Lesson-36. Profit Maximization and A Perfectly Competitive Firm

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1 Lesson-36 Profit Maximization and A Perfectly Competitive Firm A firm s behavior comes within the context of perfect competition. Then comes the stepby-step explanation of how perfectly competitive firms maximize their profits, both algebraically and graphically. In perfectly competitive markets, no individual firm has any influence over the market price, since there are many firms and each is a small player in the overall market. Since each firm s product is identical to that of other firms (i.e. products are homogeneous), all firms face the same price. Firms cannot individually influence the market price through their actions, but collectively they do so. Therefore, one should start with the market demand and supply curves. These are the same demand and supply curves as in the Consumer Theory. Market demand P = Q d Market supply P =.02Q s + 2 Solving for equilibrium price and quantity, we get P*= $22 Q*= 1000 units These values represent the price that each firm will charge and the total number of units that will be produced overall. A typical firm in this market has the following costs: Total cost TC = q 2 + 2q Average cost AC = q (100/q) Marginal cost MC = 2q + 2 It should be noticed that in the TC equation, q 2 + 2q represents the firm s variable cost and 100 represents the fixed cost. The AC equation is obtained by dividing the TC equation by q. This means, in the AC equation, q + 2 is the average variable cost and 100/q is the average fixed cost. Given these costs, how much should the firm produce? The firm will always produce when the MC of a certain level of output equals the market price. That is, the firm will adjust its output level until P = MC. To find this output level, set the MC equation equal to the equilibrium price as follows:

2 P* = MC 22 = 2q + 2 q = 10 The firm will maximize its profits by producing 10 units. It is possible to characterize this firm and market level information with the following pair of demand and supply graphs. The graph (refer to figure 26.2) on the right represents the market, while the graph on the left (refer to figure 26.1) represents the firm. Figure 26.1 Figure 26.2 The equilibrium price corresponds with where the market demand (D M ) intersects the market supply (S). The firm accepts this price and decides how much to produce. This occurs where the firm s marginal cost curve (MC) crosses the firm s demand curve (D f ). It should be noted that the firm s demand curve is a horizontal line at the equilibrium price of $22. Another way to see whether the firm is maximizing profits is to assume that P = MC rule is not true. Suppose, the firm decides to test this rule by varying its output. If profits decline as one moves away from where q = 10 (e.g., as one moves between 8 and 12 units), profits should be maximized in the row where P = MC. P q MC AC Profits

3 Table 26.1 As the table 26.1 makes clear, profits reach their highest level when the firm produces 10 units. Although it is true that the price equals both marginal and average cost in this row yet this is the only coincidence at present in the short-run. There is only one condition of profit maximization and that is P should be equal to the MC. How to calculate the firm s profits? To find the firm s profits, one can opt either of two approaches which are as follows: TR - TC approach P - AC approach Profit = TR - TC Profit = (P - AC)q Profit = (22 x 10) - [(10) 2 + 2(10) + 100] Profit = (22 - [(10) (100/(10)]) x (10) Profit = Profit = (0) x 10 Profit = 0 Profit = 0 Where TR = Total Revenue, i.e. P x q The result is that this firm produces 10 units and makes zero economic profit. Graphically, one may find this result by comparing P and AC. P comes from the action of the market (as a whole) and it is represented by the horizontal demand curve D f. AC is found by the following method: Locating the firm s output level Tracing a dotted line from this output level to the AC curve From the point where the dotted line hits AC, go left over to the vertical axis Figure 26.3

4 In the figure 26.3, both P and AC are the same. TR can be obtained by multiplying P and q and TC by multiplying AC and q. By this method, the firm s TR and TC are represented by the same shaded area on the graph. Why would the firm produce if it makes zero profit? One way to answer this question is by seeing what happens if the firm shuts down. After that, compare the profits (or losses) under the following two situations: Producing Shut down As we know, the firm has fixed cost of $100. Assume that these fixed cost are all sunk (i.e. non-recoverable). If so, shutting down will cost the firm its $100 in sunk costs. This is worse than making zero profits, so the firm will produce. Suppose that all the fixed cost are recoverable. In this case, the firm would be indifferent between producing and shutting down since both situations would involve making zero profit. In a lot of introductory economic analysis, however, fixed costs are implicitly assumed to be 100% sunk. The important thing here is that these profits are economic profits, not accounting profits. To see why this is important, consider how economic profits and accounting profits are calculated: Economic profit = Actual revenue - (Actual costs + Opportunity costs) Accounting profit = Actual revenue - Actual costs While zero accounting profit would be undesirable, zero economic profit is not. A person could work all day to make $1 in accounting profit and be very unhappy since that person could probably do better in some other money-making activity (i.e. the next best alternative occupation). By including opportunity cost, economic profit accounts for things like the value of one s time in producing goods or performing services.

5 Slide 1 Production Central to our analysis is production. It is the process by which inputs are combined, transformed and turned into outputs. Slide 2 Firm and Household Decisions Firms demand factors of production in input markets and supply goods and services in output markets Slide 3 What is a firm? A firm is an organization that comes into being when a person or a group of people decides to produce goods or perform services to meet a perceived demand Most of the firms exist to make a profit Production is not limited to firms Many important differences exist among firms

6 Slide 4 Perfect Competition Perfect competition is an industry structure in which there are many small firms related to the industry. These small firms produce virtually identical products. No one firm is large enough to have any control over prices. In perfectly competitive industries, new competitors can freely enter and exit the market Slide 5 Homogeneous Products Homogeneous products are undifferentiated products, i.e. the products that are identical to, or indistinguishable from, one another In a perfectly competitive market, individual firms are price-takers Firms have no control over price as price is determined by the interaction of market supply and demand Slide 6 Demand Faced by a Single Firm in a Perfectly Competitive Market A perfectly competitive firm faces a perfectly elastic demand curve for its product

7 Slide 7 The Behavior of Profit-Maximizing Firms The three decisions that all firms should make include the following: 1. How much output to supply 2. Which production technology to use 3. How much of each input to demand Slide 8 Profit and Economic Costs Profit (economic profit) is the difference between total revenue and total economic cost Economic profit = Total revenue Total economic cost Total revenue is the amount received from the sale of the product (q x P) Slide 9 Profit and Economic Costs Total cost (total economic cost) is the total of the following: Out-of-pocket costs Normal rate of return on capital Opportunity cost of each factor of production

8 Slide 10 Profit and Economic Costs The rate of return, often referred to as the yield of the investment, is the annual flow of net income generated by an investment expressed as a percentage of the total investment Slide 11 Profit and Economic Costs The normal rate of return is a rate of return on capital that is just sufficient to keep owners and investors satisfied For relatively risk-free firms, the normal rate of return is nearly the same as the interest rate on risk-free government bonds Slide 12 Profit and Economic Costs Out-of-pocket costs are sometimes referred to as explicit costs or accounting costs Economic costs, often referred to as implicit cots, include the full opportunity cost of every input

9 Slide 13 Calculating Total Revenue, Total Cost and Profit Initial Investment: Market Interest Rate Available: Total Revenue (3,000 belts x $10 each) Costs Belts from supplier Labor Cost Normal return/opportunity cost of capital ($20,000 x.10) Total Cost Profit = total revenue total cost a There is a loss of $1,000. $20, or 10% $30,000 $15,000 14,000 2,000 $31,000 $ 1,000 a Slide 14 Short-Run Versus Long-Run Decisions The short-run is a period of time for which the following two conditions hold: A firm is operating under a fixed scale (or fixed factor) of production A firm can neither enter nor exit the industry Slide 15 Short-Run Versus Long-Run Decisions The long-run is a period of time for which there are no fixed factors of production The firms can increase or decrease scale of operation New firms can enter and existing firms can exit the industry

10 Slide 16 The Bases of Decisions The fundamental things to know with the objective of maximizing profit are as follows: 1. The market price of the output 2. The techniques of production that are available 3. The prices of inputs Slide 17