Microeconomics

The supply decision

Professor Neil Rickman

31 AD 00

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 Question

• What principle should a profit maximising firm use to choose its

output level?
– Answering this requires us to bring costs and revenue together
– We shall arrive at the well-known 𝑀𝑅 = 𝑀𝐶 condition

• Outline
– Marginal Revenue (MR) and Average Revenue (AR)
– Profit maximising output decision
• Diagram
• Maths
• Maths example

• Note
– We are assuming that the firm wishes to maximise profit
– Other options are possible; e.g. maximising sales revenue
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 The demand curve

• Firms can only sell output at the price consumers

will pay
𝑃

𝑃1

𝑃2
𝐷
0 𝑄1 𝑄2 𝑄
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 !" $#
𝐴𝑅 = #
= #
= 𝑃 = Demand

Revenue 𝑑𝑇𝑅/𝑑𝑄
Assume: 𝑃 = 11 – 𝑄
Quantity Price Total Revenue Average Revenue Marginal Revenue
(Q) (P) (TR = PQ) (AR = TR/Q) (MR = ΔTR/ΔQ)
0 11 0 0
10
1 10 10 10
8
2 9 18 9
6
3 8 24 8
4
4 7 28 7
2
5 6 30 6
0
6 5 30 5
-2
7 4 28 4
-4 4
8 3 24 3
 Marginal Revenue (MR) and Average
Revenue (AR)
12

10
(Notice that AR is falling
and MR is below it)
8

𝐴𝑅
4
Price

0
0 2 4 6 8 10 12 14 16 18

-2

-4
𝑀𝑅

-6
Quantity
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 Profit maximising output decision: Diagram
• Bringing costs and revenue together

Costs,
Revenue
𝑀𝐶 = 𝑀𝑅 𝑀𝐶

𝑀𝑅 < 𝑀𝐶
𝑀𝑅 > 𝑀𝐶
𝑀𝑅

0 𝑄1 𝑄∗ 𝑄2 Q
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 Profit maximising output decision: Maths

• The firm chooses output (𝑄) to maximise profit (𝜋), given by:
𝜋 = 𝑇𝑅 − 𝑇𝐶
• The FOC for a stationary point of the profit function is
𝑑𝜋 𝑑𝑇𝑅 𝑑𝑇𝐶
= − =0
𝑑𝑄 𝑑𝑄 𝑑𝑄
– I.e. 𝑀𝑅 = 𝑀𝐶
• The SOC for profit to be maximised at the stationary point is:
𝑑# 𝜋 𝑑 𝑑𝑇𝑅 𝑑 𝑑𝑇𝐶
#
= −
𝑑𝑄 𝑑𝑄 𝑑𝑄 𝑑𝑄 𝑑𝑄
𝑑𝑀𝑅 𝑑𝑀𝐶
= − <0
𝑑𝑄 𝑑𝑄
– I.e. 𝑀𝐶 must be falling slower than 𝑀𝑅 is
• This makes sense: if costs are falling faster than revenues then you can
probably increase your profit by increasing output 7
Illustrating the SOC

Costs,
Revenue 𝑀𝐶 = 𝑀𝑅 𝑀𝐶

𝑀𝑅
𝑀𝑅 > 𝑀𝐶

0 𝑄1 𝑄∗ 𝑄
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When does the SOC hold?
• Consider these three 𝑀𝐶 curves (𝑀𝐶&, 𝑀𝐶', 𝑀𝐶():
𝑑𝑀𝑅 𝑑𝑀𝐶
Costs, − >0
𝑑𝑄 𝑑𝑄
Revenue
𝑑𝑀𝑅 𝑑𝑀𝐶
− <0
𝑑𝑄 𝑑𝑄
𝑀𝐶(
𝑀𝐶'

𝑀𝐶&
𝑀𝑅
𝑑𝑀𝑅 𝑑𝑀𝐶
− <0
𝑑𝑄 𝑑𝑄
0 𝑄
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 Example

• Demand: 𝑃 = 16 − 2𝑄
– " Total revenue: 𝑇𝑅 = 𝑃×𝑄 = 16𝑄 − 2𝑄!
"#$
– " Marginal revenue: 𝑀𝑅 = = 16 − 4𝑄
"%
• Total cost: 𝑇𝐶 = 2𝑄!
"#&
– → Marginal cost: 𝑀𝐶 = = 4𝑄
"%
• Profit: 𝜋 = 𝑇𝑅 − 𝑇𝐶 = (16𝑄 − 2𝑄! ) − 2𝑄!
• FOC:
𝑑𝜋
= 16 − 4𝑄 − 4𝑄
8 = 0 → 𝑄∗ = 2
𝑑𝑄 "$
"#
• SOC:
𝑑! 𝜋
= −8 < 0
𝑑𝑄!
– So profit is maximised at 𝑄∗ = 2
• This output is sold at the price 𝑃∗ = 16 − 2𝑄∗ = 12
• Therefore, 𝑇𝑅 = 12×2 = 24, 𝑇𝐶 = 2 2 ! = 8 → 𝜋 ∗ = 24 − 8 = 16
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 𝑇𝐶 = 2𝑄 !

TR and TC
𝑇𝑅 = 16𝑄 − 2𝑄 !

Demand
𝑀𝐶 = 4𝑄

MR and MC
𝑃 = 16 − 2𝑄
𝑀𝑅 = 16 − 4𝑄

𝜋
𝜋 = 𝑇𝑅 − 𝑇𝐶 = 16𝑄 − 4𝑄 !

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• Notice two things
– For a linear demand curve, AR has half the slope of MR
𝐴𝑅 = 𝑃 = 16 − 2𝑄, 𝑀𝑅 = 16 − 4𝑄
– From looking at the shapes of the demand and total cost
curves, we can see that the SOC is likely to be satisfied in
this case
• Demand curve
– 𝑃 = 16 − 2𝑄 = 𝐴𝑅
– i.e. AR is falling, so MR will be below it and may well, therefore, be
falling
» Like the example at the start of these notes
• Total cost curve
– 𝑇𝐶 = 2𝑄!
– This is increasing at an increasing rate (convex), i.e. its slope is
getting bigger
» i.e. MC is increasing
• Thus, if MR is likely to be decreasing and MC is increasing, the
SOC is likely to be satisfied (see 𝑀𝐶. on Slide 9)
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 Summary

• Firms maximise profit when 𝑀𝑅 = 𝑀𝐶

– We shall see this principle whenever we study a profit maximising
firm
• Looking forward, we shall see that different
competitive conditions affect the demand (= AR)
that a firm faces
– This affects its MR curves
• And this affects precisely where 𝑀𝑅 = 𝑀𝐶
– Which determines how much output it chooses
• But 𝑀𝑅 = 𝑀𝐶 will always be relevant

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