Introduction to Economics –ECO401 VU

Lesson 18

PROFIT MAXIMIZATION ANALYSIS (CONTINUED) & MARKET STRUCTURES

PROFIT MAXIMIZATION USING CALCULUS

If total revenue (TR) and total cost equation are given as follows:
TR = 48q – q2
TC = 12 + 16q + 3Q2

Q TR TC Tπ = TR –TC
0 0 12 -12
1 47 31 16
2 92 56 36
3 135 87 48
4 176 124 52
5 215 167 48
6 252 216 36
7 287 271 16

Profit is maximized at the point where:

MC = MR
MC function can be found by taking derivative of total cost function. i.e.:
MC = d TC / dQ
MC = 16 + 6Q
MR function can be found by taking derivative of total revenue (TR) function i.e.:
MR = d TR / dQ
= 48 – 2Q
As profit is maximized at the point where MR = MC, so by equating values of MC and MR
function, we get,
MR =MC
16 + 6Q = 48 – 2Q
6Q + 2Q = 48 – 16
8Q = 32
Q=4
The equation for total profit is,
Tπ = TR – TC
= 48Q – Q2 - (12 + 16Q + 3Q2)
= 48Q – Q2 – 12 – 16Q – 3Q2
= -4Q2 + 32Q – 12
Putting Q = 4, we get,
Tπ = - 4(4)2 + 32 (4) – 12
= -64 + 128 - 12
Tπ = 52

So profit is maximized where output is 4 and the maximum profit is 52.

We can also calculate AR from this information:
TR=48Q – Q2
AR=TR/Q= 48Q/Q-Q2/Q
= 48-Q
= 48- 4
AR = 44

Slope of MR curve is twice as the slope of AR curve:

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Introduction to Economics –ECO401 VU

Slope of AR is obtained by differentiating AR function with respect to Q.

Slope of AR = dAR / dQ
= d/dQ (48-Q)
= -1
Slope of MR is obtained by differentiating MR function with respect to Q.
Slope of MR = dMR / dQ
= d/dQ (48-2Q)
= -2
MARKET STRUCTURES
Economists have identified four broad market structures:
• Perfect competition
• Monopoly
• Monopolistic competition
• Oligopoly
Type of Number Freedom of Nature of Implication for demand
Examples
market of firms entry product curve of firm
Grains
Perfect Very Homogenous Horizontal; firm is a price
Unrestricted (wheat) or
competition many (undifferentiated) taker
vegetables
Downward sloping but
Monopolistic Many / Plumbers,
Unrestricted Differentiated relatively elastic; firm has
competition Several restaurants
some control over prices.
Cement,
1. Downward sloping relatively
cars,
Oligopoly or Undifferentiated inelastic but depends on
Few Restricted electrical
Cartel or 2. reactions of rivals to a price
appliance,
Differentiated change
oil.
Restricted Downward sloping more
or WAPDA, or inelastic than oligopoly; firm
Monopoly One Unique
completely KESC has considerable control
blocked over price
Market structure refers to how an industry (broadly called market) that a firm is operating in is
structured or organized.
The key ingredients of any market structure are:
• Number of firms in the market/industry
• Extent of barriers to entry
• Nature of product
• Degree of control over price
Knowledge about market structure can help answer four questions:
ii. How much profit a firm will make (normal or supernormal)
iii. How much quantity it will produce at its profit-maximization point (i.e. whether it will be a
large level of output or a small one relative to the market)
iv. Whether or not a higher level of output would increase the cost or productive efficiency of
the firm or allocative efficiency for society (see the summary on monopoly for details)
v. Are the prices set too high, too low, or just right?

PERFECT COMPETITION
The main assumptions of perfect competition are:
i. Large number of buyers and sellers, therefore firms price-takers.
ii. No barriers to entry (also implies free mobility of factors of production).
iii. Identical/homogeneous products
iv. Perfect information/knowledge

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Introduction to Economics –ECO401 VU

The word perfect in perfect competition is not used its normative sense. Rather it means that
competition in the industry is of an extreme nature. It is used as a benchmark with which to
compare other types of market structures.
Perfect competition can be thought of as an extreme form of capitalism, i.e. all the firms are
fully subject to the market forces of demand and supply.
Concentration ratio is used to assess the level of competition in an industry. It is simply the
percentage of total industry output that is produced by the five largest firms in the industry.

PROFIT MAXIMIZATION UNDER PERFECT COMPETITION IN THE SHORT RUN

The short run is the period where at least one factor of production is fixed. In perfect competition,
it also means that no new firms can enter the market. Equilibrium analysis can help us answer
questions about the market-clearing price and quantity; where the profits are maximized and
how much are these profits; how individual firms make their short run supply decisions and how
these translate into the long-run industry supply curve.
In the short run, a perfectly competitive firm can settle at equilibrium where it is making super
normal profits, normal profits, loss, or where it decides to shut down.
In the short run, the firm’s supply curve is identical to the positive part of MC. The short run
industry supply curve is simply the horizontal summation of the supply curves of individual firms.

The demand (or AR) curve for the industry is downward sloping but for any individual perfectly
competitive firm, is horizontal. Thus, the firm can sell as much at the given market price. For this
reason, the AR and MR curves align under perfect competition.

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