Features Price, Quantity and

Profit Maximization
Diagrammatic and
Mathematical - Perfect
Competition
 Learning Objectives
 Discuss 3 characteristics of perfectly competitive markets
 Explain why the demand curve facing a perfectly
competitive firm is perfectly elastic and serves as the
firm’s marginal revenue curve
 Find short run profit maximizing output, derive firm and
industry supply curves, and identify producer surplus
 Explain characteristics of long run competitive
equilibrium for a firm, derive long run industry supply,
and identify economic rent and producer surplus
 Find the profit maximizing level of a variable input
 Employ empirically estimated values of market price,
average variable cost, and marginal cost to calculate
profit maximizing output and profit
 Perfect Competition
 Firms are price-takers
~ Each produces only a very small portion of
total market or industry output
 All firms produce a homogeneous product
 Entry into & exit from the market is
unrestricted
 Demand for a Competitive
Price-Taker
 Demand curve is horizontal at price determined
by intersection of market demand & supply
~ Perfectly elastic
 Marginal revenue equals price
~ Demand curve is also marginal revenue curve
(D = MR)
 Can sell all they want at the market price
~ Each additional unit of sales adds to total revenue an
amount equal to price
 Demand for a Competitive
Price-Taking Firm (Figure 11.2)
S

Price (dollars)
Price (dollars)

P0 P0
D = MR

0 Q0 0

Quantity Quantity

Panel A – Panel B – Demand curve

Market facing a price-taker
 Profit-Maximization in the
Short Run
 In the short run, managers must make two
decisions:
1. Produce or shut down?
~ If shut down, produce no output and hires no variable
inputs
~ If shut down, firm loses amount equal to TFC
2. If produce, what is the optimal output level?
~ If firm does produce, then how much?
~ Produce amount that maximizes economic profit

Profit = π = TR - TC
 Profit-Maximization in the
Short Run
 In the short run, the firm incurs costs that
are:
~ Unavoidable and must be paid even if output
is zero
~ Variable costs that are avoidable if the firm
chooses to shut down
 In making the decision to produce or shut
down, the firm considers only the
(avoidable) variable costs & ignores fixed
costs
Profit Margin (or Average Profit)
 Level of output that maximizes total profit
occurs at a higher level than the output that
maximizes profit margin (& average profit)
~ Managers should ignore profit margin (average
profit) when making optimal decisions

 ( P  ATC )Q
Average profit  
Q Q

 P  ATC  Profit margin

 Short-Run Output Decision
 Firm will produce output where P = SMC
as long as:
~ Total revenue ≥ total avoidable cost or total
variable cost (TR  TVC)
 Equivalently, the firm should produce if
P  AVC
 Short-Run Output Decision
 The firm will shut down if:
~ Total revenue cannot cover total avoidable
cost (TR < TVC) or, equivalently, P  AVC
~ Produce zero output
~ Lose only total fixed costs
~ Shutdown price is minimum AVC
 Fixed, Sunk,& Average Costs
 Fixed, sunk, & average costs are
irrelevant in the production decision
~ Fixed costs have no effect on marginal cost or
minimum average variable cost—thus optimal
level of output is unaffected
~ Sunk costs are forever unrecoverable and
cannot affect current or future decisions
~ Only marginal costs, not average costs,
matter for the optimal level of output
Profit Maximization: P = $36
(Figure 11.3)
Profit Maximization: P = $36
(Figure 11.3)
 Profit Maximization: P = $36
(Figure 11.4)

Break-even point

Panel A: Total revenue

& total cost

Break-even point

Panel B: Profit curve when

P = $36
Short-Run Loss Minimization:
P = $10.50 (Figure 11.5)

Profit
Total =cost
$3,150 - $5,100
= $17 x 300
= -$1,950
= $5,100

Total revenue = $10.50 x 300

= $3,150
 Summary of Short-Run
Output Decision
 AVC tells whether to produce
~ Shut down if price falls below minimum
AVC
 SMC tells how much to produce
~ If P  minimum AVC, produce output at
which P = SMC
 ATC tells how much profit/loss if
produce
π = (P – ATC)Q
 Short-Run Supply Curves
 For an individual price-taking firm
~ Portion of firm’s marginal cost curve above
minimum AVC
~ For prices below minimum AVC, quantity
supplied is zero
 For a competitive industry
~ Horizontal sum of supply curves of all
individual firms; always upward sloping
~ Supply prices give marginal costs of
production for every firm
 Short-Run Producer Surplus
 Short-run producer surplus is the amount
by which TR exceeds TVC
~ The area above the short-run supply curve
that is below market price over the range of
output supplied
~ Exceeds economic profit by the amount of
TFC
 Computing Short-Run
Producer Surplus (Figure 11.6)
Producer surplus  TR  TVC
 $9 110  $5.55 110
 $990  $610
 $380
Or, equivalently,
Producer surplus = Area of trapezoid edba in Figure 11.6
= Height  Average base
 80  110 
 ($9  $5)   
 2 
 $380
$380 multiplied by 100 firms  ($380  100)  $38, 000
Short-Run Firm & Industry Supply
(Figure 11.6)
Long-Run Profit-Maximizing
Equilibrium (Figure 11.7)

Profit = ($17 - $12) x

240 = $1,200
Long-Run Competitive Equilibrium
 All firms are in profit-maximizing
equilibrium (P = LMC)
 Occurs because of entry/exit of firms
in/out of industry
~ Market adjusts so P = LMC = LAC
Long-Run Competitive Equilibrium
(Figure 11.8)
 Long-Run Industry Supply
 Long-run industry supply curve can be flat
(perfectly elastic) or upward sloping
~ Depends on whether constant cost industry or
increasing cost industry
 Economic profit is zero for all points on
the long-run industry supply curve for both
types of industries
 Long-Run Industry Supply
 Constant cost industry
~ As industry output expands, input prices remain
constant, & minimum LAC is unchanged
~ P = minimum LAC, so curve is horizontal
(perfectly elastic)
 Increasing cost industry
~ As industry output expands, input prices rise, &
minimum LAC rises
~ Long-run supply price rises & curve is upward
sloping
 Long-Run Industry Supply for a
Constant Cost Industry (Figure 11.9)
 Long-Run Industry Supply for an
Increasing Cost Industry (Figure 11.10)

Firm’s output
 Economic Rent
 Payment to the owner of a scarce, superior
resource in excess of the resource’s
opportunity cost
 In long-run competitive equilibrium firms that
employ such resources earn zero economic
profit
~ Potential economic profit is paid to the resource
as economic rent
~ In increasing cost industries, all long-run producer
surplus is paid to resource suppliers as economic
rent
 Economic Rent in Long-Run
Competitive Equilibrium (Figure 11.11)
Profit-Maximizing Input Usage
 Profit-maximizing level of input usage
produces exactly that level of output
that maximizes profit
Profit-Maximizing Input Usage
 Marginal revenue product (MRP)
~ MRP of an additional unit of a variable input is the
additional revenue from hiring one more unit of the
input
TR
MRP   P  MP
L

 If choose to produce:
~ If the MRP of an additional unit of input is greater
than the price of input, that unit should be hired
~ Employ amount of input where MRP = input price
Profit-Maximizing Input Usage
 Average revenue product (ARP)
~ Average revenue per worker

TR
ARP   P  AP
L

 Shut down in short run if ARP < MRP

~ When ARP < MRP, TR < TVC
Profit-Maximizing Labor Usage
(Figure 11.12)
 Implementing the
Profit-Maximizing Output Decision
 Step 1: Forecast product price
~ Use statistical techniques from Chapter 7
 Step 2: Estimate AVC & SMC
~ AVC = a + bQ + cQ2
~ SMC = a + 2bQ + 3cQ2
 Implementing the
Profit-Maximizing Output Decision
 Step 3: Check shutdown rule
~ If P  AVCmin then produce
~ If P < AVCmin then shut down
~ To find AVCmin substitute Qmin into AVC
equation
b
Qmin 
2c
AVC min  a  bQmin  cQ 2
min
 Implementing the
Profit-Maximizing Output Decision
 Step 4: If P  AVCmin, find output where
P = SMC
~ Set forecasted price equal to estimated
marginal cost & solve for Q*

P = a + 2bQ* + 3cQ*2
 Implementing the
Profit-Maximizing Output Decision
 Step 5: Compute profit or loss
~ Profit = TR – TC
= P x Q* - AVC x Q* - TFC
= (P – AVC)Q* - TFC

~ If P < AVCmin, firm shuts down & profit

is -TFC
Profit & Loss at Beau Apparel
(Figure 11.13)
Profit & Loss at Beau Apparel
(Figure 11.13)
 Summary
 Perfect competitors are price-takers, produce
homogenous output, and have no barriers to entry
 The demand curve for a perfectly competitive firm is
perfectly elastic (or horizontal) at the market
determined equilibrium price, and marginal revenue
equals price
 Managers make two decisions in the short run: (1)
produce or shut down, and (2) if produce, how much to
produce
~ When positive profit is possible, profit is maximized at the output
where P = SMC
~ When market price falls below minimum AVC the firm shuts
down and produces nothing, losing only TFC
 Summary
 In long-run competitive equilibrium, all firms are in
profit-maximizing equilibrium (P = LMC)
~ No incentive for firms to enter or exit the industry because
economic profit is zero (P = LAC)
 Choosing either output or input usage leads to the
same optimal output decision and profit level
 Five steps to find the profit-maximizing rate of
production and the level of profit for a competitive firm:
1) Forecast the price of the product
2) Estimate average variable cost and marginal cost
3) Check the shutdown rule
4) If P ≥ min AVC find the output level where P = SMC
5) Compute profit or loss