Perfect Competition. Profit-Maximizing Level of Output. Profit-Maximizing Level of Output. Profit-Maximizing Level of Output.

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1 erfect Competition Chapter rofit Maximizing and Shutting Down rofit-maximizing Level of The goal of the firm is to maximize profits. rofit is the difference between total revenue and total cost. rofit-maximizing Level of What happens to profit in response to a change in output is determined by marginal revenue (MR) and marginal cost (). A firm maximizes profit when = MR. rofit-maximizing Level of revenue (MR) the change in total revenue associated with a change in quantity. cost () the change in total cost associated with a change in quantity. Revenue A perfect competitor accepts the market price as given. As a result, marginal revenue equals price (MR = ). Initially, marginal cost falls and then begins to rise. concepts are best defined between the numbers. 1

2 rofit Maximization: = MR To maximize profits, a firm should produce where marginal cost equals marginal revenue. How to Maximize rofit If marginal revenue does not equal marginal cost, a firm can increase profit by changing output. The supplier will continue to produce as long as marginal cost is less than marginal revenue. How to Maximize rofit The supplier will cut back on production if marginal cost is greater than marginal revenue. Thus, the profit-maximizing condition of a competitive firm is = MR =. Again! MR= rofit is maximized when MR=. If the cost of producing one more unit is less than the revenue it generates, then a profit is available for the firm that increases production by one unit. If the cost of producing one more unit is more than the revenue it generates, then increasing production reduces profit., Revenue, and rice rice = MR uantity roduced $ $ s A A C B = D = MR uantity rofit Maximization: Graphical Analysis McGraw-Hill/Irwin 4 The McGraw-Hill Companies, Inc., All Rights Reserved. 2

3 rofit Maximization: The Numbers TR $ $2 $3 $4 $ $6 $7 $8 $9 1 TC. $2. $2.8 $3. $4. $4. $. $6. $6.86 $7.86 $ TR-TC $.8 -$. $. $. $ $ MR MR=. $.8 $.7 $. $. $.7 $.8 $.86.. $2.64 $ $.9 $.87 $.86 $.86 $.87 $.94.9 The Curve Is the Supply Curve The marginal cost curve is the firm's supply curve above the point where price exceeds average variable cost. The Curve Is the Supply Curve The curve tells the competitive firm how much it should produce at a given price. The firm can do no better than produce the quantity at which marginal cost equals marginal revenue which in turn equals price. The Curve Is the Firm s Supply Curve, rice $7 B A cost C uantity Firms Maximize Total rofit Firms seek to maximize total profit, not profit per unit. Firms do not care about profit per unit. As long as increasing output increases total profits, a profit-maximizing firm should produce more. rofit Maximization Using Total Revenue and Total rofit is maximized where the vertical distance between total revenue and total cost is greatest. At that output, MR (the slope of the total revenue curve) and (the slope of the total cost curve) are equal. 3

4 rofit Determination Using Total and Revenue Curves Total cost, revenue TC TR $38 Loss Maximum profit =$81 rofit rofit =$4 7 3 Loss uantity Total rofit at the rofit- Maximizing Level of The = MR = condition tells us how much output a competitive firm should produce to maximize profit. It does not tell us how much profit the firm makes. McGraw-Hill/Irwin 4 The McGraw-Hill Companies, Inc., All Rights Reserved. Determining rofit and Loss From a Table of s rofit can be calculated from a table of costs and revenues. rofit is determined by total revenue minus total cost. = MR s Relevant to a Firm Total Average Total Total Revenue rofit TR-TC McGraw-Hill/Irwin 4 The McGraw-Hill Companies, Inc., All Rights Reserved. = MR s Relevant to a Firm Total Average Total Total Revenue rofit TR-TC Determining rofit and Loss From a Graph Find output where = MR. The intersection of = MR () determines the quantity the firm will produce if it wishes to maximize profits. McGraw-Hill/Irwin 4 The McGraw-Hill Companies, Inc., All Rights Reserved. 4

5 Determining rofit and Loss From a Graph Find profit per unit where = MR. Drop a line down from where equals MR, and then to the curve. This is the profit per unit. Extend a line back to the vertical axis to identify total profit. Determining rofit and Loss From a Graph The firm makes a profit when the curve is below the MR curve. The firm incurs a loss when the curve is above the MR curve. Determining rofit and Loss From a Graph Zero profit or loss where =MR. Firms can earn zero profit or even a loss where = MR. Even though economic profit is zero, all resources, including entrepreneurs, are being paid their opportunity costs. rice Determining rofits Graphically D rofit C A = MR B E rice uantity uantity uantity (a) rofit case (b) Zero profit case (c) Loss case = MR rice Loss = MR Irwin/McGraw-Hill The McGraw-Hill Companies, Inc., Loss Minimization Average cost of a unit of output The Shutdown oint Revenue generated by a unit of output Market price falls 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. If price falls below that point it makes sense to shut down temporarily and save the variable costs.

6 The Shutdown oint The shutdown point is the point at which the firm will be better off it it shuts down than it will if it stays in business. The Shutdown oint If total revenue is more than total variable cost, the firm s best strategy is to temporarily produce at a loss. It is taking less of a loss than it would by shutting down. The Shutdown Decision rice Loss = MR 7.8 A uantity Minimizing Loss Shutdown price: the minimum point of the average-variable-cost () curve. Break-even price: A price that is equal to the minimum point of the average-totalcost () curve. At this price, economic profit is zero. rofit Maximizing Level of The goal of the firm is to maximize profits, the difference between total revenue and total cost A firm maximizes profit when marginal revenue equals marginal cost revenue (MR) is the change in total revenue associated with a change in quantity cost () is the change in total cost associated with a change in quantity 14-3 rofit Maximizing Level of The profit-maximizing condition of a competitive firm is: MR = For a competitive firm, MR = A firm maximizes total profit, not profit per unit If MR >, a firm can increase profit by increasing output If MR <, a firm can increase profit by decreasing its output

7 , Revenue, and rice Graph $3 = D = MR <, increase output to increase total profit = = at 8 units, total profit is maximized >, decrease output to increase total profit The Curve is the Supply Curve $61 $ = Firm s Supply Curve Because the marginal cost curve tells us how much of a good a firm will supply at a given price, the marginal cost curve is the firm s supply curve rofit Maximization using Total Revenue and Total An alternative method to determine the profit-maximizing level of output is to look at the total and total cost curves Total cost is the cumulative sum revenue of the and marginal total cost costs, curves plus the fixed costs Total profit is the difference between total Total Revenue and Total Table Total, Total Revenue Max profit = $81 at 8 units of output $28 7 Losses 3 rofits 8 TC TR Losses The total revenue curve is a straight line The total cost curve is bowed upward at most quantities reflecting increasing marginal cost rofits are maximized when the vertical distance between TR and TC is greatest Determining rofits Graphically: A Firm with rofit = MR rofits = D = MR at profit max profit max Find output where = MR, this is the profit maximizing Find profit per unit where the profit max intersects Since > at the profit maximizing quantity, this firm is earning profits Determining rofits Graphically: A Firm with Zero rofit or Losses Find output where = MR, this is the profit maximizing Find profit per unit where the profit max intersects Since = at the profit maximizing quantity, this firm is earning zero profit or loss = = MR profit max = D = MR at profit max

8 Determining rofits Graphically: A Firm with Losses at profit max Losses profit max = MR = D = MR Find output where = MR, this is the profit maximizing Find profit per unit where the profit max intersects Since < at the profit maximizing quantity, this firm is earning losses Determining rofits Graphically: The Shutdown Decision The shutdown point is the point below which the firm will be better off if it shuts down than it will if it stays in business If >min of, then the firm will still produce, but earn a loss If <min of, the firm will shut down If a firm shuts down, it still has to pay its fixed costs Shut down profit max = D = MR Short-Run Market Supply and Demand While the firm s demand curve is perfectly elastic, the industry s demand curve is downward sloping The market supply curve takes into account any changes in input prices that might occur Short-Run Market Supply and Demand Graph Market Market Supply rofits Firm = D = MR The market (industry) supply curve is the horizontal sum of all the firms marginal cost curves Market Demand profit max