Economic Principles I

Lecture 11:
Profit Maximisation in Conditions of
Perfect Competition
Perfect Competition
A (perfectly) competitive market
Many buyers and sellers
Goods are largely the same
(homogeneous)
So no one buyer or seller can influence
price, and must take the market price as
given
Free entry and exit
What does the Firm Earn?
Revenue
Total Revenue = Price times Quantity of Output
TR = P.Q
Average Revenue = Total Revenue divided by
Output
AR = TR/Q= (P.Q)/Q = P
Marginal Revenue is the extra revenue from
selling another unit of output
MR = TR/Q
The Soft Drinks Example again
No of Soft
Drinks Price
Total
Revenue
Average
Revenue
Marginal
Revenue
Q P TR=P.Q AR=TR/Q MR=TR/Q
1 2 2 2
2 2 4 2 2
3 2 6 2 2
4 2 8 2 2
5 2 10 2 2
6 2 12 2 2
7 2 14 2 2
8 2 16 2 2
Putting these Ideas together:
Because price doesnt change with output,
average and marginal revenue are constant
For a competitive firm marginal revenue
equals the price of the good
The firms objective is to maximise profits,
so we need to match together this revenue
information with cost information
Where Profit is Maximised
No of Soft
Drinks
Total
Revenue Total Cost Profit
Marginal
Revenue
Marginal
Cost
Q TR TC TR-TC MR=TR/Q MC=TC/Q
1 2 3 -1
2 4 3.5 0.5 2 0.5
3 6 4.5 1.5 2 1
4 8 6 2 2 1.5
5 10 8 2 2 2
6 12 10.5 1.5 2 2.5
7 14 13.5 0.5 2 3
8 16 18 -2 2 4.5
Changes at the Margin (1)
Why does profit fall at 6 units of output and
above?
The 6
th
drink sold brings in extra (marginal)
revenue of 2
But it incurs extra (marginal) cost of 2.50
So total profit must fall as it has cost more to
produce than it raises when sold
Rational people think at the margin!
Changes at the Margin (2)
Why does profit rise up to 4 units of output?
The 3
rd
drink sold brings in marginal revenue of
2
But it only incurs marginal cost of 1.50
So total profit must rise as it has cost less to
produce than it raises when sold
Conclusion: the competitive firm maximises
profits at the quantity of output where price
equals marginal cost
Putting the Curves
Together
At Q
1
P is
greater than
MC and so
profits rise if
output
increases
At Q
2
MC is
greater than P
and so profits
rise if output
decreases

Q
max
is where
profits are
maximised
P=AR=MR
Costs and
Revenue
Quantity
0
MC
1

MC
2
Q
1
Q
2
Q
max

MC

ATC

AVC

Market Equilibrium
We can now see how the competitive firm
decides how much to supply to the market
At any given price the profit maximising output is
found at the intersection of price and MC
So if the price the firm faces goes up, the chosen
level of output rises in line with the MC curve
So the marginal cost curve is the competitive
firms supply curve
Price Rises for
the Firm
Costs and
Revenue
Quantity
0
P
1

P
2
Q
1
Q
2

MC

ATC

AVC

Increase in P
leads to
increase in
profit
maximising
output
MC curve
shows quantity
supplied at any
given price
MC curve is the
firms supply
curve
Conclusion
We have looked at the competitive firm and
where it maximises profits
Profits are maximised at the level of output
where price equals marginal cost
The competitive firms supply curve is its
marginal cost curve
Lecture 13 will examine the firms decisions to
enter and to exit a market
Economic Principles I
Lecture 11:
Profit Maximisation in Conditions of
Perfect Competition