Chapter 8

Chapter 8
Profit Maximization
and Competitive
Supply
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 Firms Short-Run

Supply Curve
Short-Run Market Supply
Choosing Output in the Long-Run
The Industrys Long-Run Supply Curve
Chapter 8 Slide 3
Characteristics of Perfectly Competitive

Markets
1) Price taking
2) Product homogeneity
3) Free entry and exit
Chapter 8 Slide 4
Price Taking
The individual firm sells a very small share
of the total market output and, therefore,
cannot influence market price.
The individual consumer buys too small a
share of industry output to have any impact
on market price.
Chapter 8 Slide 5
Product Homogeneity
The products of all firms are perfect
substitutes.
Examples
Agricultural products, oil, copper, iron,

lumber
Chapter 8 Slide 6
Free Entry and Exit

Buyers can easily switch from one supplier
to another.
Suppliers can easily enter or exit a market.
Chapter 8 Slide 7
Discussion Questions
What are some barriers to entry and exit?
Are all markets competitive?
When is a market highly competitive?
Chapter 8 Slide 8
Profit Maximization
Do firms maximize profits?

Possibility of other objectives
Revenue maximization
Dividend maximization
Short-run profit maximization
Chapter 8 Slide 9
Profit Maximization

Implications of non-profit objective
Over the long-run investors would not
support the company
Without profits, survival unlikely
Chapter 8 Slide
Profit Maximization

Long-run profit maximization is valid and
does not exclude the possibility of
altruistic behavior.
Chapter 8 Slide
Marginal Revenue, Marginal Cost,
and Profit Maximization
Determining the profit maximizing level

of output
Profit ( ) = Total Revenue - Total Cost
Total Revenue (R) = Pq
Total Cost (C) = Cq
Therefore:
(q ) R(q) C (q)
Chapter 8 Slide
Profit Maximization in the Short Run
Cost, Total Revenue

Revenue, R(q)
Profit
($s per year)
Slope of R(q) = MR
Output (units per year)
Chapter 8 Slide
Profit Maximization in the Short Run
C(q)
Cost,
Revenue,
Profit
$ (per year) Total Cost
Slope of C(q) = MC
Why is cost positive when q is zero?
Chapter 8 Slide
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.
Chapter 8 Slide
Comparing R(q) and C(q)

Cost,
Output Revenue,
levels: 0- q0: Profit
($s per year) C(q)
C(q)> R(q) R(q)
A
Negative profit
FC + VC > R(q) B
MR > MC
Indicates higher
profit at higher
output 0 q0 q*
(q)
Chapter 8 Slide

Cost,
Question: Why is profit Revenue,
Profit
negative when output is $ (per year) C(q)
zero? R(q)
A
0 q0 q*
(q )
Chapter 8 Slide

Cost,
Output Revenue,
levels: q0 - q* Profit
$ (per year) C(q)
R(q)> C(q) R(q)
A
MR > MC
Indicates higher B
profit at higher
output
Profit is increasing
0 q0 q*
(q)
Chapter 8 Slide

Cost,
Output Revenue,
level: q* Profit
$ (per year) C(q)
R(q)= C(q)
A R(q)
MR = MC
Profit is maximized B
0 q0 q*
(q)
Chapter 8 Slide
Question Cost,
Revenue,
Why is profit reduced Profit
C(q)
$ (per year)
when producing more R(q)
A
or less than q*?
B
0 q0 q*
(q)
Chapter 8 Slide

Cost,
Output Revenue,
levels beyond q*: Profit
$ (per year) C(q)
R(q)> C(q)
A R(q)
MC > MR
Profit is decreasing B
0 q0 q*
(q)
Chapter 8 Slide
Therefore, it can be Cost,

said: Revenue,
Profit
$ (per year) C(q)
Profits
are maximized R(q)
A
when MC = MR.
B
0 q0 q*
(q)
Chapter 8 Slide
R
MR
q
R-C
C
MC
q
Chapter 8 Slide
Profits are maximized when :

R C
0 or
q q q
MR MC 0 so that
MR(q) MC(q)
Chapter 8 Slide
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
Chapter 8 Slide
Demand and Marginal Revenue Faced
by a Competitive Firm
Price Price
$ per Firm $ per Industry
bushel bushel
$4 d $4
Output Output
100 200 (bushels)
100 (millions
of bushels)

The competitive firms demand
Individual producer sells all units for $4
regardless of the producers level of
output.
If the producer tries to raise price, sales
are zero.
Chapter 8 Slide

The competitive firms demand
If the producers tries to lower price he
cannot increase sales
P = D = MR = AR
Chapter 8 Slide

Profit Maximization
MC(q) = MR = P
Chapter 8 Slide
Choosing Output in the Short Run
We will combine production and cost

analysis with demand to determine
output and profitability.
Chapter 8 Slide
A Competitive Firm
Making a Positive Profit
Price 60 MC
($ per
unit)
50 Lost profit for Lost profit for
qq < q * q2 > q *
D A
40 AR=MR=P
ATC
C B
30 AVC
q1 : MR > MC and At q*: MR = MC

and P > ATC
q2: MC > MR20 and
q0: MC = MR but (P - AC) x q*
10
MC falling or ABCD
0 1 2 3 4 5 6 7 8 9 10 11
q0 q1 q q2 * Output
Chapter 8 Slide
A Competitive Firm
Incurring Losses
Price MC ATC
($ per
unit) B
C
D P = MR
At q*: MR = MC A
and P < ATC
Losses = P- AC) x q* AVC
or ABCD
F Would this producer
E continue to produce
with a loss?
q* Output
Chapter 8 Slide
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
The Short-Run Output of
an Aluminum Smelting Plant
Observations
Cost Price between $1140 & $1300: q = 600
(dollars per item) Price > $1300: q = 900
Price < $1140: q = 0
1400
P2
1300
P1
1200
Question
1140
Should the firm stay in business
1100 when P < $1140?
Output
0 300 600 900 (tons per day)
Chapter 8 Slide
Some Cost Considerations for Managers
Three guidelines for estimating

marginal cost:
1) Average variable cost should not be

used as a substitute for marginal
cost.
Chapter 8 Slide

marginal cost:
2) A single item on a firms accounting

ledger may have two components,
only one of which involves marginal
cost.
Chapter 8 Slide

marginal cost:
3) All opportunity cost should be

included in determining marginal
cost.
Chapter 8 Slide
A Competitive Firms
Short-Run Supply Curve
Price The firm chooses the
($ per output level where MR = MC,
unit) as long as the firm is able to
cover its variable cost of
production.
MC
P2 ATC
P1 AVC
What happens
P = AVC if P < AVC?
q1 q2 Output
Chapter 8 Slide
A Competitive Firms
Observations:
P = MR
MR = MC
P = MC
Supply is the amount of output for every

possible price. Therefore:
If P = P1, then q = q1
If P = P2, then q = q2
Chapter 8 Slide
A Competitive Firms
Price S = MC above AVC
($ per
unit)
MC
P2 ATC
P1 AVC
P = AVC
Shut-down
Output
q1 q2
Chapter 8 Slide
A Competitive Firms
Observations:
Supply is upward sloping due to
diminishing returns.
Higher price compensates the firm for
higher cost of additional output and
increases total profit because it applies to
all units.
Chapter 8 Slide
A Competitive Firms
Firms Response to an Input Price

Change
When the price of a firms product
changes, the firm changes its output level,
so that the marginal cost of production
remains equal to the price.
Chapter 8 Slide
The Response of a Firm to
a Change in Input Price
Price
Input cost increases
($ per
and MC shifts to MC2
unit) MC2 and q falls to q2.
Savings to the firm
from reducing output
MC1
$5
q2 q1 Output
Chapter 8 Slide
The Short-Run Production
of Petroleum Products
Cost
The MC of producing
($ per a mix of petroleum products
barrel) 27 from crude oil increases SMC
sharply at several levels
of output as the refinery
shifts from one processing
unit to another.
26
How much would

25 be produced if
P = $23?
P = $24-$25?
24
23 Output
(barrels/day)
8,000 9,000 10,000 11,000
Chapter 8 Slide
Stepped SMC indicates a different

production (cost) process at various
capacity levels.
Observation:
With a stepped MC function, small
changes in price may not trigger a change
in output.
Chapter 8 Slide
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:
Chapter 8 Slide
Industry Supply in the Short Run
The short-run S
$ per MC1 MC2 MC3 industry supply curve
is the horizontal
unit
summation of the supply
curves of the firms.
P3
P2
P1 Question: If increasing
output raises input
costs, what impact
would it have on
market supply?
0 2 4 5 7 8 10 15 Quantity 21
Chapter 8 Slide
The Short-Run Market Supply Curve
Elasticity of Market Supply
Es (Q / Q) /( P / P )
Chapter 8 Slide
Perfectly inelastic short-run supply

arises when the industrys 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.
Chapter 8 Slide
Questions
1) Give an example of a perfectly

inelastic supply.
2) If MC rises rapidly, would the supply

be more or less elastic?
Chapter 8 Slide
The World Copper Industry (1999)
Annual Production Marginal Cost
Country (thousand metric tons) (dollars/pound)
Australia 600 0.65
Canada 710 0.75
Chile 3660 0.50
Indonesia 750 0.55
Peru 450 0.70
Poland 420 0.80
Russia 450 0.50
United States 1850 0.70
Zambia 280 0.55
Chapter 8 Slide
The Short-Run World Supply of Copper
Price
($ per pound)
0.90
MCPo
0.80
MCCa
MCP,MCUS
0.70 MCA
0.60
MCJ,MCZ
MCC,MCR
0.50
0.40
0 2000 4000 6000 8000 10000
Production (thousand metric tons)
Chapter 8 Slide
Producer Surplus in the Short Run

Firms 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.
Chapter 8 Slide
Producer Surplus for a Firm
At q* MC = MR.
Between 0 and q ,
Price MR > MC for all units.
($ per Producer
unit of Surplus MC AVC
output)
B
A P
Alternatively, VC is the
sum of MC or ODCq* .
R is P x q* or OABq*.
D Producer surplus =
C
R - VC or ABCD.
0 q* Output
Chapter 8 Slide
Producer Surplus in the Short-Run
Producer Surplus PS R - VC
Profit - R - VC - FC
Chapter 8 Slide
Observation
Short-run with positive fixed cost
PS
Chapter 8 Slide
Producer Surplus for a Market
Price S
($ per
unit of
output)
Market producer surplus is

P* the difference between P*
and S from 0 to Q*.
Producer
Surplus D
Q* Output
Chapter 8 Slide
Choosing Output in the Long Run
In the long run, a firm can alter all its

inputs, including the size of the plant.
We assume free entry and free exit.
Chapter 8 Slide
Output Choice in the Long Run
Price In the long run, the plant size will be
($ per increased and output increased to q3.
Long-run profit, EFGD > short run
LMC
unit of
output) profit ABCD.
LAC
SMC
SAC
D A E
$40 P = MR
C
B
G F
$30
In the short run, the
firm is faced with fixed
inputs. P = $40 > ATC.
Profit is equal to ABCD.
q1 q2 q3 Output
Chapter 8 Slide
Output Choice in the Long Run
Price Question: Is the producer making
($ per a profit after increased output
lowers the price to $30? LMC
unit of
output) LAC
SMC
SAC
D A E
$40 P = MR
C
B
G F
$30
q1 q2 q3 Output
Chapter 8 Slide
Accounting Profit & Economic Profit

Accountingprofit ( ) = R - wL
Economic profit ( ) = R = wL - rK
wl = labor cost
rk = opportunity cost of capital
Chapter 8 Slide
Long-Run
Long-Run Competitive
Competitive Equilibrium
Equilibrium
Zero-Profit
If R > wL + rk, economic profits are positive
If R = wL + rk, zero economic profits, but
the firms is earning a normal rate of return;
indicating the industry is competitive
IfR < wl + rk, consider going out of
business
Chapter 8 Slide
Long-Run
Long-Run Competitive
Competitive Equilibrium
Equilibrium
Entry and Exit

The 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.
Chapter 8 Slide
Long-Run Competitive Equilibrium
Profit attracts firms
Supply increases until profit = 0
$ per Firm $ per Industry
unit of unit of S1
output output
LMC
$40 P1
LAC S2
$30 P2
q2 Output Q1 Q2 Output
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
Questions
1) Explain the market adjustment when
P < LAC and firms have identical
costs.
2) Explain the market adjustment when
firms have different costs.
3) What is the opportunity cost of land?
Chapter 8 Slide
Economic Rent
Economic 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
An Example
Two firms A & B
Both own their land
A is located on a river which lowers As
shipping cost by $10,000 compared to B.
The demand for As river location will
increase the price of As land to $10,000
Chapter 8 Slide
An Example
Economic rent = $10,000
$10,000 - zero cost for the land
Economic rent increases
Economic profit of A = 0
Chapter 8 Slide
Firms Earn Zero Profit in
Long-Run Equilibrium
A baseball team
Ticket in a moderate-sized city
Price sells enough
tickets so that price
is equal to marginal
LMC LAC and average cost
(profit = 0).
$7
Season Tickets
Sales (millions)
1.0
Chapter 8 Slide
Ticket
Price
Economic Rent LMC LAC
$10
$7 A team with the same

cost in a larger city
sells tickets for $10.
Season Tickets
Sales (millions)
1.3
Chapter 8 Slide
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.
Chapter 8 Slide
If the opportunity cost of the input (rent)

is not taken into consideration it may
appear that economic profits exist in the
long-run.
Chapter 8 Slide
The shape of the long-run supply curve

depends on the extent to which
changes in industry output affect the
prices the firms must pay for inputs.
Chapter 8 Slide
To determine long-run supply, we

assume:
All firms have access to the available
production technology.
Output is increased by using more inputs,
not by invention.
Chapter 8 Slide
To determine long-run supply, we

assume:
The market for inputs does not change with
expansions and contractions of the
industry.
Chapter 8 Slide
Long-Run Supply in a
Constant-Cost Industry
Economic profits attract new
firms. Supply increases to S2 and Q1 increase to Q2.
the market returns to long-run Long-run supply = SL = LRAC.
$ per equilibrium. $ per Change in output has no impact on
unit of unit of input cost.
output output
MC AC S1 S2
P2 P2 C
A B
P1 P1 SL
D1 D2
q1 q2 Output Q1 Q2 Output
Constant-Cost Industry
In a constant-cost industry, long-run

supply is a horizontal line at a price that
is equal to the minimum average cost of
production.
Chapter 8 Slide
Long-Run Supply in an
Increasing-Cost Industry Due to the increase
in input prices, long-run
equilibrium occurs at
$ per $ per a higher price.
unit of unit of
output LAC2 output S1 S2
SMC2 SL
SMC1
P2 LAC1 P2
P3 P3 B
P1 P1 A
D1 D1
q1 q2 Output Q1 Q2 Q3 Output
Increasing-Cost Industry
In a increasing-cost industry, long-run

supply curve is upward sloping.
Chapter 8 Slide
The Industrys
Long-Run Supply Curve
Questions
1) Explain how decreasing-cost is

possible.
2) Illustrate a decreasing cost industry.
3) What is the slope of the SL in a

decreasing-cost industry?
Chapter 8 Slide
Long-Run Supply in an
Decreasing-Cost Industry
Due to the decrease
in input prices, long-run
equilibrium occurs at
$ per $ per a lower price.
unit of unit of
output output S1 S2
SMC1
SMC2 LAC1
P2 P2
LAC2
P1 A
P1 B
P3 P3
SL
D1 D2
q1 q2 Output Q1 Q2 Q3 Output
Increasing-Cost Industry
In a decreasing-cost industry, long-run

supply curve is downward sloping.
Chapter 8 Slide
The Industrys
The Effects of a Tax

In an earlier chapter we studied how firms
respond to taxes on an input.
Now, we will consider how a firm responds
to a tax on its output.
Chapter 8 Slide
Effect of an Output Tax on a
Competitive Firms Output
Price MC2 = MC1 + tax The firm will
($ per MC1 reduce output to
unit of An output tax the point at which
output) raises the firms the marginal cost
marginal cost by the plus the tax equals
amount of the tax. the price.
t
P1
AVC2
AVC1
q2 q1 Output
Chapter 8 Slide
Effect of an Output
Tax on Industry Output
Price
($ per S2 = S 1 + t
unit of
output) S1
P2 t
Tax shifts S1 to S2 and

P1 output falls to Q2. Price
increases to P2.
Q2 Q1 Output
Chapter 8 Slide
The Industrys
Long-Run Elasticity of Supply
1) Constant-cost industry
Long-run supply is horizontal
Small increase in price will induce an
extremely large output increase
Chapter 8 Slide
The Industrys
1) Constant-cost industry
Long-run supply elasticity is infinitely
large
Inputs would be readily available
Chapter 8 Slide
The Industrys
2) Increasing-cost industry
Long-run supply is upward-sloping and
elasticity is positive
The slope (elasticity) will depend on the
rate of increase in input cost
Long-run elasticity will generally be greater
than short-run elasticity of supply
Chapter 8 Slide
The Industrys
Question:
Describe the long-run elasticity of supply in
a decreasing -cost industry.
Chapter 8 Slide
The Long-Run Supply of Housing
Scenario 1: Owner-occupied housing

Suburban or rural areas
National market for inputs
Chapter 8 Slide
Questions
Is this an increasing or a constant-cost
industry?
What would you predict about the elasticity
of supply?
Chapter 8 Slide
Scenario 2: Rental property

Zoning restrictions apply
Urban location
High-rise construction cost
Chapter 8 Slide
Questions
Is this an increasing or a constant-cost
industry?
What would you predict about the elasticity
of supply?
Chapter 8 Slide
Summary
The managers of firms can operate in

accordance with a complex set of
objectives and under various
constraints.
A competitive market makes its output
choice under the assumption that the
demand for its own output is horizontal.
Chapter 8 Slide
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
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
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.
Chapter 8 Slide
End of Chapter 8
Profit Maximization
and Competitive
Supply

Chapter 8

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Chapter 8

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Chapter 8

Perfectly Competitive Markets

The Competitive Firms Short-Run

Characteristics of Perfectly Competitive

3) Free entry and exit

Agricultural products, oil, copper, iron,

Free Entry and Exit

Do firms maximize profits?

Do firms maximize profits?

Do firms maximize profits?

Determining the profit maximizing level

Cost, Total Revenue

Output (units per year)

Why is cost positive when q is zero?

Output (units per year)

Marginal revenue is the additional

Comparing R(q) and C(q)

Comparing R(q) and C(q)

Comparing R(q) and C(q)

Comparing R(q) and C(q)

Comparing R(q) and C(q)

Therefore, it can be Cost,

Profits are maximized when :

The Competitive Firm

The Competitive Firm

The Competitive Firm

The Competitive Firm

We will combine production and cost

q1 : MR > MC and At q*: MR = MC

Summary of Production Decisions

Three guidelines for estimating

1) Average variable cost should not be

Three guidelines for estimating

2) A single item on a firms accounting

Three guidelines for estimating

3) All opportunity cost should be

Supply is the amount of output for every

Firms Response to an Input Price

How much would

Stepped SMC indicates a different

The short-run market supply curve

Elasticity of Market Supply

Perfectly inelastic short-run supply

1) Give an example of a perfectly

2) If MC rises rapidly, would the supply

Producer Surplus in the Short Run

Producer Surplus in the Short-Run

Market producer surplus is

In the long run, a firm can alter all its

Accounting Profit & Economic Profit

Entry and Exit

Long-Run Competitive Equilibrium

3) Equilibrium Market Price

Economic Rent LMC LAC

$7 A team with the same

With a fixed input such as a unique

If the opportunity cost of the input (rent)

The shape of the long-run supply curve

To determine long-run supply, we

To determine long-run supply, we

In a constant-cost industry, long-run

In a increasing-cost industry, long-run

1) Explain how decreasing-cost is