Distribution of Grades Midterm #2 25 20 15 10 5 0 10 15 20 25 30 35 40 45 50 Mean = 28. 30 Median = 29 © 2005 Pearson Education, Inc. Chapter 8 1
Chapter 8 Profit Maximization and Competitive Supply
Perfectly Competitive Markets l The model of perfect competition can be used to study a variety of markets l Basic assumptions of Perfectly Competitive Markets 1. 2. 3. Price taking Product homogeneity Free entry and exit © 2005 Pearson Education, Inc. Chapter 8 3
When are Markets Competitive? l Few real products are perfectly competitive l Many markets are, however, highly competitive m They face relatively low entry and exit costs m Highly elastic demand curves l No rule of thumb to determine whether a market is close to perfectly competitive m Depends © 2005 Pearson Education, Inc. on how they behave in situations Chapter 8 4
Profit Maximization l Do firms maximize profits? m Managers in firms may be concerned with other objectives l Revenue maximization l Revenue growth l Dividend maximization l Short-run profit maximization (due to bonus or promotion incentive) m Could © 2005 Pearson Education, Inc. be at expense of long run profits Chapter 8 5
Profit Maximization l Implications of non-profit objective m Over the long run, investors would not support the company m Without profits, survival is unlikely in competitive industries l Managers have constrained freedom to pursue goals other than long-run profit maximization © 2005 Pearson Education, Inc. Chapter 8 6
Marginal Revenue, Marginal Cost, and Profit Maximization l We can study profit maximizing output for any firm, whether perfectly competitive or not m Profit ( ) = Total Revenue - Total Cost m If q is output of the firm, then total revenue is price of the good times quantity m Total Revenue (R) = Pq © 2005 Pearson Education, Inc. Chapter 8 7
Marginal Revenue, Marginal Cost, and Profit Maximization l Costs of production depends on output m Total Cost (C) = C(q) l Profit for the firm, , is difference between revenue and costs © 2005 Pearson Education, Inc. Chapter 8 8
Profit Maximization – Short Run Cost, Revenue, Profit ($s per year) Profits are maximized where MR (slope at A) and MC (slope at B) are equal C(q) A R(q) Profits are maximized where R(q) – C(q) is maximized B 0 q 0 © 2005 Pearson Education, Inc. q* Chapter 8 Output (q) 9
Marginal Revenue, Marginal Cost, and Profit Maximization l Profit is maximized at the point at which an additional increment to output leaves profit unchanged © 2005 Pearson Education, Inc. Chapter 8 10
Marginal Revenue, Marginal Cost, and Profit Maximization l The Competitive Firm m Price taker – market price and output determined from total market demand supply m Market output (Q) and firm output (q) m Market demand (D) and firm demand (d) © 2005 Pearson Education, Inc. Chapter 8 11
The Competitive Firm l Demand curve faced by an individual firm is a horizontal line m Firm’s sales have no effect on market price l Demand curve faced by whole market is downward sloping m Shows amount of goods all consumers will purchase at different prices © 2005 Pearson Education, Inc. Chapter 8 12
The Competitive Firm Price $ per bushel Industry S $4 d $4 D 100 © 2005 Pearson Education, Inc. 200 Output (bushels) Chapter 8 100 Output (millions of bushels) 13
The Competitive Firm l The competitive firm’s demand m Individual producer sells all units for $4 regardless of that producer’s level of output m MR = P with the horizontal demand curve m For a perfectly competitive firm, profit maximizing output occurs when © 2005 Pearson Education, Inc. Chapter 8 14
Choosing Output: Short Run l In the short run, capital is fixed and firm must choose levels of variable inputs to maximize profits l We can look at the graph of MR, MC, ATC and AVC to determine profits l The point where MR = MC, the profit maximizing output is chosen © 2005 Pearson Education, Inc. Chapter 8 15
A Competitive Firm MC Price Lost Profit for q 1 < q* 50 40 Lost Profit for q 2>q* A AR=MR=P ATC AVC 30 q 1 : MR > MC q 2: MC > MR q*: MC = MR 20 10 0 1 © 2005 Pearson Education, Inc. 2 3 4 5 6 Chapter 8 7 q 1 8 q* 9 q 2 10 11 Output 16
A Competitive Firm – Positive Profits Price 50 40 Profit per unit = PAC(q) = A to B MC Total Profit = ABCD A D AR=MR=P ATC 30 C Profits are determined by output per unit times quantity AVC B 20 10 0 1 © 2005 Pearson Education, Inc. 2 3 4 5 6 Chapter 8 7 q 1 8 q* 9 q 2 10 11 Output 17
The Competitive Firm l A firm does not have to make profits l It is possible a firm will incur losses if the P < AC for the profit maximizing quantity m Still measured by profit per unit times quantity m Profit per unit is negative (P – AC < 0) © 2005 Pearson Education, Inc. Chapter 8 18
A Competitive Firm – Losses MC Price B C D A q *: At MR = MC and P < ATC Losses = (PAC) x q* or ABCD P = MR AVC q* © 2005 Pearson Education, Inc. ATC Chapter 8 Output 19
Choosing Output in the Short Run l Summary of Production Decisions m Profit is maximized when MC = MR m If P > ATC the firm is making profits m If P < ATC the firm is making losses © 2005 Pearson Education, Inc. Chapter 8 20
Short Run Production l Why would a firm produce at a loss? m Might think price will increase in near future m Shutting down and starting up could be costly l Firm has two choices in short run m Continue producing m Shut down temporarily m Will compare profitability of both choices © 2005 Pearson Education, Inc. Chapter 8 21
Short Run Production l When should the firm shut down? m If AVC < P < ATC, the firm should continue producing in the short run l Can cover all of its variable costs and some of its fixed costs m If AVC > P < ATC, the firm should shut down l Cannot cover its variable costs or any of its fixed costs © 2005 Pearson Education, Inc. Chapter 8 22
A Competitive Firm – Losses MC Price ATC Losses B C D P < ATC but ØAVC so firm will continue to produce in short run A P = MR AVC F E q* © 2005 Pearson Education, Inc. Chapter 8 Output 23
Competitive Firm – Short Run Supply l Supply curve tells how much output will be produced at different prices l Competitive firms determine quantity to produce where P = MC m Firm shuts down when P < AVC l Competitive firms’ supply curve is portion of the marginal cost curve above the AVC curve © 2005 Pearson Education, Inc. Chapter 8 24
A Competitive Firm’s Short-Run Supply Curve Price ($ per unit) The firm chooses the output level where P = MR = MC, as long as P > AVC. Supply is MC above AVC MC S P 2 ATC P 1 AVC P = AVC q 1 © 2005 Pearson Education, Inc. Chapter 8 q 2 Output 25
The Response of a Firm to a Change in Input Price ($ per unit) MC 2 Savings to the firm from reducing output Input cost increases and MC shifts to MC 2 and q falls to q 2. MC 1 $5 q 2 © 2005 Pearson Education, Inc. Chapter 8 q 1 Output 26
Short-Run Market Supply Curve l Shows the amount of product the whole market will produce at given prices l Is the sum of all the individual producers in the market l We can show graphically how we can sum the supply curves of individual producers © 2005 Pearson Education, Inc. Chapter 8 27
Industry Supply in the Short Run MC 1 $ per unit MC 2 MC 3 S The short-run industry supply curve is the horizontal summation of the supply curves of the firms. P 3 P 2 P 1 2 © 2005 Pearson Education, Inc. 4 5 7 8 10 Chapter 8 15 Q 21 28
Long-Run Competitive Equilibrium l For long run equilibrium, firms must have no desire to enter or leave the industry l Relate economic profit to the incentive to enter and exit the market l Relate accounting profit to economic profit © 2005 Pearson Education, Inc. Chapter 8 29
Long-Run Competitive Equilibrium l Accounting profit m Difference between firm’s revenues and direct costs l Economic profit m Difference between firm’s revenues and direct and indirect costs m Takes into account opportunity costs © 2005 Pearson Education, Inc. Chapter 8 30
Long-Run Competitive Equilibrium l Firm uses labor (L) and capital (K) with purchased capital l Accounting Profit and Economic Profit profit: = R - w. L m Economic profit: = R = w. L - r. K m Accounting l wl = labor cost l rk = opportunity cost of capital © 2005 Pearson Education, Inc. Chapter 8 31
Long-Run Competitive Equilibrium l Zero-Profit m. A firm is earning a normal return on its investment m Doing as well as it could by investing its money elsewhere m Normal return is firm’s opportunity cost of using money to buy capital instead of investing elsewhere m Competitive market long run equilibrium © 2005 Pearson Education, Inc. Chapter 8 32
Long-Run Competitive Equilibrium l Zero Economic Profits m If R > w. L + rk, economic profits are positive m If R = w. L + rk, zero economic profits, but the firm is earning a normal rate of return, indicating the industry is competitive m If R < wl + rk, consider going out of business © 2005 Pearson Education, Inc. Chapter 8 33
Long-Run Competitive Equilibrium l Entry and Exit m The long-run response to short-run profits is to increase output and profits m Profits will attract other producers m More producers increase industry supply, which lowers the market price m This continues until there are no more profits to be gained in the market – zero economic profits © 2005 Pearson Education, Inc. Chapter 8 34
Long-Run Competitive Equilibrium – Profits • Profit attracts firms • Supply increases until profit = 0 $ per unit of output Firm Industry S 1 LMC $40 LAC P 1 S 2 P 2 $30 D q 2 © 2005 Pearson Education, Inc. Output Chapter 8 Q 1 Q 2 Output 35
Long-Run Competitive Equilibrium – Losses • Losses cause firms to leave • Supply decreases until profit = 0 $ per unit of output Firm LMC $ per unit of output LAC $30 S 2 P 2 $20 Industry P 1 S 1 D q 2 © 2005 Pearson Education, Inc. Output Chapter 8 Q 2 Q 1 Output 36
Long-Run Competitive Equilibrium 1. All firms in industry are maximizing profits m MR = MC 2. No firm has incentive to enter or exit industry m Earning zero economic profits 3. Market is in equilibrium m QD = Q S © 2005 Pearson Education, Inc. Chapter 8 37
Choosing Output in the Long Run l Economic Rent m The difference between what firms are willing to pay for an input less the minimum amount necessary to obtain it m When some have accounting profits that are larger than others, they still earn zero economic profits because of the willingness of other firms to use the factors of production that are in limited supply © 2005 Pearson Education, Inc. Chapter 8 38
Choosing Output in the Long Run l An Example m Two firms A & B that both own their land m A is located on a river which lowers A’s shipping cost by $10, 000 compared to B m The demand for A’s river location will increase the price of A’s land to $10, 000 = economic rent m Although economic rent has increased, economic profit has become zero © 2005 Pearson Education, Inc. Chapter 8 39
Firms Earn Zero Profit in Long-Run Equilibrium Ticket Price LMC LAC A baseball team in a moderate-sized city sells enough tickets so that price is equal to marginal and average cost (profit = 0). $7 1. 0 © 2005 Pearson Education, Inc. Chapter 8 Season Tickets Sales (millions) 40
Firms Earn Zero Profit in Long-Run Equilibrium Ticket Price LMC Economic Rent LAC $10 $7. 20 A team with the same cost in a larger city sells tickets for $10. 1. 3 © 2005 Pearson Education, Inc. Chapter 8 Season Tickets Sales (millions) 41
Firms Earn Zero Profit in Long-Run Equilibrium l With a fixed input such as a unique location, the difference between the cost of production (LAC = 7) and price ($10) is the value or opportunity cost of the input (location) and represents the economic rent from the input © 2005 Pearson Education, Inc. Chapter 8 42
Firms Earn Zero Profit in Long-Run Equilibrium l If the opportunity cost of the input (rent) is not taken into consideration, it may appear that economic profits exist in the long run (positive accounting profits) © 2005 Pearson Education, Inc. Chapter 8 43
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