Chapter 7

1. Chapter 7 Profit Maximization and Perfect Competition Chapter 7

2. Perfectly Competitive Markets • Characteristics of Perfectly Competitive Markets 1) Price taking 2) Product homogeneity 3) Free entry and exit Chapter 7

3. 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 7

4. Perfectly Competitive Markets • Product Homogeneity • The products of all firms are perfect substitutes. • Examples • Agricultural products, oil, copper, iron, Chapter 7

5. 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 7

6. Profit Maximization • Do firms maximize profits? • Revenue maximization • Dividend maximization • Short-run profit maximization Chapter 7

7. 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 Chapter 7

8. 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 7

9. Total Revenue R(q) Slope of R(q) = MR Profit Maximization in the Short Run Cost, Revenue, Profit ($s per year) 0 Output (units per year) Chapter 7

10. C(q) Total Cost Slope of C(q) = MC Profit Maximization in the Short Run Cost, Revenue, Profit $ (per year) 0 Output (units per year) Chapter 7

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 7

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 7

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 7

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 7

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* • R(q)= C(q) • MR = MC • Profit is maximized Chapter 7

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 • Question • Why is profit reduced when producing more or less than q*? Chapter 7

17. 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*: • R(q)> C(q) • MC > MR • Profit is decreasing Chapter 7

18. 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 • Therefore, it can be said: • Profits are maximized when MC = MR. Chapter 7

19. Marginal Revenue, Marginal Cost,and Profit Maximization Chapter 7

20. Marginal Revenue, Marginal Cost,and Profit Maximization Chapter 7

21. 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 7

22. $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 Chapter 7

23. 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 7

24. Marginal Revenue, Marginal Cost,and Profit Maximization • The Competitive Firm • Profit Maximization • MC(q) = MR = P Chapter 7

25. Choosing Output in the Short Run • We will combine production and cost analysis with demand to determine output and profitability. Chapter 7

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

27. MC ATC B C D P = MR A At q*: MR = MC and P < ATC or ABCD AVC F E q* A Competitive FirmIncurring Losses Price ($ per unit) Would this producer continue to produce with a loss? Output Chapter 7

28. 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 should produce at a loss. • If P < AVC < ATC the firm should shut-down. Chapter 7

29. 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 7

30. 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 7

31. 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 7

32. 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 7

33. A Competitive Firm’sShort-Run Supply Curve • Firm’s Response to an Input Price Change • When the price of a firm’s product changes, the firm changes its output level, Chapter 7

34. 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 7

35. The Short-Run Market Supply Curve • Elasticity of Market Supply Chapter 7

36. The Short-Run Market Supply Curve • Perfectly inelastic short-run supply arises when the industry’s plant and equipment are so fully utilized that new plants must be built to achieve greater output. • Perfectly elastic short-run supply arises when marginal costs are constant. Chapter 7

37. The Short-Run Market Supply Curve • Producer Surplus in the Short Run • 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 7

38. 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 7

39. The Short-Run Market Supply Curve • Producer Surplus in the Short-Run Chapter 7

40. 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 7