Profit Maximization and Competitive Supply

1
Chapter 8

• Profit Maximization and Competitive Supply

2
Perfectly Competitive Markets

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

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.

4
Perfectly Competitive Markets

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

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.

6
Profit Maximization

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

7
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

8
Profit Maximization

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

9
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

10
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)
12
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)
• 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)gt C(q)
• MR MC
• Profit is maximized

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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

• 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

18
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
19
Marginal Revenue, Marginal Cost,and Profit
Maximization

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

20
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
21
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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A Competitive FirmsShort-Run Supply Curve
Price ( per unit)
Output
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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 input 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
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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

• 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
31
The Short-Run Market Supply Curve

• Producer Surplus in the Short-Run

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Producer Surplus for a Market
Price ( per unit of output)
Output
33
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
  firm is earning a normal rate of return
  indicating the industry is competitive
• If R lt wL rK, consider going out of business

38
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
40
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

• 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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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
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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.

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Long-Run Supply in anIncreasing-Cost Industry
per unit of output
per unit of output
Output
Output
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Long-Run Supply in anDecreasing-Cost Industry
per unit of output
per unit of output
Output
Output
50
Effect of an Output Tax on a Competitive Firms
Output
Price ( per unit of output)
Output
51
Effect of an OutputTax on Industry Output
Price ( per unit of output)
Output
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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

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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

55
The IndustrysLong-Run Supply Curve

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