Chapter 8 Slide 1

Topics to be Discussed

Perfectly Competitive Markets

Profit Maximization

Marginal Revenue, Marginal Cost, and Profit Maximization

Choosing Output in the Short-Run

Chapter 8 Slide 2

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

Chapter 8 Slide 3

Perfectly Competitive Markets

Characteristics of Perfectly Competitive Markets

1) Price taking

2) Product homogeneity

3) Free entry and exit

Chapter 8 Slide 4

Profit Maximization

Do firms maximize profits?

Possibility of other objectivesRevenue maximizationDividend maximizationShort-run profit maximization

Chapter 8 Slide 5

Profit Maximization

Do firms maximize profits?

Implications of non-profit objectiveOver the long-run investors would not

support the companyWithout profits, survival unlikely

Chapter 8 Slide 6

Marginal Revenue, Marginal Cost,and Profit Maximization

Determining the profit maximizing level of outputProfit ( ) = Total Revenue - Total Cost

Total Revenue (R) = Pq

Total Cost (C) = Cq

Therefore:

)()()( qCqRq

Chapter 8 Slide 7

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.

Marginal Revenue, Marginal Cost,and Profit Maximization

Chapter 8 Slide 8

Profits are maximized when MC = MR.

Marginal Revenue, Marginal Cost,and Profit Maximization

R(q)

0

Cost,Revenue,

Profit$ (per year)

Output (units per year)

C(q)

A

B

q0 q*

)(q

Chapter 8 Slide 9

orq

C

q

R 0

q

: whenmaximized are Profits

MC(q)MR(q)

MCMR

thatso0

Marginal Revenue, Marginal Cost,and Profit Maximization

Chapter 8 Slide 10

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

Marginal Revenue, Marginal Cost,and Profit Maximization

Chapter 8 Slide 11

q0

Lost profit forqq < q*

Lost profit forq2 > q*

q1 q2

A Competitive FirmMaking a Positive Profit

10

20

30

40

Price($ per

unit)

0 1 2 3 4 5 6 7 8 9 10 11

50

60MC

AVC

ATCAR=MR=P

Outputq*

At q*: MR = MCand P > ATC

ABCDor

qx AC) -(P *

D A

BC

q1 : MR > MC andq2: MC > MR andq0: MC = MR but

MC falling

Chapter 8 Slide 12

Would this producercontinue to produce with a loss?

A Competitive FirmIncurring Losses

Price($ per

unit)

Output

AVC

ATCMC

q*

P = MR

B

F

C

A

E

DAt q*: MR = MCand P < ATCLosses = P- AC) x q* or ABCD

Chapter 8 Slide 13

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 8 Slide 14

Price($ per

unit)

MC

Output

AVC

ATC

P = AVC

P1

P2

q1 q2

S = MC above AVC

A Competitive Firm’sShort-Run Supply Curve

Shut-down

Chapter 8 Slide 15

The short-run market supply curve shows the amount of output that the industry will produce in the short-run for every possible price.

Consider, for simplicity, a competitive market with three firms:

The Short-Run Market Supply

Chapter 8 Slide 16

MC3

Industry Supply in the Short Run

$ perunit

0 2 4 8 105 7 15 21

MC1

SSThe short-runindustry supply curve

is the horizontalsummation of the supply

curves of the firms.

Quantity

MC2

P1

P3

P2

Question: If increasingoutput raises inputcosts, what impactwould it have on market supply?

Chapter 8 Slide 17

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.

The Short-Run Market Supply Curve

Chapter 8 Slide 18

Producer Surplus in the Short RunFirms earn a surplus on all but the last unit

of output.

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.

The Short-Run Market Supply Curve

Chapter 8 Slide 19

AA

DD

BB

CC

ProducerProducerSurplusSurplus

Alternatively, VC is thesum of MC or ODCq* .R is P x q* or OABq*.Producer surplus =

R - VC or ABCD.

Producer Surplus for a Firm

Price($ per

unit ofoutput)

Output

AVCAVCMCMC

00

PP

qq**

At q* MC = MR.Between 0 and q ,

MR > MC for all units.

Chapter 8 Slide 20

Producer Surplus in the Short-Run

The Short-Run Market Supply Curve

VC- R PS Surplus Producer

FC - VC- R - Profit

Chapter 8 Slide 21

DD

PP**

QQ**

ProducerProducerSurplusSurplus

Market producer surplus isthe difference between P*

and S from 0 to Q*.

Producer Surplus for a Market

Price($ per

unit ofoutput)

Output

SS

Chapter 8 Slide 22

Choosing Output in the Long Run

Entry and ExitThe long-run response to short-run profits

is to increase output and profits.

Profits will attract other producers.

More producers increase industry supply which lowers the market price.

Long-Run Competitive EquilibriumLong-Run Competitive Equilibrium

S1

Long-Run Competitive Equilibrium

Output Output

$ per unit ofoutput

$ per unit ofoutput

$40LAC

LMC

D

S2

P1

Q1q2

Firm Industry

$30

Q2

P2

•Profit attracts firms•Supply increases until profit = 0

Chapter 8 Slide 24

Choosing Output in the Long Run

Long-Run Competitive Equilibrium

1) MC = MR

2) P = LAC

No incentive to leave or enter

Profit = 0

3) Equilibrium Market Price

Chapter 8 Slide 25

Choosing Output in the Long Run

Economic RentEconomic rent is the difference between

what firms are willing to pay for an input less the minimum amount necessary to obtain it.

Chapter 8 Slide 26

Choosing Output in the Long Run

An Example

Two firms A & B

Both own their land

A is located on a river which lowers A’s shipping cost by $10,000 compared to B.

The demand for A’s river location will increase the price of A’s land to $10,000

Chapter 8 Slide 27

Choosing Output in the Long Run

An Example

Economic rent = $10,000

$10,000 - zero cost for the land

Economic rent increases

Economic profit of A = 0

If the opportunity cost of the input (rent) is not taken into consideration it may appear that economic profits exist in the long-run.

AP1

AC

P1

MC

q1

D1

S1

Q1

C

D2

P2P2

q2

B

S2

Q2

Economic profits attract newfirms. Supply increases to S2 and

the market returns to long-run equilibrium.

Long-Run Supply in aConstant-Cost Industry

Output Output

$ per unit ofoutput

$ per unit ofoutput

SL

Q1 increase to Q2.Long-run supply = SL = LRAC.

Change in output has no impact on input cost.

Chapter 8 Slide 29

Effect of an Output Tax on a Competitive Firm’s Output

Price($ per

unit ofoutput)

Output

AVC1

MC1

P1

q1

The firm willreduce output to

the point at whichthe marginal cost

plus the tax equalsthe price.

q2

tt

MC2 = MC1 + tax

AVC2

An output taxraises the firm’s

marginal cost by theamount of the tax.

Chapter 8 Slide 30

Effect of an OutputTax on Industry Output

Price($ per

unit ofoutput)

Output

DD

P1

SS1

Q1

P2

Q2

SS2 = S1 + t

t

Tax shifts S1 to S2 andoutput falls to Q2. Price

increases to P2.

Chapter 8 Slide 31

Summary

In the short run, a competitive firm maximizes its profit by choosing an output at which price is equal to (short-run) marginal cost.

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

Chapter 8 Slide 32

Summary

The producer surplus for a firm is the difference between revenue of a firm and the minimum cost that would be necessary to produce the profit-maximizing output.

Economic rent is the payment for a scarce resource of production less the minimum amount necessary to hire that factor.

Chapter 8 Slide 33

Summary

In the long-run, profit-maximizing competitive firms choose the output at which price is equal to long-run marginal cost.

The long-run supply curve for a firm can be horizontal, upward sloping, or downward sloping.