Chapter 8. Profit Maximization and Competitive Supply. Perfectly Competitive Markets. Profit Maximization. Q: Decision Making of Ownermanaged

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1 Chapter 8 Profit Maximization and Competitive upply Q: ecision Making of Ownermanaged usiness uppose 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? 2005 Pearson Education, Inc. Chapter 8 2 Perfectly Competitive Markets asic assumptions of Perfectly Competitive Markets 1. taking 2. Product homogeneity 3. Free entry and exit Profit Maximization Costs of production depends on output Total Cost (C) = C(q) Profit for the firm,, is difference between revenue and costs ( q) R( q) C( q) 2005 Pearson Education, Inc. Chapter Pearson Education, Inc. Chapter 8 4

2 Profit Maximization Profit Maximization lope in revenue curve is the marginal revenue Change in revenue resulting from a one-unit increase in output lope of total cost curve is marginal cost dditional cost of producing an additional output Cost, Revenue, Profit ($s per year) C(q) R(q) 0 q 0 q* (q) 2005 Pearson Education, Inc. Chapter Pearson Education, Inc. Chapter 8 6 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 0 MR 2005 Pearson Education, Inc. Chapter 8 7 The Competitive Firm taker price is determined at the market by demand and supply emand curve faced by an individual firm is a horizontal line emand curve faced by whole market is downward sloping 2005 Pearson Education, Inc. Chapter 8 8

3 The Competitive Firm The Competitive Firm bushel Firm bushel Industry The competitive firm s demand MR = P with the horizontal demand curve $4 d $4 For a perfectly competitive firm, profit maximizing output occurs when (bushels) Pearson Education, Inc. Chapter 8 9 (millions of bushels) ( q) MR P R 2005 Pearson Education, Inc. Chapter 8 10 Competitive Firm Competitive Firm Positive Profits Lost Profit for q 2 >q* Lost Profit for q 2 >q* R=MR=P q 1 : MR > q 2 : > MR q 0 : = MR Profit per unit = P- C(q) = to C Total Profit = C R=MR=P TC Profits are determined by output per unit times quantity q 1 q 2 11 Education, Inc. Chapter Pearson Pearson Education, Inc. Chapter 8 12

4 Q: What to do when < 0? Competitive Firm Losses firm does not have to make profits TC It is possible a firm will incur losses if the P < C for the profit maximizing quantity Profit per unit is negative (P C < 0) t : MR = and P < TC Losses = (P- C) x or C C P = MR VC 2005 Pearson Education, Inc. Chapter Pearson Education, Inc. Chapter 8 14 Choosing in the hort Run ummary of Production ecisions Profit is maximized when = MR If P > TC the firm is making profits. If P < TC the firm is making losses hort Run Production Why would firm produce at a loss? Firm has two choices in short run Continue producing hut down temporarily Will compare profitability of both choices 2005 Pearson Education, Inc. Chapter Pearson Education, Inc. Chapter 8 16

5 hort Run Production Competitive Firm Losses When should the firm shut down? If VC < P < TC the firm should continue producing in the short run If VC > P < TC the firm should shut-down. P < TC but VC so firm will continue to produce in short run C F Losses E VC TC P = MR 2005 Pearson Education, Inc. Chapter Pearson Education, Inc. Chapter 8 18 Competitive Firm s hort-run upply Curve ( unit) P 2 TC Industry upply in the hort Run unit P 3 The short-run industry supply curve is the horizontal summation of the supply curves of the firms. P 1 VC P 2 P 1 P = VC q 1 q Q 2005 Pearson Education, Inc. Chapter Pearson Education, Inc. Chapter 8 20

6 Producer urplus for a Firm Producer urplus versus Profit ( output) Producer urplus VC P Profit is revenue minus total cost (not just variable cost) When fixed cost is positive, producer surplus is greater than profit Producer urplus P R - VC Profit - R - VC - FC 2005 Pearson Education, Inc. Chapter Pearson Education, Inc. Chapter 8 22 Producer urplus for a Market Choosing in the Long Run ( output) P * Market producer surplus is the difference between P* and from 0 to Q *. 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. Producer urplus Q * 2005 Pearson Education, Inc. Chapter Pearson Education, Inc. Chapter 8 24

7 Long-run Competitive Equilibrium Long-Run Competitive Equilibrium Profits 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 output output $40 P LC 1 $30 Firm L P 2 Industry 1 2 q 2 Q 1 Q Pearson Education, Inc. Chapter Pearson Education, Inc. Chapter 8 26