1 Prot Maximization

14.01 Principles of Microeconomics, Fall 2007

Chia-Hui Chen

October 19, 2007

Lecture 15

Short Run and Long Run Supply

Outline
1. Chap 8: Prot Maximization
2. Chap 8: Short Run Supply
3. Chap 8: Producer Surplus
4. Chap 8: Long Run Competitive Equilibrium

Prot Maximization

For perfect competition in a product market, we make some assumptions:

Price taking: either individual rms or consumers cannot aect the price.
Product homogeneity: product of all rms are perfect substitutes.
Free entry and exit: no special cost to enter or exit the market.
Firms choose the level of output to maximize their prots. Prot equals
total revenue minus total cost, namely
(q) = R(q) C(q) = P (q)q C(q).
To maximize the prot, the following condition must hold:
d(q)
dR dC
=

= M R(q) M C(q) = 0,
dq
dq
dq
and thus
M R(q) = M C(q).
Since
R(q) = P q,
we have
M R(q) =

dR(q)
= P,
dq

and
M R = AR,
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2 Short Run Supply

thus
M C(q) = P = M R = AR
is the maximization condition. Note that the condition is not sucient. In
Figure 1), if the price is P2 , q2 and q3 both satisfy the condition, but only q3
maximizes the prot.
10
9
8

P1

MC

5
4
3

P 2

2
1
0

q1

10

Figure 1: Prot Maximization.

Short Run Supply

Assume the rm has production costs shown in Figure 2, let us discuss its
behavior under dierent prices.
When P = P1 , the rm is making prots, so it will continue to produce;
When P = P2 , the rm has losses but still continues to produce, because if
it shuts down, the prot is F C, and if continuing to produce, the prot
is R T V C F C > F C.
Since R < SV C, when P = P3 , the prot if the rm shuts down, F C, is
more than the prot if it continues, R T V C F C, so it will shut down.
When the rm produces, it chooses the output level where M C(q) = P . There
fore, the rms supply curve when it produces is just the part of M C above
T V C. When P < AV C, the rm shuts down and q = 0.
We can derive market supply from an individual rms supply (see Figure 3).
Dene elasticity of market supply as follows:
ES =

dQ/Q
.
dP/P

Figure 4 and 5 stand for inelastic and elastic supply curves, respectively.
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OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month
YYYY].

2 Short Run Supply

10

MC
P1

ATC

4
P2

AVC
P3

5
q

10

Figure 2: Individual Firms Supply in Short Run.

10

7
MC1

Market Supply

MC2

5
q

10

Figure 3: Market Supply in Short Run.

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OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month
YYYY].

2 Short Run Supply

10

MC

5
q

10

10

Figure 4: Inelastic Market Supply Curve.

10

MC

5
q

Figure 5: Elastic Market Supply Curve.

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OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month
YYYY].

2 Short Run Supply

10
9
8
7

6
5
4
3
2
1
0

10

Figure 6: Perfectly Inelastic Market Supply Curve.

10
9
8
7

6
5
4
3
2
1
0

10

Figure 7: Perfectly Elastic Market Supply Curve.

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YYYY].

3 Producer Surplus

Similarly, we have perfectly inelastic market supply (see Figure 6) and perfectly
elastic market supply (see Figure 7).
Perfectly elastic market supply happens when
M C = const.

Producer Surplus

Producer Surplus is the dierence between the rms revenue and the sum of
the total variable cost of producing q (see Figure 8):
P S = R T V C = R T V C F C + F C = P rof it + F C.
Thus, producer surplus is the sum of prot and xed cost.

MC

AVC

4
q

Figure 8: Producer Surplus.

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OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month
YYYY].