit of output)
0
Output
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The Short-Run Market Supply Curve

• Producer Surplus in the Short-Run

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The Short-Run Market Supply Curve

• Observation
• Short-run with positive fixed cost

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Producer Surplus for a Market
Price ( per unit of output)
Output
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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.

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Output Choice in the Long Run
Price ( per unit of output)
Output
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Output Choice in the Long Run
Price ( per unit of output)
Question Is the producer making a profit after
increased output lowers the price to 30?
D
A
C
B
G
F
q1
q3
q2
Output
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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

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Choosing Output in the Long Run
Long-Run Competitive Equilibrium

• Zero-Profit
• If R gt 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 lt wl rk, consider going out of business

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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.

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Long-Run Competitive Equilibrium
per unit of output
per unit of output
Firm
Industry
40
Output
q2
Output
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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

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Choosing Output in the Long Run

• Questions
• 1) Explain the market adjustment when P lt
  LAC and firms have identical costs.
• 2) Explain the market adjustment when firms
  have different costs.
• 3) What is the opportunity cost of land?

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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.

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Choosing Output in the Long Run

• An Example
• Two firms A B
• Both own their land
• A is located on a river which lowers As shipping
  cost by 10,000 compared to B.
• The demand for As river location will increase
  the price of As land to 10,000

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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

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Firms Earn Zero Profit inLong-Run Equilibrium
Ticket Price
Season Tickets Sales (millions)
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Firms Earn Zero Profit inLong-Run Equilibrium
Ticket Price
A team with the same cost in a larger city sells
tickets for 10.
Season Tickets Sales (millions)
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Firms Earn Zero Profit inLong-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.

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Firms Earn Zero Profit inLong-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.

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The Industrys 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.

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The Industrys Long-Run Supply Curve

• To determine long-run supply, we assume
• All firms have access to the available production
  technology.
• Output is increased by using more inputs, not by
  invention.

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The Industrys Long-Run Supply Curve

• To determine long-run supply, we assume
• The market for inputs does not change with
  expansions and contractions of the industry.

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Long-Run Supply in aConstant-Cost Industry
per unit of output
per unit of output
Output
Output
78
Long-Run Supply in aConstant-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.

79
Long-Run Supply in anIncreasing-Cost Industry
per unit of output
per unit of output
Output
Output
80
Long-Run Supply in aIncreasing-Cost Industry

• In a increasing-cost industry, long-run supply
  curve is upward sloping.

81
The IndustrysLong-Run Supply Curve

• Questions
• 1) Explain how decreasing-cost is possible.
• 2) Illustrate a decreasing cost industry.
• 3) What is the slope of the SL in a
  decreasing-cost industry?

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Long-Run Supply in anDecreasing-Cost Industry
per unit of output
per unit of output
Output
Output
83
Long-Run Supply in aIncreasing-Cost Industry

• In a decreasing-cost industry, long-run supply
  curve is downward sloping.

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The IndustrysLong-Run Supply Curve

• The Effects of a Tax
• In an earlier chapter we studied how firms
  respond to taxes on an input.
• Now, we will consider how a firm responds to a
  tax on its output.

85
Effect of an Output Tax on a Competitive Firms
Output
Price ( per unit of output)
Output
86
Effect of an OutputTax on Industry Output
Price ( per unit of output)
Output
87
The IndustrysLong-Run Supply Curve

• Long-Run Elasticity of Supply
• 1) Constant-cost industry
• Long-run supply is horizontal
• Small increase in price will induce an extremely
  large output increase

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The IndustrysLong-Run Supply Curve

• Long-Run Elasticity of Supply
• 1) Constant-cost industry
• Long-run supply elasticity is infinitely large
• Inputs would be readily available

89
The IndustrysLong-Run Supply Curve

• Long-Run Elasticity of Supply
• 2) Increasing-cost industry
• Long-run supply is upward-sloping and elasticity
  is positive
• The slope (elasticity) will depend on the rate of
  increase in input cost
• Long-run elasticity will generally be greater
  than short-run elasticity of supply

90
The IndustrysLong-Run Supply Curve

• Question
• Describe the long-run elasticity of supply in a
  decreasing -cost industry.

91
The Long-Run Supply of Housing

• Scenario 1 Owner-occupied housing
• Suburban or rural areas
• National market for inputs

92
The Long-Run Supply of Housing

• Questions
• Is this an increasing or a constant-cost
  industry?
• What would you predict about the elasticity of
  supply?

93
The Long-Run Supply of Housing

• Scenario 2 Rental property
• Zoning restrictions apply
• Urban location
• High-rise construction cost

94
The Long-Run Supply of Housing

• Questions
• Is this an increasing or a constant-cost
  industry?
• What would you predict about the elasticity of
  supply?

95
Summary

• The managers of firms can operate in accordance
  with a complex set of objectives and under
  various constraints.
• A competitive market makes its output choice
  under the assumption that the demand for its own
  output is horizontal.

96
Summary

• In the short run, a competitive firm maximizes
  its profit by choosing an output at which price
  is equal to (short-run) marginal cost.
• The short-run market supply curve is the
  horizontal summation of the supply curves of the
  firms in an industry.

97
Summary

• The producer surplus for a firm is the difference
  between revenue of a firm and the minimum cost
  that would be necessary to produce the
  profit-maximizing output.
• Economic rent is the payment for a scarce
  resource of production less the minimum amount
  necessary to hire that factor.

98
Summary

• In the long-run, profit-maximizing competitive
  firms choose the output at which price is equal
  to long-run marginal cost.
• The long-run supply curve for a firm can be
  horizontal, upward sloping, or downward sloping.

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End of Chapter 8

• Profit Maximization and Competitive Supply