PRODUCTION, COST AND

PROFIT, MONOPOLY AND

COMPETITION
PERFECTLY COMPETITIVE MARKET
 A perfectly competitive market has 5
characteristics and these are the following:
 Very large numbers of buyers and sellers
 A perfectly competitive market is characterized by the
presence of a large number of sellers and buyers who act
independently.
 Since there are many economic agents, each one is too small

to affect the market price of a the good.

 Standardized product
 It sells standard or identical product. From the consumer’s
perspective, the products are perfect substitutes.
 So firms do not attempt to differentiate their products and do

not engage in advertising or other forms of non-price

competition
 No artificial restraints
 The forces of demand and supply work freely to determine the
equilibrium prices and quantities. Price ceilings or price floors
PERFECTLY COMPETITIVE MARKET
 Free entry and exit
 There are no geographical or business constraints for
firms to either enter or exit the industry. Resources are
free to move and producers can sell their output in any
market. No legal, technological, or financial constraint
exists to hamper the firm’s decisions.
 Perfect information
 Consumers have knowledge of what goods are being
sold, where they are being marketed, and what prices
are being charged. Producers also know what
consumers want and what prices would entice them to
make a purchase.
PERFECTLY COMPETITIVE MARKET
 Demand as Seen by a Perfectly
Competitive Firm
 In a perfectly competitive market the demand
faced or perceived by the firms is perfectly
elastic.
 The price is still determined by the forces of
demand and supply but since the firm is just one
of the many firms in the market, it can sell as
much quantity as it wants at the market
determined price.
 The market demand curve is still downward
sloping
 An individual firm cannot influence the price, so
it sees a horizontal or perfectly elastic demand
curve at the market price.
DEMAND AS SEEN BY A PERFECTLY
COMPETITIVE FIRM

P
P
S

P* D
P*

Q Q
Market Firm
REVENUES OF THE FIRM IN A
PERFECTLY COMPETITIVE MARKET
 Total revenue or total sales or the firm’s
gross income is given by:
TR=PXQ
Where P is the market equilibrium price (i.e., fixed)
and Q is the amount of output sold.
 Marginal Revenue
 The additional revenue that the firm earns from
each additional unit of output sold it is given by:
MR=∆TR/∆Q
 Average Revenue
AR= TR/∆Q
REVENUES OF THE FIRM IN A
PERFECTLY COMPETITIVE MARKET
Total Price Total Margina Average Tota Marginal Profit
Produc Revenu l Revenu l Cost
t e Revenu e Cost
e
0 50 0 - - 120 - -120
1 50 50 50 50 150 30 -100
2 50 100 50 50 175 25 -75
3 50 150 50 50 193 18 -43
4 50 200 50 50 218 25 -18
5 50 250 50 50 248 30 2
6 50 300 50 50 282 34 18
7 50 350 50 50 322 40 28
8 50 400 50 50 372 50 28
9 50 450 50 50 427 55 23
10 50 500 50 50 485 58 15
11 50 550 50 50 545 60 5
12 50 600 50 50 615 70 -15
SHORT RUN PROFIT MAXIMIZATION
   the short run the plant size is fixed.
In
Therefore the firm can adjust its output
through changes in the amount of variable
resources it employ to achieve the output
level that maximizes profit or minimize
losses.
 Economic profit is defined as

Where: TR= Total Revenues

TC= Total Costs which includes implicit and
explicit
costs.
If the firm’s goal is to maximize profit, it only needs to
identify the output that will generate the largest surplus
of TR over TC. There are two ways to do this: we can
THE TOTAL REVENUE-TOTAL COST
APPROACH
 The Total Revenue Curve is a straight line
since the output level is multiplied by a
constant price. Whereas the Total Cost Curve
increases as more output is produced. When
the TR and TC curves intersect there is no
TR, economic
TC profit. TC>TR
TR=TC

TR=TC B

C
A
TC>TR

Q0 Q1 Q2 Q
THE TOTAL REVENUE-TOTAL COST
APPROACH
 TR and TC curves intersect at points A and D,
at these points the firm does not have any
economic profit.
 The firm earns profits if the TR curve is above
the TC curve.
 The firm loses if TC is above TR

 The firm achieves maximum profit where the

vertical distance between TR and TC curves
is greatest.
THE MARGINAL REVENUE-MARGINAL
COST APPROACH
 In the second approach we will compare the
marginal revenue and marginal cost of each
additional unit of output produced and sold.
The profit maximizing level of output is the
output level where MR=MC. This is known as
the MR=MC rule.
 The MR=MC rule
 Ittells us that each additional unit of output adds
the same amount of total revenue and total cost.
In a perfectly competitive market the MR=MC
rule can be restated as P=MC because in a
perfectly competitive market price is identical to
marginal revenue.
THE MARGINAL REVENUE-MARGINAL
COST APPROACH
 The graph below illustrates the MR=MC rule
Revenue, Costs

MC

AC
A
P* P=MR=AR
AVC
B
D

C
E

0
Q* Q
 THE IMPORTANCE OF FIXED AND
VARIABLE COSTS (BREAK EVEN POINT
 In order to decide when to stop producing or
when to stop producing, to answer we need
to analyze the firm’s behavior given different
price levels. OP0AQ0 =total
Revenue, Costs MC revenue at P0
AC
A OP1CQ1 =total
P0 MR0 revenue at P1
• At this price
Break even point B total revenue is
AVC also equal to
total cost
C
P1 MR1 because Price
(and MR is
equal to the
minimum level
Q1 Q0 Q of average cost)
Thus Q1 is the
THE IMPORTANCE OF FIXED AND
VARIABLE COSTS (LOSS
MINIMIZATION)
 But what if the price drops again and the
Price level and in the case of a perfectly
competitive market the MR is between the
Average Cost and Average Variable Costs
does the firm need to shutdown.
 To answer this question let us analyze the
given graph
THE IMPORTANCE OF FIXED AND
VARIABLE COSTS (LOSS
MINIMIZATION) In the graph the
Price is Between
Revenue,
P Costs
MC AC the AC and AVC
curves the
TFC question is will
the firm stop
AVC operations
D A
Loss because it is
B
P2 MR2 incurring losses
Loss

E
Minimization the answer is
C NO.
TVC

0 Q2 Q
THE IMPORTANCE OF FIXED AND
VARIABLE COSTS (LOSS
MINIMIZATION) Because there are
two kind of cost the
Revenue, Fixed Cost and
MC AC
P Costs Variable Cost this is
the reason why the
TFC firm will continue
production. Because
AVC the revenue it earns
D A could still pay a
Loss portion of the fixed
B
P2 MR2 cost represented by
Loss
Minimization
the area EP2BC and
E the whole variable
C
TVC cost represented by
the area OECQ2.
0 Q2 Q
THE IMPORTANCE OF FIXED AND
VARIABLE COSTS (LOSS
MINIMIZATION) The loss to the firm is
represented by the area
P2DAB this area is
Revenue,
MC AC much smaller than
P Costs EDAC which it losses
when it stops
production. The area
TFC
EDAC represents fixed
cost the firm would still
AVC be incurring this cost so
D A
when the firm shuts
Loss down it still needs to
B
P2 MR2 pay for this cost. That is
Loss why it is much advisable
Minimization
E to continue production.
C So when does the firm
TVC stop its operations.

0 Q2 Q
THE IMPORTANCE OF FIXED AND
VARIABLE COSTS (SHUT DOWN
POINT) Suppose the prices
have dropped further
Revenue, Price and MR are
MC AC equal to the lowest
P Costs point of the AVC
curve. The loss to the
TFC firm is represented by
the area EDAC which
AVC is the firm’s fixed cost
D A at this point the firm
should consider
B shutting down
E Loss MR3
because its losses are
P3 of the same amount if
C he continues
TVC production and if it
shuts down.
0 Q2 Q
THE FIRM’S SHORT RUN SUPPLY
CURVE
 Seeing that the firm will shutdown when
P=MR=AVC we need to qualify the MR=MC
rule that the firm will maximize profit if P=MC
and provided that market price exceeds
minimum average variable cost.
 Since the firm’s best option is to continue
production whenever the market price is
greater than the minimum point of the
average variable cost curve. The firm’s short
run supply curve is the upward sloping
portion of its marginal cost curve that lies
above the minimum average variable cost
curve.
THE MARGINAL REVENUE-MARGINAL
COST APPROACH
 The graph below illustrates the MR=MC rule
MC, AC
AVC
Short Run MC
Supply AC
Curve

AVC

Q
PROFIT MAXIMIZATION IN THE LONG
RUN
 In the long run firms may enter or exit the market . For
firms operating in a perfectly competitive market (PCM),
equilibrium is achieved when the Long Run Marginal Cost
(LMC) is equal to the marginal revenue and price
(LMC=MR=P). If entering the business will earn more
profits firms will enter the market and this means that the
market supply curve will shift to the right causing a fall in
MR and a decline in the profit maximizing level of output
for the firm.
 If profits are still positive then firms will continue to enter
the market. The entry of firms will only stop when there
are no more profits to be made. The market at this point
will be in long run equilibrium.
 At this point LMC=MR=P=Short run MC. Likewise at this
point , long run average cost= short run average cost=
price.
LONG RUN EQUILIBRIUM
Price
and LMC
Costs

SMC
SAC
LAC

MR

Q
Q