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Chapter 8

Chapter 8. Profit Maximization and Competitive Supply. Topics to be Discussed. Perfectly Competitive Markets Profit Maximization Marginal Revenue, Marginal Cost, and Profit Maximization Choosing Output in the Short-Run. Topics to be Discussed. The Competitive Firm’s Short-Run Supply Curve

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Chapter 8

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  1. Chapter 8 Profit Maximization and Competitive Supply

  2. Topics to be Discussed • Perfectly Competitive Markets • Profit Maximization • Marginal Revenue, Marginal Cost, and Profit Maximization • Choosing Output in the Short-Run Chapter 8

  3. Topics to be Discussed • The Competitive Firm’s Short-Run Supply Curve • Short-Run Market Supply • Choosing Output in the Long-Run • The Industry’s Long-Run Supply Curve Chapter 8

  4. Perfectly Competitive Markets • Characteristics of Perfectly Competitive Markets 1) Price taking 2) Product homogeneity 3) Free entry and exit Chapter 8

  5. Perfectly Competitive Markets • Price Taking • The individual firm sells a very small share of the total market output and, therefore, cannot influence market price. • The individual consumer buys too small a share of industry output to have any impact on market price. Chapter 8

  6. Perfectly Competitive Markets • Product Homogeneity • The products of all firms are perfect substitutes. • Examples • Agricultural products, oil, copper, iron, lumber Chapter 8

  7. Perfectly Competitive Markets • Free Entry and Exit • Buyers can easily switch from one supplier to another. • Suppliers can easily enter or exit a market. Chapter 8

  8. Profit Maximization • Do firms maximize profits? • Possibility of other objectives • Revenue maximization • Dividend maximization Chapter 8

  9. Profit Maximization • Do firms maximize profits? • Implications of non-profit objective • Over the long-run investors would not support the company • Without profits, survival unlikely • Long-run profit maximization is valid and does not exclude the possibility of altruistic behavior. Chapter 8

  10. Marginal Revenue, Marginal Cost,and Profit Maximization • Determining the profit maximizing level of output • Profit ( ) = Total Revenue - Total Cost • Total Revenue (R) = Pq • Total Cost (C) = Cq • Therefore: Chapter 8

  11. Marginal Revenue, Marginal Cost,and Profit Maximization • Marginal revenue is the additional revenue from producing one more unit of output. • Marginal cost is the additional cost from producing one more unit of output. Chapter 8

  12. C(q) R(q) A B q0 q* Marginal Revenue, Marginal Cost,and Profit Maximization • Comparing R(q) and C(q) • Output levels: 0- q0: • C(q)> R(q) • Negative profit • FC + VC > R(q) • MR > MC • Indicates higher profit at higher output Cost, Revenue, Profit ($s per year) 0 Output (units per year) Chapter 8

  13. Cost, Revenue, Profit $ (per year) C(q) R(q) A B q0 q* 0 Output (units per year) Marginal Revenue, Marginal Cost,and Profit Maximization • Comparing R(q) and C(q) • Question: Why is profit negative when output is zero? Chapter 8

  14. Cost, Revenue, Profit $ (per year) C(q) R(q) A B q0 q* 0 Output (units per year) Marginal Revenue, Marginal Cost,and Profit Maximization • Comparing R(q) and C(q) • Output levels: q0 - q* • R(q)> C(q) • MR > MC • Indicates higher profit at higher output • Profit is increasing Chapter 8

  15. Cost, Revenue, Profit $ (per year) C(q) R(q) A B q0 q* 0 Output (units per year) Marginal Revenue, Marginal Cost,and Profit Maximization • Comparing R(q) and C(q) • Output level: q* • MR = MC • Profit is maximized Chapter 8

  16. Cost, Revenue, Profit $ (per year) C(q) R(q) A B q0 q* 0 Output (units per year) Marginal Revenue, Marginal Cost,and Profit Maximization • Comparing R(q) and C(q) • Output levels beyond q*: • MC > MR • Profit is decreasing Chapter 8

  17. Marginal Revenue, Marginal Cost,and Profit Maximization Chapter 8

  18. Marginal Revenue, Marginal Cost,and Profit Maximization Chapter 8

  19. Marginal Revenue, Marginal Cost,and Profit Maximization • The Competitive Firm • Price taker • Market output (Q) and firm output (q) • Market demand (D) and firm demand (d) • R(q) is a straight line Chapter 8

  20. $4 d $4 D Demand and Marginal Revenue Facedby a Competitive Firm Price $ per bushel Price $ per bushel Firm Industry Output (millions of bushels) Output (bushels) 100 200 100

  21. Marginal Revenue, Marginal Cost,and Profit Maximization • The Competitive Firm • The competitive firm’s demand • Individual producer sells all units for $4 regardless of the producer’s level of output. • If the producer tries to raise price, sales are zero. Chapter 8

  22. Marginal Revenue, Marginal Cost,and Profit Maximization • The Competitive Firm • AR = MR = P • Profit Maximization • MC(q) = MR = P Chapter 8

  23. Choosing Output in the Short Run • We will combine production and cost analysis with demand to determine output and profitability. Chapter 8

  24. MC Lost profit for q1 < q* Lost profit for q2 > q* AR=MR=P ATC AVC q0 q1 q* q2 A Competitive FirmMaking a Positive Profit Price ($ per unit) 60 50 A D 40 C B 30 At q*: MR = MC and P > ATC q1 : MR > MC and q2: MC > MR and q*: MC = MR but MC falling 20 10 0 1 2 3 4 5 6 7 8 9 10 11 Output Chapter 8

  25. MC ATC B C D P = MR A At q*: MR = MC and P < ATC Losses = (P- ATC) x q* or ABCD AVC F E q* A Competitive FirmIncurring Losses Price ($ per unit) Would this producer continue to produce with a loss? Output Chapter 8

  26. 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 AVC < P < ATC the firm produces at a loss. • If P < AVC < ATC the firm should shut-down. Chapter 8

  27. The firm chooses the output level where MR = MC, as long as the firm is able to cover its variable cost of production. MC ATC P2 AVC P1 What happens if P < AVC? P = AVC q1 q2 A Competitive Firm’sShort-Run Supply Curve Price ($ per unit) Output Chapter 8

  28. A Competitive Firm’sShort-Run Supply Curve • Observations: • P = MR • MR = MC • P = MC • Supply is the amount of output for every possible price. Therefore: • If P = P1, then q = q1 • If P = P2, then q = q2 Chapter 8

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

  30. A Competitive Firm’sShort-Run Supply Curve • Observations: • Supply is upward sloping due to diminishing returns. • Higher price compensates the firm for higher cost of additional output and increases total profit because it applies to all units. Chapter 8

  31. A Competitive Firm’sShort-Run Supply Curve • Firm’s Response to an Input Price Change • When the price of a firm’s input changes, the firm changes its output level, so that the marginal cost of production remains equal to the price. Chapter 8

  32. Input cost increases and MC shifts to MC2 and q falls to q2. MC2 Savings to the firm from reducing output MC1 $5 q2 q1 The Response of a Firm toa Change in Input Price Price ($ per unit) Output Chapter 8

  33. S The short-run industry supply curve is the horizontal summation of the supply curves of the firms. MC1 MC2 MC3 P3 P2 P1 Industry Supply in the Short Run $ per unit Quantity 0 2 4 5 7 8 10 15 21 Chapter 8

  34. The Short-Run Market Supply Curve • Producer Surplus in the Short Run • Firms earn a surplus on all but the last unit of output. • The producer surplus is the sum over all units produced of the difference between the market price of the good and the marginal cost of production. Chapter 8

  35. At q* MC = MR. Between 0 and q , MR > MC for all units. Producer Surplus MC AVC B A P Alternatively, VC is the sum of MC or ODCq* . R is P x q*or OABq*. Producer surplus = R - VC or ABCD. D C q* Producer Surplus for a Firm Price ($ per unit of output) 0 Output Chapter 8

  36. The Short-Run Market Supply Curve • Producer Surplus in the Short-Run • Profit = R - VC - FC • Profit < producer surplus Chapter 8

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

  38. Choosing Output in the Long Run • 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

  39. In the long run, the plant size will be increased and output increased to q3. Long-run profit, EFGD > short run profit ABCD. LMC LAC SMC SAC D A E $40 P = MR C B G F $30 In the short run, the firm is faced with fixed inputs. P = $40 > ATC. Profit is equal to ABCD. q1 q2 q3 Output Choice in the Long Run Price ($ per unit of output) Output Chapter 8

  40. Choosing Output in the Long Run • Accounting Profit & Economic Profit • Accounting profit = R - wL • Economic profit = R - wL - rK • wl = labor cost • rk= opportunity cost of capital Chapter 8

  41. Choosing Output in the Long Run Long-Run Competitive Equilibrium • Zero-Profit • If R > wL + rk, economic profits are positive • If R = wL + rk, zero economic profits, but the firms is earning a normal rate of return; indicating the industry is competitive • If R < wl + rk, consider going out of business Chapter 8

  42. Choosing Output in the Long Run Long-Run Competitive Equilibrium • Entry and Exit • The long-run response to short-run profits is to increase output. • Profits will attract other producers. • More producers increase industry supply which lowers the market price. Chapter 8

  43. Profit attracts firms • Supply increases until profit = 0 S1 LMC P1 LAC S2 $30 P2 D Q1 Q2 Long-Run Competitive Equilibrium $ per unit of output $ per unit of output Firm Industry $40 q2 Output Output

  44. Choosing Output in the Long Run • Long-Run Competitive Equilibrium 1) MC = MR 2) P = LAC • No incentive to leave or enter • Profit = 0 3) Equilibrium Market Price Chapter 8

  45. Economic profits attract new firms. Supply increases to S2 and the market returns to long-run equilibrium. Q1 increase to Q2. Long-run supply = SL = LRAC. Change in output has no impact on input cost. S1 S2 MC AC C P2 P2 A B SL P1 P1 D1 D2 q1 q2 Q1 Q2 Long-Run Supply in aConstant-Cost Industry $ per unit of output $ per unit of output Output Output

  46. Long-Run Supply in aConstant-Cost Industry • In a constant-cost industry, long-run supply is a horizontal line Chapter 8

  47. Due to the increase in input prices, long-run equilibrium occurs at a higher price. S1 S2 AC2 MC2 SL MC1 P2 AC1 P2 P3 P3 B A P1 P1 D1 D2 q1 q2 Q1 Q2 Q3 Long-Run Supply in anIncreasing-Cost Industry $ per unit of output $ per unit of output Output Output

  48. Long-Run Supply in aIncreasing-Cost Industry • In a increasing-cost industry, long-run supply curve is upward sloping. Chapter 8

  49. Due to the decrease in input prices, long-run equilibrium occurs at a lower price. S1 S2 MC1 AC1 MC2 P2 P2 AC2 P1 A P1 B P3 P3 SL D1 D2 q1 q2 Q1 Q2 Q3 Long-Run Supply in anDecreasing-Cost Industry $ per unit of output $ per unit of output Output Output

  50. Long-Run Supply in aIncreasing-Cost Industry • In a decreasing-cost industry, long-run supply curve is downward sloping. Chapter 8

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