Profit Maximization and the Decision to Supply

Market Structure

• Firms are assumed to maximize economic profits • Economic Profit = Revenue – Total Opportunity

Costs• Costs are dependent on technology and input

prices• Revenue is dependent upon the market structure in

which a firm operates• Therefore, the profit maximization decision must

be analyzed by market structure

Market Structures

• Competitive Markets

• Monopoly

• Oligopoly

• Monopolistic Competition

Quick Overview

• Marginal benefits from a firms perspective are marginal revenue from selling output

• Marginal revenue equal the extra revenue from selling another unit of output

• Assuming the firm produces (does not shutdown), the firm will maximize profit (or minimize losses) where MR=MC

Marginal Revenue and Market Structure

• Competitive markets – sellers are price takers so MR = Market Price

• Monopoly – the seller is a price maker and faces the entire market demand curve so MR < Price

• Oligopoly – the seller directly competes with a few firms so MR depends on the actions of competitors

• Monopolistic Competition – sellers possess some market power and can set their own prices in the short-run, so MR<P

Competitive Markets or Pure Competition

• Assumptions revisited– Many buyers and sellers

• Each buyer and seller is a price taker

– Homogenous or identical products• Competition is based only on the price

– Perfect information or knowledge• All firms have access to the same technology

• Competition is based upon price

– Firms can freely enter or exit• Profits will be eliminated in the long-run

Revenue in Competitive Markets

• The market demand and supply curves determine the equilibrium price and quantity and the price that buyers will pay and sellers receive

• As with producer surplus, sellers are price takers and the price they receive is their MR. The marginal revenue and the price remain the same no matter how much output is sold.

Table 1 Total, Average, and Marginal Revenue for a Competitive Firm

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Competitive Firm in the Short-run

• Short-run – at least one fixed factor = fixed costs. Assume the plant size is fixed.

• Set MR=MC to find profit maximizing level of output. Use the average cost curves to determine whether one – Operates and earn profits

– Operate and breakeven

– Operates and make losses

– Shutdowns and minimize losses

Table 2 Profit Maximization: A Numerical Example

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Figure 1 Profit Maximization for a Competitive Firm

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Quantity0

Costsand

Revenue

MC

ATC

AVC

MC1

Q1

MC2

Q2

The firm maximizesprofit by producing the quantity at whichmarginal cost equalsmarginal revenue.

QMAX

P = MR1 = MR2 P = AR = MR

Conditions for Profits, Breakeven, Losses and Shutdown• Profits

– P > ATC

• Breakeven– P = ATC

• Losses but operate– P > AVC but P < ATC or– ATC > P > AVC

• Shutdown – P < AVC

Figure 5 Profit as the Area between Price and Average Total Cost

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(a) A Firm with Profits

Quantity0

Price

P = AR = MR

ATCMC

P

ATC

Q(profit-maximizing quantity)

Profit

Figure 5 Profit as the Area between Price and Average Total Cost

Copyright © 2004 South-Western

(b) A Firm with Losses

Quantity0

Price

ATCMC

(loss-minimizing quantity)

P = AR = MRP

ATC

Q

Loss

Short-run Supply

• Individual Firm: The short-run supply curve is MC curve above minimum AVC.

• Market: The short-run supply curve is the horizontal sum of all of the individual firm’s MC curves above the minimum AVC.

Figure 3 The Competitive Firm’s Short Run Supply Curve

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MC

Quantity

ATC

AVC

0

Costs

Firmshutsdown ifP< AVC

Firm’s short-runsupply curve

If P > AVC, firm will continue to produce in the short run.

If P > ATC, the firm will continue to produce at a profit.

Figure 6 Market Supply with a Fixed Number of Firms

Copyright © 2004 South-Western

(a) Individual Firm Supply

Quantity (firm)0

Price

MC

1.00

100

$2.00

200

(b) Market Supply

Quantity (market)0

Price

Supply

1.00

100,000

$2.00

200,000

Assume 100 firms with identical plant sizes and horizontally sum their marginal cost curves above minimum AVC

Price Determination in the Short-run

• Fixed plant sizes implies a fixed number of firms.• Market supply and demand curve determine the

price and the profit loss situations of existing firms.

• If demand increase, firms increase the quantity supplied by utilizing increasing capacity.

• The law of diminishing returns implies that supply is upward sloping at that prices will rise.

Long-run Supply and Price Determination

• Long-run – all factors are variable = no fixed costs and plant size can be changed, ALSO firms can enter and exit

• If economic profits are positive, new firms will enter.• If economic profits are negative, existing firms will

exit.• Long-run equilibrium:

– Firms must chose the plant that minimizes LRATC or they will suffer losses.

– Economic profits are reduced to zero.

Figure 7 Market Supply with Entry and Exit

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(a) Firm’s Zero-Profit Condition

Quantity (firm)0

Price

(b) Market Supply

Quantity (market)

Price

0

P = minimumATC

Supply

MC

ATC

LRMC

LRATC

Figure 8 An Increase in Demand in the Short Run and Long Run

Firm

(a) Initial Condition

Quantity (firm)0

Price

Market

Quantity (market)

Price

0

DDemand, 1

SShort-run supply, 1

P1

ATC

Long-runsupply

P1

1Q

A

MC

Figure 8 An Increase in Demand in the Short Run and Long Run

Copyright © 2004 South-Western

P1

Firm

(c) Long-Run Response

Quantity (firm)0

Price

MC ATC

Market

Quantity (market)

Price

0

P1

P2

Q1 Q2

Long-runsupply

B

D1

D2

S1

A

S2

Q3

C

Long-run Supply Curve

• Constant cost industries – horizontal or perfectly elastic supply

• Increasing cost industries – upward sloping supply– Some resource may be available in limited quantities

(farm land)– Some resources may increase in cost or be less

productive (skilled labor)

• Decreasing cost industries – downward sloping supply– Increased output may stimulate increased productivity or

technological change (computers)

Competitive Markets:Short-run and Long-run

• Short-run supply response to changes in demand are to increase or decrease the use of existing capacity.

• Long-run supply response is to build efficient plant size and increase or decrease capacity.

• In both the short-run and long-run, the profit maximizing behavior of firms leads to supply responses to accommodate changes in demand.

• In the short-run, prices act as signals and, in the long-run,prices and profits act as signals to increase or decrease output.

Efficiency Revisited

• Maximize human satisfaction from resources = maximize total surplus = maximize consumer surplus + producer surplus.

• Two conditions:– Produce what is most highly valued and the

amount that maximizes total surplus– Produce it at the least possible cost.

• In the absence of market failures, competitive markets are efficient in both the short-run and the long-run:– Supply responds to what consumers demand

– Goods are produced at least possible cost

• Price and profits are extremely important as signals for the allocation of scarce resources.– Examples of when prices and profits no longer act as

signal are rent controls and price supports