Profit Maximization and Competitive Supply

Chapter 8
Profit Maximization
and Competitive
Supply
Topics to be Discussed
 Perfectly Competitive Markets

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

Markets
1) Price taking
2) Product homogeneity
3) Free entry and exit

 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.
 Product Homogeneity
The products of all firms are perfect
substitutes.
Examples
 Agricultural products, oil, copper, iron,

lumber
 Free Entry and Exit

Buyers can easily switch from one supplier
to another.
Suppliers can easily enter or exit a market.
 Discussion Questions
What are some barriers to entry and exit?
Are all markets competitive?
When is a market highly competitive?
Profit Maximization
 Do firms maximize profits?

Possibility of other objectives
 Revenue maximization
 Dividend maximization
 Short-run profit maximization
Profit Maximization

Implications of non-profit objective
 Over the long-run investors would not
support the company
 Without profits, survival unlikely
Profit Maximization

Long-run profit maximization is valid and
does not exclude the possibility of
altruistic behavior.
Marginal Revenue, Marginal Cost,
and Profit Maximization
 Determining the profit maximizing level

of output
Profit ( π ) = Total Revenue - Total Cost
Total Revenue (R) = Pq
Total Cost (C) = Cq
Therefore:
π (q) = R(q) − C (q)

Profit Maximization in the Short Run
Cost, Total Revenue

Revenue, R(q)
Profit
($s per year)
Slope of R(q) = MR
Output (units per year)

Profit Maximization in the Short Run
C(q)
Cost,
Revenue,
Profit
$ (per year) Total Cost
Slope of C(q) = MC
Why is cost positive when q is zero?

 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.
 Comparing R(q) and C(q)

Cost,
Revenue,
 Output levels: 0- q0: Profit
($s per year) C(q)
 C(q)> R(q) R(q)
A
 Negative profit
 FC + VC > R(q) B
 MR > MC
 Indicates higher
profit at higher
output 0 q0 q*
π (q )

Cost,
 Question: Why is profit Revenue,
Profit
negative when output is $ (per year) C(q)
zero? R(q)
A
0 q0 q*
π (q )

Cost,
Revenue,
 Output levels: q0 - q* Profit
$ (per year) C(q)
 R(q)> C(q) R(q)
A
 MR > MC
 Indicates higher B
profit at higher
output
 Profit is increasing
0 q0 q*
π (q )

Cost,
 Output Revenue,
level: q* Profit
$ (per year) C(q)
 R(q)= C(q)
A R(q)
 MR = MC
 Profit is maximized B
0 q0 q*
π (q )
 Question Cost,
Revenue,
 Why is profit reduced Profit
C(q)
$ (per year)
when producing more R(q)
A
or less than q*?
B
0 q0 q*
π (q )

Cost,
 Output Revenue,
levels beyond q*: Profit
$ (per year) C(q)
 R(q)> C(q)
A R(q)
 MC > MR
 Profit is decreasing B
0 q0 q*
π (q )
 Therefore, it can be Cost,

said: Revenue,
Profit
$ (per year) C(q)
 Profits
are maximized R(q)
A
when MC = MR.
B
0 q0 q*
π (q )
∆R
MR =
∆q
π = R-C
∆C
MC =
∆q
Profits are maximized when :

∆π ∆R ∆C
= − = 0 or
∆q ∆q ∆q
MR − MC = 0 so that
MR(q) = MC(q)
 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
Demand and Marginal Revenue Faced
by a Competitive Firm
Price Price
$ per Firm $ per Industry
bushel bushel
$4 d $4
Output Output
100 200 (bushels)
100 (millions
of bushels)

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.

The competitive firm’s demand
 If the producers tries to lower price he
cannot increase sales
 P = D = MR = AR

Profit Maximization
 MC(q) = MR = P
Choosing Output in the Short Run
 We will combine production and cost

analysis with demand to determine
output and profitability.
A Competitive Firm
Making a Positive Profit
Price 60 MC
($ per
unit)
50 Lost profit for Lost profit for
qq < q * q2 > q *
D A
40 AR=MR=P
ATC
C B
30 AVC
q1 : MR > MC and At q*: MR = MC

and P > ATC
q2: MC > MR20 and
q0: MC = MR but π = (P - AC) x q*
10
MC falling or ABCD
0 1 2 3 4 5 6 7 8 9 10 11
q0 q1 q q2 * Output
A Competitive Firm
Incurring Losses
Price MC ATC
($ per
unit) B
C
D P = MR
At q*: MR = MC A
and P < ATC
Losses = P- AC) x q* AVC
or ABCD
F Would this producer
E continue to produce
with a loss?
q* Output
Choosing Output in the Short Run
 Summary of Production Decisions

Profit is maximized when MC = MR
If P > ATC the firm is making profits.
If AVC < P < ATC the firm should produce
at a loss.
If P < AVC < ATC the firm should shut-
down.
The Short-Run Output of
an Aluminum Smelting Plant
Observations
Cost •Price between $1140 & $1300: q = 600
(dollars per item) •Price > $1300: q = 900
•Price < $1140: q = 0
1400
P2
1300
P1
1200
Question
1140
Should the firm stay in business
1100 when P < $1140?
Output
0 300 600 900 (tons per day)
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.

marginal cost:
2) A single item on a firm’s accounting

ledger may have two components,
only one of which involves marginal
cost.

marginal cost:
3) All opportunity cost should be

included in determining marginal
cost.
A Competitive Firm’s
Short-Run Supply Curve
Price The firm chooses the
($ per output level where MR = MC,
unit) as long as the firm is able to
cover its variable cost of
production.
MC
P2 ATC
P1 AVC
What happens
P = AVC if P < AVC?
q1 q2 Output
 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
Price S = MC above AVC

($ per
unit)
MC
P2 ATC
P1 AVC
P = AVC
Shut-down
Output
q1 q2
 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.
 Firm’s Response to an Input Price

Change
When the price of a firm’s product
changes, the firm changes its output level,
so that the marginal cost of production
remains equal to the price.
The Response of a Firm to
a Change in Input Price
Price
Input cost increases
($ per
and MC shifts to MC2
unit) MC2 and q falls to q2.
Savings to the firm
from reducing output
MC1
$5
q2 q1 Output
The Short-Run Production
of Petroleum Products
Cost
The MC of producing
($ per a mix of petroleum products
barrel) 27 from crude oil increases SMC
sharply at several levels
of output as the refinery
shifts from one processing
unit to another.
26
How much would

25 be produced if
P = $23?
P = $24-$25?
24
23 Output
(barrels/day)
8,000 9,000 10,000 11,000
 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.
 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:
Industry Supply in the Short Run
The short-run S
$ per MC1 MC2 MC3 industry supply curve
is the horizontal
unit
summation of the supply
curves of the firms.
P3
P2
P1 Question: If increasing
output raises input
costs, what impact
would it have on
market supply?
0 2 4 5 7 8 10 15 Quantity 21
The Short-Run Market Supply Curve
 Elasticity of Market Supply
Es = (∆Q / Q) /( ∆P / P )
 Perfectly inelastic short-run supply

arises when the industry’s 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.
 Questions
1) Give an example of a perfectly

inelastic supply.
2) If MC rises rapidly, would the supply

be more or less elastic?
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
The Short-Run World Supply of Copper
Price
($ per pound)
0.90
MCPo
0.80
MCCa
MCP,MCUS
0.70 MCA
0.60
MCJ,MCZ
MCC,MCR
0.50
0.40
0 2000 4000 6000 8000 10000
Production (thousand metric tons)
 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.
Producer Surplus for a Firm
At q* MC = MR.
Between 0 and q ,
Price MR > MC for all units.
($ per Producer
unit of Surplus MC AVC
output)
B
A P
Alternatively, VC is the
sum of MC or ODCq* .
R is P x q* or OABq*.
D Producer surplus =
C
R - VC or ABCD.
0 q* Output
 Producer Surplus in the Short-Run
Producer Surplus = PS = R - VC
Profit = π - R - VC - FC
 Observation
Short-run with positive fixed cost
PS > π
Producer Surplus for a Market
Price S
($ per
unit of
output)
Market producer surplus is

P* the difference between P*
and S from 0 to Q*.
Producer
Surplus D
Q* Output
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.
Output Choice in the Long Run
Price In the long run, the plant size will be
($ per increased and output increased to q3.
Long-run profit, EFGD > short run
LMC
unit of
output) profit ABCD.
LAC
SMC
SAC
D A E
$40 P = MR
C
B
G F
$30
In the short run, the
firm is faced with fixed
inputs. P = $40 > ATC.
Profit is equal to ABCD.
q1 q2 q3 Output
Output Choice in the Long Run
Price Question: Is the producer making
($ per a profit after increased output
lowers the price to $30? LMC
unit of
output) LAC
SMC
SAC
D A E
$40 P = MR
C
B
G F
$30
q1 q2 q3 Output
 Accounting Profit & Economic Profit

Accountingprofit (π ) = R - wL
Economic profit (π ) = R = wL - rK
 wl = labor cost
 rk = opportunity cost of capital
Long-Run
Long-Run Competitive
Competitive Equilibrium
Equilibrium
 Zero-Profit
If R > 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 < wl + rk, consider going out of
business
Long-Run
Long-Run Competitive
Competitive Equilibrium
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.
Long-Run Competitive Equilibrium
•Profit attracts firms
•Supply increases until profit = 0
$ per Firm $ per Industry
unit of unit of S1
output output
LMC
$40 P1
LAC S2
$30 P2
q2 Output Q1 Q2 Output
 Long-Run Competitive Equilibrium

1) MC = MR
2) P = LAC
 No incentive to leave or enter
 Profit = 0
3) Equilibrium Market Price

 Questions
1) Explain the market adjustment when
P < LAC and firms have identical
costs.
2) Explain the market adjustment when
firms have different costs.
3) What is the opportunity cost of land?
 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.
 An Example
Two firms A & B
Both own their land
A is located on a river which lowers A’s
shipping cost by $10,000 compared to B.
The demand for A’s river location will
increase the price of A’s land to $10,000
 An Example
Economic rent = $10,000
 $10,000 - zero cost for the land
Economic rent increases
Economic profit of A = 0
Firms Earn Zero Profit in
Long-Run Equilibrium
A baseball team
Ticket in a moderate-sized city
Price sells enough
tickets so that price
is equal to marginal
LMC LAC and average cost
(profit = 0).
$7
Season Tickets
Sales (millions)
1.0
Ticket
Price
Economic Rent LMC LAC
$10
$7 A team with the same

cost in a larger city
sells tickets for $10.
Season Tickets
Sales (millions)
1.3
 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.
 If the opportunity cost of the input (rent)

is not taken into consideration it may
appear that economic profits exist in the
long-run.
The Industry’s 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.
 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.
 To determine long-run supply, we

assume:
The market for inputs does not change with
expansions and contractions of the
industry.
Long-Run Supply in a
Constant-Cost Industry
Economic profits attract new
firms. Supply increases to S2 and Q1 increase to Q2.
the market returns to long-run Long-run supply = SL = LRAC.
$ per equilibrium. $ per Change in output has no impact on
unit of unit of input cost.
output output
MC AC S1 S2
P2 P2 C
A B
P1 P1 SL
D1 D2
q1 q2 Output Q1 Q2 Output
Constant-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.
Long-Run Supply in an
Increasing-Cost Industry
Due to the increase
in input prices, long-run
equilibrium occurs at
$ per $ per a higher price.
unit of unit of
output LAC2 output S1 S2
SMC2 SL
SMC1
P2 LAC1 P2
P3 P3 B
P1 P1 A
D1 D1
q1 q2 Output Q1 Q2 Q3 Output
 In a increasing-cost industry, long-run

supply curve is upward sloping.
The Industry’s
Long-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?
Long-Run Supply in an
Decreasing-Cost Industry
Due to the decrease
in input prices, long-run
equilibrium occurs at
$ per $ per a lower price.
unit of unit of
output output S1 S2
SMC1
SMC2 LAC1
P2 P2
LAC2
P1 A
P1 B
P3 P3
SL
D1 D2
q1 q2 Output Q1 Q2 Q3 Output
 In a decreasing-cost industry, long-run

supply curve is downward sloping.
The Industry’s
 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.
Effect of an Output Tax on a
Competitive Firm’s Output
Price MC2 = MC1 + tax The firm will
($ per MC1 reduce output to
unit of An output tax the point at which
output) raises the firm’s the marginal cost
marginal cost by the plus the tax equals
amount of the tax. the price.
t
P1
AVC2
AVC1
q2 q1 Output
Effect of an Output
Tax on Industry Output
Price
($ per S2 = S 1 + t
unit of
output) S1
P2 t
Tax shifts S1 to S2 and

P1 output falls to Q2. Price
increases to P2.
Q2 Q1 Output
The Industry’s
 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
The Industry’s
1) Constant-cost industry
 Long-run supply elasticity is infinitely
large
 Inputs would be readily available
The Industry’s
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
The Industry’s
 Question:
Describe the long-run elasticity of supply in
a decreasing -cost industry.
The Long-Run Supply of Housing
 Scenario 1: Owner-occupied housing

Suburban or rural areas
National market for inputs
 Questions
Is this an increasing or a constant-cost
industry?
What would you predict about the elasticity
of supply?
 Scenario 2: Rental property

Zoning restrictions apply
Urban location
High-rise construction cost
 Questions
Is this an increasing or a constant-cost
industry?
What would you predict about the elasticity
of supply?
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.
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.
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.
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.
End of Chapter 8
Profit Maximization
and Competitive
Supply

Profit Maximization and Competitive Supply

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Profit Maximization and Competitive Supply

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Chapter 8

 Perfectly Competitive Markets

 The Competitive Firm’s Short-Run

 Characteristics of Perfectly Competitive

3) Free entry and exit

 Agricultural products, oil, copper, iron,

 Free Entry and Exit

 Do firms maximize profits?

 Do firms maximize profits?

 Do firms maximize profits?

 Determining the profit maximizing level

π (q) = R(q) − C (q)

Cost, Total Revenue

Output (units per year)

Why is cost positive when q is zero?

Output (units per year)

 Marginal revenue is the additional

 Comparing R(q) and C(q)

 Comparing R(q) and C(q)

 Comparing R(q) and C(q)

 Comparing R(q) and C(q)

 Comparing R(q) and C(q)

 Therefore, it can be Cost,

Profits are maximized when :

 The Competitive Firm

 The Competitive Firm

 The Competitive Firm

 The Competitive Firm

 We will combine production and cost

q1 : MR > MC and At q*: MR = MC

 Summary of Production Decisions

 Three guidelines for estimating

1) Average variable cost should not be

 Three guidelines for estimating

2) A single item on a firm’s accounting

 Three guidelines for estimating

3) All opportunity cost should be

 Supply is the amount of output for every

Price S = MC above AVC

 Firm’s Response to an Input Price

How much would

 Stepped SMC indicates a different

 The short-run market supply curve

 Elasticity of Market Supply

 Perfectly inelastic short-run supply

1) Give an example of a perfectly

2) If MC rises rapidly, would the supply

 Producer Surplus in the Short Run

 Producer Surplus in the Short-Run

Market producer surplus is

 In the long run, a firm can alter all its

 Accounting Profit & Economic Profit

 Entry and Exit

 Long-Run Competitive Equilibrium

3) Equilibrium Market Price

Economic Rent LMC LAC

$7 A team with the same

 With a fixed input such as a unique

 If the opportunity cost of the input (rent)

 The shape of the long-run supply curve

 To determine long-run supply, we

 To determine long-run supply, we

 In a constant-cost industry, long-run