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Profit Maximization and Competitive Supply

This chapter discusses the decision-making process of owner-managed businesses, focusing on profit maximization and competitive supply in perfectly competitive markets.

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Profit Maximization and Competitive Supply

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  1. Chapter 8 Profit Maximization and Competitive Supply

  2. Q: Decision Making of Owner-managed Business • Suppose you are running a small business. • What is your objective? • What are you supposed to decide? • What is profit? • How can you make your profit max? Chapter 8

  3. Perfectly Competitive Markets • Basic assumptions of Perfectly Competitive Markets • Price taking • Product homogeneity • Free entry and exit Chapter 8

  4. Profit Maximization • Costs of production depends on output • Total Cost (C) = C(q) • Profit for the firm, , is difference between revenue and costs Chapter 8

  5. Profit Maximization • Slope in revenue curve is the marginal revenue • Change in revenue resulting from a one-unit increase in output • Slope of total cost curve is marginal cost • Additional cost of producing an additional unit of output Chapter 8

  6. C(q) A R(q) B q* q0 (q) Profit Maximization Cost, Revenue, Profit ($s per year) 0 Output Chapter 8

  7. Marginal Revenue, Marginal Cost, and Profit Maximization • Profit is maximized at the point at which an additional increment to output leaves profit unchanged Chapter 8

  8. The Competitive Firm • Price taker – price is determined at the market by demand and supply • Demand curve faced by an individual firm is a horizontal line • Demand curve faced by whole market is downward sloping Chapter 8

  9. Price $ per bushel Price $ per bushel S $4 d $4 D Output (bushels) Output (millions of bushels) 100 200 100 The Competitive Firm Firm Industry Chapter 8

  10. The Competitive Firm • The competitive firm’s demand • MR = P with the horizontal demand curve • For a perfectly competitive firm, profit maximizing output occurs when Chapter 8

  11. MC Price Lost Profit for q2>q* 50 Lost Profit for q2>q* AR=MR=P 40 30 20 10 0 1 2 3 4 5 6 7 8 9 10 11 Output q1 q* q2 A Competitive Firm A q1 : MR > MC q2: MC > MR q0: MC = MR Chapter 8

  12. MC Price 50 A D AR=MR=P 40 ATC 30 C 20 10 0 1 2 3 4 5 6 7 8 9 10 11 Output q* A Competitive Firm – Positive Profits Total Profit = ABCD Profits are determinedby output per unit times quantity Profit per unit = P-AC(q) = A to B Chapter 8

  13. Q: What to do when  < 0? • A firm does not have to make profits • It is possible a firm will incur losses if the P < AC for the profit maximizing quantity • Profit per unit is negative (P – AC < 0) Chapter 8

  14. MC ATC B C D P = MR A AVC q* A Competitive Firm – Losses Price At q*: MR = MC and P < ATC Losses = (P- AC) x q* or ABCD Output Chapter 8

  15. Choosing Output in the Short Run • Summary of Production Decisions • Profit is maximized when MC = MR • If P > ATC the firm is making profits. • If P < ATC the firm is making losses Chapter 8

  16. Short Run Production • Why would firm produce at a loss? • Firm has two choices in short run • Continue producing • Shut down temporarily • Will compare profitability of both choices Chapter 8

  17. Short Run Production • When should the firm shut down? • If AVC < P < ATC the firm should continue producing in the short run • If AVC > P < ATC the firm should shut-down. Chapter 8

  18. MC ATC Losses B C D P = MR A AVC F E q* A Competitive Firm – Losses Price • P < ATC but • AVC so firm will continue to produce in short run Output Chapter 8

  19. S ATC P2 AVC P1 P = AVC q1 q2 A Competitive Firm’sShort-Run Supply Curve Price ($ per unit) MC Output Chapter 8

  20. S MC1 MC2 MC3 P3 P2 P1 2 4 7 8 10 15 21 5 Industry Supply in the Short Run The short-run industry supply curve is the horizontal summation of the supply curves of the firms. $ per unit Q Chapter 8

  21. MC AVC Producer Surplus B A P q* Producer Surplus for a Firm Price ($ per unit of output) Output Chapter 8

  22. Producer Surplus versus Profit • Profit is revenue minus total cost (not just variable cost) • When fixed cost is positive, producer surplus is greater than profit Chapter 8

  23. S P* Producer Surplus D Q* Producer Surplus for a Market Price ($ per unit of output) Market producer surplus is the difference between P* and S from 0 to Q*. Output Chapter 8

  24. Choosing Output in the Long Run • In short run, one or more inputs are fixed • In the long run, a firm can alter all its inputs, including the size of the plant. • We assume free entry and free exit. Chapter 8

  25. Long-run Competitive Equilibrium • Entry and Exit • Profits will attract other producers. • More producers increase industry supply which lowers the market price. • This continues until there are no more profits to be gained in the market – zero economic profits Chapter 8

  26. S1 LMC $40 P1 LAC S2 P2 $30 D q2 Q1 Q2 Long-Run Competitive Equilibrium – Profits $ per unit of output $ per unit of output Firm Industry Output Output Chapter 8

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