Microeconomics Lecture ----profit Maximization And Competitive Supply

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

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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

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Perfectly Competitive Markets  Basic assumptions of Perfectly Competitive Markets 1. Price taking 2. Product homogeneity 3. Free entry and exit

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When are Markets Competitive  Very rarely markets are perfectly competitive, but many markets are (relatively) highly competitive. They face relatively low entry and exit costs Highly elastic demand curves We do not always need many firms to have a highly competitive market  an example …

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Profit Maximization  Do firms maximize profits? Managers in firms may be concerned with other objectives, such as revenue maximization, revenue growth, or others. But, without profits, survival is unlikely in competitive industries.

 Thus, profit maximization assumption is reasonable. ©2005 Pearson Education, Inc.

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Marginal Revenue, Marginal Cost, and Profit Maximization  We can study profit maximizing output for any firm whether perfectly competitive or not Profit () = Total Revenue - Total Cost If q is output of the firm, then total revenue is price of the good times quantity Total Revenue (R) = P.q

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Marginal Revenue, Marginal Cost, and Profit Maximization  Costs of production depends on output Total Cost (C) = C.q

 Profit for the firm, , is the difference between revenue and costs

 (q)  R(q)  C(q) ©2005 Pearson Education, Inc.

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Marginal Revenue, Marginal Cost, and Profit Maximization  Firm selects output to maximize the difference between revenue and cost  We can graph the total revenue and total cost curves to show maximizing profits for the firm

 Distance between revenues and costs show profits

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Marginal Revenue, Marginal Cost, and Profit Maximization  Slope of the revenue curve is the marginal revenue Change in revenue resulting from a one-unit increase in output  R  q  q

 Slope of the total cost curve is marginal cost Additional cost of producing an additional unit of output  C  q  q

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Profit Maximization – Short Run Cost, Revenue, Profit ($s per year)

Profits are maximized where MR (slope at A) and MC (slope at B) are equal

C(q) A R(q) B

0

q0

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Profits are maximized where R(q) – C(q) is maximized

  q  0 q q*

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Output

(q) 12

Marginal Revenue, Marginal Cost, and Profit Maximization  Profit is maximized at the point at which an additional increment to output leaves profit unchanged   R C  R C   0 q q q  MR  MC  0 MR  MC

max q  (q)  R(q)  C (q) f.o.c. for max

  q  R  q  C  q    0 q q q MR

MC

 2  q  check for the s.o.c. 0 2 q solve for q*

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Marginal Revenue, Marginal Cost, and Profit Maximization  The Competitive Firm Price taker – market price and output determined from total market demand and supply Market output (Q) and firm output (q)

Market demand (D) and firm demand (d)

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The Competitive Firm  Demand curve faced by an individual firm is a horizontal line Firm’s sales have no effect on market price

 Demand curve faced by whole market is downward sloping Shows amount of good all consumers will purchase at different prices

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The Competitive Firm Price $ per bushel

Firm

Price $ per bushel

Industry S

$4

d

$4

D 100 ©2005 Pearson Education, Inc.

200

Output (bushels) Chapter 8

100

Output (millions of bushels) 16

The Competitive Firm  The competitive firm’s demand Individual producer sells all units for $4 regardless of that producer’s level of output. R=P.q  P does not depend on q MR = P and AR=P.q / q with the horizontal demand curve For a perfectly competitive firm, profit maximizing output occurs when

MC (q)  MR  P  AR ©2005 Pearson Education, Inc.

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Choosing Output: Short Run  The point where MR = MC, the profit maximizing output is chosen MR=MC at quantity, q*, of 8 At a quantity less than 8, MR>MC so more profit can be gained by increasing output At a quantity greater than 8, MC>MR, increasing output will decrease profits

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A Competitive Firm MC

Price

Lost Profit for q2>q*

Lost Profit for q2>q*

50

A

40

AR=MR=P ATC AVC

30

q1 : MR > MC q2: MC > MR q0: MC = MR

20 10 0

1

2

3

4

5

6

7

q1 ©2005 Pearson Education, Inc.

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8

q*

9

q2

10

11

Output 19

A Competitive Firm – Positive Profits Price 50 40

MC

Total Profit = ABCD

A

D

AR=MR=P ATC

Profit per unit = PAC(q) = A to B

30 C

Profits are determined by output per unit times quantity

AVC

B

20 10 0

1

2

3

4

5

6

7

q1 ©2005 Pearson Education, Inc.

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8

q*

9

q2

10

11

Output 20

A Competitive Firm – Losses MC

Price

ATC

B

C D

A

P = MR

q *:

At MR = MC and P < ATC Losses = (P- AC) x q* or ABCD

AVC

q* ©2005 Pearson Education, Inc.

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Output 21

Short Run Production  Why would firm produce at a loss? Might think price will increase in near future Shutting down and starting up could be costly

 Firm has two choices in short run Continue producing Shut down temporarily

Will compare profitability of both choices ©2005 Pearson Education, Inc.

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Short Run Production  When should the firm shut down? If AVC < P < ATC the firm should continue producing in the short run  Can

cover some of its variable costs and all of its fixed costs

If AVC > P < ATC the firm should shut-down.  Can

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not cover even its fixed costs

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A Competitive Firm – Losses MC

Price

ATC

Losses

B

C D P < ATC but AVC so firm will continue to produce in short run

A

P1= MR1 AVC

E

F G

H

P2= MR2 P3= MR3

Shut Down Point

q* ©2005 Pearson Education, Inc.

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Output 24

Competitive Firm – Short Run Supply  Supply curve tells how much output will be produced at different prices  Competitive firms determine quantity to produce where P = MC Firm shuts down when P < AVC

 Competitive firms supply curve is portion of the marginal cost curve above the AVC curve ©2005 Pearson Education, Inc.

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A Competitive Firm’s Short-Run Supply Curve Price ($ per unit)

The firm chooses the output level where P = MR = MC, as long as P > AVC.

Supply is MC above AVC

MC

S

P2

ATC

P1

AVC

P = AVC

q1 ©2005 Pearson Education, Inc.

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q2 Output 26

Short-Run Market Supply Curve  Shows the amount of product the whole market will produce at given prices  Is the sum of all the individual producers in the market  We can show graphically how we can sum the supply curves of individual producers

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Industry Supply in the Short Run S

The short-run industry supply curve is the horizontal summation of the supply curves of the firms.

$ per unit

P3

P2 P1

Q 2 ©2005 Pearson Education, Inc.

4

5

7 8

10

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15

21 28

Elasticity of Market Supply  Elasticity of Market Supply Measures the sensitivity of industry output to market price The percentage change in quantity supplied, Q, in response to 1-percent change in price

Es  (Q / Q) /( P / P) ©2005 Pearson Education, Inc.

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Elasticity of Market Supply  When MC increase rapidly in response to increases in output, elasticity is low  When MC increase slowly, supply is relatively elastic  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. ©2005 Pearson Education, Inc.

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Choosing Output in the Long Run  In short run, one or more inputs are fixed Depending on the time, it may limit the flexibility of the firm

 In the long run, a firm can alter all its inputs, including the size of the plant.  We assume free entry and free exit. No legal restrictions or extra costs ©2005 Pearson Education, Inc.

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Choosing Output in the Long Run  In the short run a firm faces a horizontal demand curve Take market price as given

 The short-run average cost curve (SAC) and short run marginal cost curve (SMC) are low enough for firm to make positive profits (ABCD)  The long run average cost curve (LRAC) Economies of scale to q2 Diseconomies of scale after q2 ©2005 Pearson Education, Inc.

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Output Choice in the Long Run Price

LMC LAC SMC SAC $40

D

A P = MR

C

B

$30 In the short run, the firm is faced with fixed inputs. P = $40 > ATC. Profit is equal to ABCD.

q1 ©2005 Pearson Education, Inc.

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q2

q3

Output 33

Output Choice in the Long Run In the long run, the plant size will be increased and output increased to q3. Long-run profit, EFGD > short run profit ABCD.

Price

LMC LAC

SMC SAC $40

D

A

C

E B

G $30

F

q1 ©2005 Pearson Education, Inc.

P = MR

Chapter 8

q2

q3

Output 34

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

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Long-Run Competitive Equilibrium – Profits •Profit attracts firms •Supply increases until profit = 0

$ per unit of output

$ per unit of output

Firm

Industry

S1

LMC

$40

LAC

P1

S2

P2

$30

D q2 ©2005 Pearson Education, Inc.

Output Chapter 8

Q1

Q2

Output 36

Long-Run Competitive Equilibrium – Losses •Losses cause firms to leave •Supply decreases until profit = 0

$ per unit of output

Firm

LMC

$ per unit of output LAC

$30

Industry

S2

P2

S1

P1

$20

D q2 ©2005 Pearson Education, Inc.

Output Chapter 8

Q2

Q1

Output 37

Long-run Competitive Equilibrium • The supply curve moves to theWith market demand D2 With market demand and market supply D S11 (a) Theright Firm (b) The Industry and market supply equilibrium price isS1P1 • Price falls With market price PC priceisis Q P1C $/unit and quantity • Entry continues $/unit while profits equilibrium the firm maximizes and quantity is QCthat exist Now assume profit by setting Existing firms maximize • MC Long-run equilibrium is restored demand MR (= PC) = MC and at price P supply curve S2 profits by increasing C and S1 to increases D1 producing quantity qc output AC to q1 D2 P1

S2

P1 Excess profits induce PC new firms to enter the market

PC

qc q ©2005 Pearson Education, Inc.

1

Quantity

D2

Q C

Q1 Q´C

Quantity

Long-Run Competitive Equilibrium 1. All firms in industry are maximizing profits MR = MC

2. No firm has incentive to enter or exit industry Earning zero economic profits

3. Market is in equilibrium Quantity supplied = Quantity demanded ©2005 Pearson Education, Inc.

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The Industry’s Long-Run Supply Curve  Assume All firms have access to the available production technology Output is increased by using more inputs, not by invention

The market for inputs does not change with expansions and contractions of the industry.

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The Industry’s Long-Run Supply Curve  To analyze long-run industry supply, will need to distinguish between three different types of industries 1. Constant-Cost 2. Increasing-Cost 3. Decreasing-Cost

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Constant-Cost Industry $

Increase in demand increases market price and firm output Positive profits cause market supply to increase and price to fall

MC

$

Q1 increases to Q2. Long-run supply = SL = LRAC. Change in output has no impact on input cost.

S1

AC

P2

P2

P1

P1

S2

SL

D1 q1 q2 ©2005 Pearson Education, Inc.

Output Chapter 8

Q1

Q2

D2 Output 42

Long-Run Supply in a Constant-Cost Industry  Price of inputs does not change  additional inputs necessary to produce higher outputs can be purchased without an increase in per unit price. Firms cost curves do not change

 In a constant-cost industry, long-run supply is a horizontal line at a price that is equal to the minimum average cost of production. ©2005 Pearson Education, Inc.

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Increasing-Cost Industry  Prices of some or all inputs rises as production is expanded when demand of inputs increases.

 When demand increases causing prices to increase and production to increase Firms enter the market increasing demand for inputs Costs increase causing an upward shift in supply curves Market supply increases but not as much ©2005 Pearson Education, Inc.

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Long-run Supply in an Increasing-Cost Industry Due to the increase in input prices, longrun equilibrium occurs at a higher price.

SMC2

$

$ SMC1

S1 S2

LAC2

LAC1

P2

Long Run Supply is upward Sloping

P2

P3

P3

P1

P1

D1 q1 ©2005 Pearson Education, Inc.

q2

Output Chapter 8

SL

Q1 Q2 Q3

D2 Output 45

Long-Run Supply in a Increasing-Cost Industry  In a increasing-cost industry, long-run supply curve is upward sloping.  More output is produced, but only at the higher price needed to compete for the increased input costs

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Decreasing-Cost Industry  Industry whose long-run supply curve is downward sloping  Increase in demand causes production to increase Increase in size allows firm to take advantage of size to get inputs cheaper Increased production may lead to better efficiencies or quantity discounts Costs shift down and market price falls ©2005 Pearson Education, Inc.

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Long-run Supply in a Decreasing-Cost Industry $

Due to the decrease in input prices, long-run equilibrium occurs at a lower price.

SMC1

Long Run Supply is Downward Sloping

$

S1

S2

SMCLAC 2 1 LAC2 P2

P2 P1

P1 P3

P3

SL D1

q 1 q2 ©2005 Pearson Education, Inc.

Output Chapter 8

Q1 Q2 Q3

D2 Output 48