PROFIT MAXIMIZATION AND

PERFECT COMPETITION
CHAPTER OUTLINE

 Perfectly Competitive Markets

 Profit Maximization

 Marginal Revenue, Marginal Cost, and Profit

Maximization
 Choosing Output in the Short Run

 The Competitive Firm’s Short-Run Supply Curve

 The Short-Run Market Supply Curve

 Choosing Output in the Long Run

 The Industry’s Long-Run Supply Curve

PERFECTLY COMPETITIVE MARKETS
 The model of perfect competition rests on four basic
assumptions:
(1) Large number of buyers and sellers
(2) price taking: Firm has no influence over market price and
thus takes the price as given.
(3) product homogeneity: products of all of the firms in a
market are perfectly substitutable with one another and
(4) free entry and exit: Condition under which there are no
special costs that make it difficult for a firm to enter (or
exit) an industry.
The Demand Curve and the Marginal Revenue Curve
for a Perfectly Competitive Firm
 Perfectly Competitive Firms are Price
Takers
• A price taker is a seller that does not have the ability to
control the price of the product it sells; it takes the price
determined in the market.
• A firms is restrained from being anything but a price taker if
it finds itself one among many firms where its supply is
small relative to the total market supply, and it sells a
homogeneous product in an environment where buyers and
sellers have all relevant information.
PROFIT MAXIMIZATION CONDITION
 A firm chooses output
q*, so that profit, the
difference AB between
revenue R and cost C, is
maximized. PROFIT
=TR-TC = + (SR)
 At that output, marginal
revenue (the slope of the
revenue curve) is equal to
marginal cost (the slope
of the cost curve). Profit
= TR –TC = 0; LR]
 DEMAND AND MARGINAL REVENUE
FOR A COMPETITIVE FIRM
 A competitive firm
supplies only a small
portion of the total
output of all the firms
in an industry.
Therefore, the firm
takes the market price
of the product as given,
choosing its output on
the assumption that the
price will be unaffected
by the output choice.
OUTPUT RULE IN PERFECT
COMPETITION
 Output rule: If a firm is producing any output, it should
produce at the level at which marginal revenue equals
marginal cost. [Q= ? MR = MC]
 Profit maximization quantity: Firms should produce at a
level where Marginal revenue equals marginal cost at a
point at which the marginal cost curve is rising.
MC = MR = P; P = MC
Output Decisions: Revenues, Costs, and Profit Maximization

Comparing Costs and Revenues to Maximize Profit

A Numerical Example [ MC = CHANGE OF VC/CHANGE OF Q

TABLE 8.6 Profit Analysis for a Simple Firm

(1) (2) (3) (4) (5) (6) (7) (8)
TR TC PROFIT
q TFC TVC MC P = MR (P x q) (TFC + TVC) (TR - TC)

0 $ 10 $ 0 $ - $ 15 $ 0 $ 10 $ -0
1 10 10 10 15 15 20 -5
2 10 15 5 15 30 25 5

3 10 20 5 15 45 30 15

4 10 30 10 15 60 40 20

5 10 50 20 15 75 60 15

6 10 80 30 15 90 90 0
CHOOSING OUTPUT IN THE SHORT RUN [ P. 288]
 In the short run, the competitive
firm maximizes its profit by
choosing an output q* at which
its marginal cost MC is equal to
the price P (or marginal revenue
MR) of its product. The profit of
the firm is measured by the
rectangle ABCD.
 Any change in output, whether
lower at q1 or higher at q2, will
lead to lower profit. [ PAGE
288]
 Q =? MR=P =MC
 PROFIT = TR-TC = P*Q-TC
 =(P-AC)*Q= P*Q - AC*Q = (40-
32)*8= 64
LOSS IN THE SHORT RUN AND SHUT-
DOWN DECISION [ P < AVCMIN]
 A competitive firm
should shut down if
price is below AVC.
 The firm may produce
in the short run if
price is greater than
average variable cost.
 [P>AVC, SUPPLY]
 [P>AC, WE MAKE
PROFIT, SR]
 P = ACmin ; PROFIT = 0;
LR; P<AC, LOSS; EXIT
IN the LR
SHORT-RUN SUPPLY CURVE OF COMPETITIVE
FIRM[ WHEN MC = AVC, AVC IS MINIMUM= 20, P = TAKA 20;
MC>AVC; SUPPLY CURVE IN THE SR]

 In the short run, the firm

chooses its output so that
marginal cost MC is equal to
price as long as the firm
covers its average variable
cost.
 The short-run supply curve
is only that part of the
marginal cost curve which is
above the average revenue
line (given by the
crosshatched portion of the
marginal cost curve in the
diagram).
© 2012 Pearson Addison-Wesley
 Profit Maximization and Loss Minimization for the
Perfectly Competitive Firm: Three Cases[ ATC = 11= AFC+AVC]
What Should a Firm Do in the Short
Run?
The firm should produce in the short run as
long as price (P) is above average variable
cost (AVC). It should shut down in the short
run if price is below average variable cost.
MATHEMATICAL EXAMPLE [ PAGE 315, EX.4]
 Suppose you are the manager of a watch making firm
operating in a competitive market. Your cost of
production is given by C = 200 + 2q2, where q is the
level of output and C is total cost. (The marginal cost of
production is 4q; the fixed cost is $200.)
a) If the price of watches is $100, how many watches
should you produce to maximize profit?
b) What will the profit level be?
c) At what minimum price will the firm produce a
positive output?
 Suppose you are the manager of a watch making firm
operating in a competitive market. Your cost of production
is given by C = 200 + 2q2, where q is the level of output and
C is total cost. (The marginal cost of production is 4q; the
fixed cost is $200.)
 Supply Decision: [the portion of MC which is above the
AVC is the short-run supply curve].
 MC = 4Q ; VC = 2Q^2; AVC = VC/Q = 2Q;

 Since MC>AVC, the firm should supply output at any

positive price.
PRODUCER SURPLUS IN THE SHORT
RUN
 The producer surplus
for a firm is measured
by the shaded area
below the market
price and above the
marginal cost curve
(SUPPLY CUVE),
between outputs 0 and
q*, the profit-
maximizing output.
MATHEMATICAL EXAMPLE [EX. 5, 11; P =315]
 Suppose that a competitive firm’s marginal cost of
producing output q is given by MC(q) = 3 + 2q. Assume
that the market price of the firm’s product is $9.
a) What level of output will the firm produce?
b) What is the firm’s producer surplus?
c) Suppose that the average variable cost of the firm is
given by AVC(q) = 3 + q. Suppose that the firm’s fixed
costs are known to be $3. Will the firm be earning a
positive, negative, or zero profit in the short run?
ANSWER
 P = MC ; 9 = 3+2Q; Q =3
 PRODUCER SURPLUS = ½*6*3 = 9

AVC(q) = 3 + q. Suppose that the firm’s fixed costs are known to be $3.

PROFIT = TR –TC = P*Q – [FC+VC]= 9*3 – [ 3+AVC*Q]

= 27- [ 3+(3+3)3] = 27 -21 = 6
 Perfect Competition In The Long Run
The following conditions characterize long run equilibrium:
1. Economic profit (PROFIT = TR-TC) is Zero: Price is equal
to short-run average total cost (SRATC).
If P > SRATC (SHORT-RUN ATC) → positive economic profit
→ entry
If P < SRATC → loss → exit
2. Firms are producing the quantity of output at which
Price is equal to Marginal Cost (MC) or MR=MC
WHAT WILL HAPPEN IN LONG TO EARN ZERO PROFIT?
MC = AC
OR dAC/dq = ……..= 0; find Q; find ACmin at this q;
set the price= ACmin
CHOOSING OUTPUT IN THE LONG RUN
P. 301, FIG.8.13

 The firm maximizes

its profit by choosing
the output at which
price equals long-run
marginal cost LMC.
 In the diagram, the
firm increases its
profit from ABCD to
EFGD by increasing
its output in the long
run.
 Ex. 10, P.316. Suppose you are given the following information
about a particular industry:
QD  6500  100P Market demand
QS  1200P Market supply
2
q
C(q)  722  Firm total cost function
200
2q
MC(q)  Firm marginal cost function.
200

 Assume that all firms are identical, and that the market is
characterized by pure competition.
a) Find the equilibrium price, the equilibrium quantity, the output
supplied by the firm and the profit of each firm.
b) Would you expect to see entry into or exit from the industry in the
long run? Explain. What effect will entry or exit have on market
equilibrium?[ new firms enter; supply should go up, price should
fall; and in the long run profit becomes zero]
c) What is the lowest price at which each firm would sell its output in
the long run? Is profit positive, negative, or zero at this price?
Explain.
ANSWRR
 Solve: D = S; 6500-100P= 1200P. We find P= $5 and putting the
price into either demand or supply equation we find Q = 6000.

To find the output for the firm set P = MC; 5 = MC(note MC =

dTC/dq = 2q/200); 5 = 2q/200; q = 500.
Number of firms = 6000/500 =1 2
Firm’s Profit = TR -TC = P*Q – C(q) = 5*500 – 722- 5002/200 =
528 [ in the short-run]
 
Notice that since the total output in the market is 6000, and the
firm output is 500, there must be 6000/500=12 firms in the
industry.
LR ; P = AC = 3.8; PROFIT= TR- TC = (P-AC)*Q = (3.8
-3.8)*380 = 0

What is the lowest price at which each firm would sell its
output in the long run? Is profit positive, negative, or zero
at this price? Explain.
MC = 2q/ 200; AC = TC/ q= [722+q2/200]/q
MC = AC
MATHEMATICAL EXAMPLE: P. 315, EX.6
5.A firm produces a product in a competitive industry and has a total cost function C = 50 + 4q +
2q2 and a marginal cost function MC = 4 + 4q. At the given market price of $20, the firm is
producing 5 units of output. Is the firm maximizing its profit? What quantity of output should the
firm produce in the long run?
……………………………………………………………………………………
Profit = TR –TC = P*Q – C = 20*5 – 50 -4*5 - 2*5^2 = -20
( Firm is not maximizing profit]
P = MC; 20 = 4+4Q ; Q =4; Profit = TR – TC = -18;
The firm should not supply output in the long-run
……………………………………………………………………………………….
{Let us verify}
AC = C/q = 50/q+4+2q; AC min = 50/5+ 4 +2*5 = Taka 24; Price = 24
MC = AC [to find long-run lowest price]; 4 +4q = 50/q +4+ 2q; q = 5; ACmin = 50/q+4+2q =
24 ; P<Acmin, so, we do not supply in the long-run; rather than EXIT from the market. In the long-run minimum price should be
$24,
EX. 11; P. 316
 C (Q) = 450+15Q+2Q^2; P = TAKA 115
P = MC; [ MC = dC/dQ = 15+4Q]
Q = 25
PROFIT = TR – TC = 115*25 – 450 – 15*25 – 2*25^2 =
TAKA 800
PRODUCER SURPLUS =?
 INDUSTRY’S LONG RUN SUPPLY CURVE (HORITONAL;
DOWNWARD, UPWARD)AND FIRM’S OUTPUT
DETERMINATION
 constant-cost industry:
Industry whose long-run
supply curve is horizontal.
 In (b), the long-run supply
curve in a constant-cost
industry is a horizontal line
SL. When demand increases,
initially causing a price rise
(represented by a move from
point A to point C), the firm
initially increases its output
from q1 to q2, as shown in
(a).
 But the entry of new firms
causes a shift to the right in
industry supply.
 OUTPUT DETERMINATION IN
INCREASING COST INDUSTRY
 increasing-cost industry:
Industry whose long-run supply
curve is upward sloping.
 In (b), the long-run supply curve in
an increasing-cost industry is an
upward-sloping curve SL. When
demand increases, initially causing
a price rise, the firms increase their
output from q1 to q2 in (a).
 In that case, the entry of new firms
causes a shift to the right in supply
from S1 to S2. Because input prices
increase as a result, the new long-
run equilibrium occurs at a higher
price than the initial equilibrium.
 Shutdown vs. Exit

• Shutdown: [P<AVC]
A short-run decision not to produce anything
because of market conditions. [ do not exit
from the market; loss = - FC; bear the fixed
cost]
• Exit:
A long-run decision to leave the market.
• A key difference:
– If shut down in SR, must still pay FC.
– If exit in LR, Zero costs.
 The Shutdown Point
• The firm will shut down if it cannot cover average variable costs.
– A firm should continue to produce as long as price is greater than
average variable cost.
– Once price falls below that point it makes sense to shut down
temporarily and save the variable costs.
– The shutdown point is the point at which the firm will gain more by
shutting down than it will by staying in business.
– As long as total revenue is more than total variable cost, temporarily
producing at a loss is the firm’s best strategy since it is taking less of a
loss than it would by shutting down.
 P. 316. Ex. 9
• 9. (a) Suppose that a firm’s production function is q =
9x1/2 in the short run, where, there are fixed costs of
$1,000 , and x is the variable input, and the cost of x
cost is $4,000 per unit. What is the total cost of
producing a some level of output q. In other words,
identify the total cost function C(q).
Q = 9X^1/2; Q^2 = [9X^1/2]^2 = 81X; X = Q2/81
C = FC + VC = 1000+4000X = 1000+4000*Q2/81 = 1000+
4000*Q2/81; MC = dC/dQ = 8000Q/81
P = MC; 1000 = 8000/81; Q =
PROFIT =
• (c) If price is $1000, how many units will the
firm produce? What is the level of profit?
P = MC = 8000q/81;
1000 = 8000q/81;
q = 10.125
PROFIT = TR – TC =P*Q –C=
= 1000*10.125-
(1000+(4000*10.125*10.125)/81) = 4062.5.
 One problem From Chapter 7, Page 272. The costs of Production ; EX. 12
[ LEARNING CURVE’S MATH]

AC = 10 - 0.1Q + 0.3q
(a)Is there a learning curve effect?
The learning curve describes the relationship between
the cumulative output and the inputs required to
produce a unit of output. Average cost measures the
input requirements per unit of output. Learning curve
effects exist if average cost falls with increases in
cumulative output. Here, average cost decreases as
cumulative output, Q, increases. Therefore, there are
learning curve effects. [ AS Q GOES UP; AC GOES
DOWN BY - 0.1; LEARNING CURVE EFFECT IS
PRESENT
 One problem From Chapter 7, Page 272.
The costs of Production ; EX. 12
[ LEARNING CURVE’S MATH]
c). During its existence, the firm has produced a total of 40,000
computers and is producing 10,000 computers this year. Next
year it plans to increase its production to 12,000 computers. Will
its average cost of production increase or decrease? Explain.
AC = 10 - 0.1Q + 0.3q
AC1 = 10 -0.1*40 +.3*10 = Taka 9
AC2 = 10 – 0.1*50 + .3*12 = Taka 8.6
 Profit Maximization
•Using the following equations, find the profit maximizing output and maximum profit
.

Q  90  2 P
P  45  0.5Q; ;

TC  Q 3  8Q 2  57Q  2

  profit  TR  TC
 Profit Maximization Rule
Q = 90 -2P
2P = 90 –Q; P = 45-0.5Q; P*Q = TR = 45Q -0.5Q^2
PROIFT = TR –TC= 45Q -0.5Q^ -Q^3+8Q^2-57Q -2
= -12Q+7.5Q^2- Q^3 -2
dprofit/dQ = -12+15Q-3Q^2 = 0 [ foc; first order
condition]
Q =1 ; Q =4 [ what we shall do?]
dPro^2/dq^2 = 15 -6Q; if Q = 1 , dPro^2/dq^2 = 9
If Q = 4; dPro^2/dq^2 = -9
Profit maximum Output = 4