Chapter 8: Profit

Maximization &
Competitive Supply

CHAPTER 8 OUTLINE

8.1 Perfectly Competitive Markets

8.2 Profit Maximization
8.3 Marginal Revenue, Marginal Cost, and Profit Maximization
8.4 Choosing Output in the Short Run
8.5 The Competitive Firms Short-Run Supply Curve
8.6 The Short-Run Market Supply Curve
8.7 Choosing Output in the Long Run
8.8 The Industrys Long-Run Supply Curve

8.1

PERFECTLY COMPETITIVE MARKETS

The model of perfect competition rests on three basic assumptions:

(1) price taking
Because each individual firm (or consumer) sells (or buys) a sufficiently
small proportion of total market output, its decisions have no impact on
market price.
(2) product homogeneity
The products of all of the firms in a market are perfectly substitutable
with one another
e.g. copper, cotton, lumber, corn, oil, gas, iron.
(3) free entry and exit.
No entry barrier
(example of entry barriers: patent, license fee, R & D cost)

When Is a Market Highly

Competitive?
No simple rule of thumb to describe whether a
market is close to being perfectly competitive.

Firms can implicitly or explicitly collude in setting

prices, the presence of many firms is not sufficient
for an industry to approximate perfect
competition.

Conversely, the presence of only a few firms in a

market does not rule out competitive behavior.

8.2

PROFIT MAXIMIZATION

Do Firms Maximize Profit?

The assumption of profit maximization is frequently used in
microeconomics because it predicts business behavior reasonably
accurately and avoids unnecessary analytical complications.
Firms that do survive in competitive industries make long-run profit
maximization one of their highest priorities.

Alternative Forms of
Organization

Cooperative Association of businesses or people jointly owned and

operated by members for mutual benefit.
Condominium A housing unit that is individually owned but provides
access to common facilities that are paid for and controlled jointly by an
association of owners.

Practice Questions
A price taker is
A) a firm that accepts different prices from different customers.
B) a consumer who accepts different prices from different firms.
C) a perfectly competitive firm.
D) a firm that cannot influence the market price.
E) both C and D
True or false:
a) Markets that have only a few sellers cannot be highly
competitive.
b) Markets with many sellers are always perfectly competitive.
c) Markets may be highly (but not perfectly) competitive even
if there are a few sellers.
d) There is no simple indicator that tells us when markets are
highly competitive.

8.3 MARGINAL REVENUE, MARGINAL COST,

AND PROFIT MAXIMIZATION

profit

Difference between total revenue and total cost.

(q) = R(q) C(q)

marginal revenue
output.

Change in revenue resulting from a one-unit increase in

Profit -Max in the Short Run

A firm chooses output q*, so that
profit, the difference AB between
revenue R and cost C, is
maximized.
At that output, marginal revenue
(the slope of the revenue curve) is
equal to marginal cost (the slope
of the cost curve).

/q = R/q C/q = 0
MR(q) = MC(q)

Demand and Marginal Revenue for a

Competitive Firm

A competitive firm supplies a small portion of the total output in an industry.

The firm takes the market price of the product as given, choosing its output
on the assumption that the price will be unaffected by the output choice.
In (a) the demand curve facing an individual firm is perfectly elastic, even
though the market demand curve in (b) is downward sloping.

Please note:
Each firm in a competitive industry sells only a small fraction of
the entire industry output. How much output the firm decides to
sell has no effect on the market price of the product.
Because it is a price taker, the demand curve facing an individual
competitive firm is given by a horizontal line.
The demand curve facing by an individual firm (i.e. curve
d) in a competitive market is both its average revenue
curve and its marginal revenue curve. Along this demand
curve, marginal revenue, average revenue, and price are
all equal.

Profit Maximization by a Competitive Firm

MC(q) = MR = P

8.4 CHOOSING OUTPUT IN THE SHORT RUN

In the short run, the
competitive firm maximizes
its profit by choosing an
output q* at which P=MC.

Output Rule: If a firm is producing

any output, it should produce at the
level at which marginal revenue
equals marginal cost.

In this case, the firm is

making a profit, measured
by the rectangle ABCD.
Any change in output,
whether lower at q1 or
higher at q2, will lead to
lower profit.

q0 will never be chosen

q*
Produce at the point MR=MC and MC is rising

When Should the Firm Shut Down?

A Competitive Firm
Incurring a Loss
The firm may produce in the
short run if price is greater
than average variable cost.
A competitive firm should
shut down if price is below
AVC.
Shut-Down Rule: The firm should shut down if
the price of the product is less than the average
variable cost of production at the profitmaximizing output.

Key Notes for the short run

1. Firm produces where P equals MC (and where the
MC curve is rising).
2. If a firm is producing any output, it should produce
the profit-max output q* (i.e. where P=MC).
3. In the SR, firm could make a profit (P>AC), break
even (i.e. P=AC), or make a loss (P<AC).
4. If AVC<P< AC, the firm will incur a loss when
producing at a level P=MC, but it loses less by
producing. So q* is set at the level where P=MC.
5. If P< AVC, firm should shut down. The optimal q*=0.

8.5

THE COMPETITIVE FIRMS SHORT-RUN

SUPPLY CURVE

The firms supply curve is the portion of the marginal

cost curve for which marginal cost is greater than
average variable cost.
In the short run, the firm
chooses its output so that
marginal cost MC is
equal to price as long as
the firm covers its
average variable cost.
The short-run supply
curve is given by the
crosshatched portion of
the marginal cost curve.

The Short-Run Profit of a Competitive Firm

The Response of a Firm to a Change in Input Price

When the marginal cost of

production for a firm
increases (from MC1 to MC2),
the level of output that
maximizes profit falls (from q1
to q2).
The shaded area in the figure
gives the total savings to the
firm (or equivalently, the
reduction in lost profit)
associated with the reduction
in output from q1 to q2.

8.6

THE SHORT-RUN MARKET SUPPLY CURVE

The short-run industry supply

curve is the summation of the
supply curves of the individual
firms.
Because the third firm has a
lower AVC than the first two
firms, the market supply curve
S begins at P1 and follows the
MC curve of the third firm MC3
until price equals P2, when
there is a kink.
For P2 and all prices above it,
the industry quantity supplied
is
Elasticity
of Market Supply
the sum of the quantities
supplied by each of the three
Es = (Q/Q)/(P/P)
firms.

Producer Surplus in the Short Run

producer surplus Sum over all units produced by a firm of
differences between the market price of a good and the marginal
cost of production.
Producer Surplus for a
single Firm
The producer surplus for a firm is
measured by the yellow area
below the market price and
above the marginal cost curve,
between outputs 0 and q*, the
profit-maximizing output.
It is equal to rectangle ABCD
because the sum of all marginal
costs up to q* is equal to the
variable costs of producing q*.

Producer Surplus versus Profit

Producer surplus = PS = R VC
Profit = = R VC FC
Producer Surplus for a
Market

The producer surplus for

a market is the area
below the market price
and above the market
supply curve, between 0
and output Q*.

Practice Questions
If a graph of a perfectly competitive firm shows that the MR =
MC point occurs where MR is above AVC but below ATC,
A) the firm is earning negative profit, and will shut down rather than produce that
level of output.
B) the firm is earning negative profit, but will continue to produce where MR = MC in
the short run.
C) the firm is still earning positive profit, as long as variable costs are covered.
D) the firm is covering explicit, but not implicit, costs.
E) the firm can cover all of fixed costs but only a portion of variable costs.

If a competitive firm's marginal cost curve is U-shaped then

A) its short run supply curve is U-shaped too
B) its short run supply curve is the downward-sloping portion of the marginal cost
curve
C) its short run supply curve is the upward-sloping portion of the marginal cost curve
D) its short run supply curve is the upward-sloping portion of the marginal cost curve
that lies above the short run average variable cost curve
E) its short run supply curve is the upward-sloping portion of the marginal cost curve
that lies above the short run average total cost curve

Practice Questions
Conigan Box Company produces cardboard boxes that
are sold in bundles of 1000 boxes. The market is highly
competitive, with boxes currently selling for $100 per
thousand. Conigan's total and marginal cost curves are:
TC = 3,000,000 + 0.001Q2 MC = 0.002Q
where Q is measured in thousand box bundles per year.
a. Calculate Conigan's profit maximizing quantity. Is the firm
earning a profit?
Competitive market-P=mc(PROFIT MAX RULE)
100=0.002Q-------Q*=50000
profit=TR-TC=PQ*-TC(Q*)
=100*50000-(3000000+0.001*50000^2)
=5000000-3000000-2500000=-500000
Lose 500000 per year

b. Analyze Conigan's position in terms of the shutdown

condition. Should Conigan operate or shut down in the short
run?
Need to compare P to AVC
TVC=TC-TFC=0.001*(Q^2)
AVC=(0.001Q^2)/Q=0.001Q
WHEN PRODUCING Q*=50000,AVC=50
P=100
FIRM SHOULD OPERATE SINCE P IS GREATER THAN AVC

8.7

CHOOSING OUTPUT IN THE LONG RUN

Long-Run Profit Maximization

The firm maximizes its profit

by choosing the output at
which price equals long-run
marginal cost LMC (i.e.
P=LMC)
In the diagram, the firm
increases its profit from ABCD
to EFGD by increasing its
output in the long run.

The long-run output of a profit-maximizing

competitive firm is the point at which longrun marginal cost equals the price.

ZERO ECONOMIC PROFIT

A firm is earning a normal return on its investmenti.e., it is doing as well as it
could by investing its money elsewhere.

ENTRY AND EXIT

In a market with entry and exit, a firm enters when it can earn a positive longrun profit and exits when it faces the prospect of a long-run loss.

Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e.

Entry and
Exit

Initially the L.R. equilibrium price is $40

per unit, shown in (b) as the
intersection of D and S1.
In (a) we see that firms earn positive
profits because LRAC reaches a
minimum of $30 (at q2).
Positive profit encourages entry of new
firms and causes S1 to shift to S2, as
shown in (b).
The long-run equilibrium occurs at a
price of $30, as shown in (a), where
each firm earns zero profit and there is
no incentive to enter or exit the
industry.

Long-Run Competitive Equilibrium

In a market with entry and exit, a firm enters
when it can earn a positive long-run profit
and exits when it faces the prospect of a
long-run loss.
long-run competitive equilibrium All firms in an
industry are maximizing profit, no firm has an
incentive to enter or exit, and price is such that
quantity supplied equals quantity demanded.
A long-run competitive equilibrium occurs when three conditions hold:
1.

All firms in the industry are maximizing profit.

2.

No firm has an incentive either to enter or exit the industry because all firms are earning zero economic profit.

3.

The price of the product is such that the quantity supplied by the industry is equal to the quantity demanded by consumers.

Three Equilibrium Conditions for the Long Run

1. Qs=Qd (intersection of market demand and supply
determines the market price)
2. P=LMC (this ensures that firm is choosing the optimal
output level.
3. P=LAC

(zero economic condition)

(Implication of 2 & 3:
LMC=LAC, i.e. LAC reaches its minimum.)

THE OPPORTUNITY COST OF LAND

Examples in which firms earning positive accounting profit may be
earning zero economic profit.
Suppose, for example, that a clothing store happens to be located near a large shopping center. The additional flow of customers can
substantially increase the stores accounting profit because the cost of the land is based on its historical cost. When the opportunity cost of
land is included, the profitability of the clothing store is no higher than that of its competitors.

Economic Rent
economic rent Amount that firms are willing to pay for an input less the
minimum amount necessary to obtain it.
In competitive markets, in both the short and the long run, economic
rent is often positive even though profit is zero.

Producer Surplus in the Long Run

In the long run, in a competitive market, the producer surplus that a
firm earns on the output that it sells consists of the economic rent
that it enjoys from all its scarce inputs.
Copyright 2009 Pearson Education, Inc. Publishing as Prentice Hall Microeconomics Pindyck/Rubinfeld, 7e.

8.8

THE INDUSTRYS LONG-RUN SUPPLY CURVE

Industry whose long-run supply curve is horizontal.

Constant-Cost Industry
Long-Run Supply in a Constant-Cost Industry

When D1 shifts to D2, initially causing a

price rise (i.e. from point A to point C), the firm
initially increases its output from q1 to q2, as
shown in (a).
But the entry of new firms causes a shift to the
right in industry supply.
Because input prices are unaffected by the
increased output of the industry, entry occurs
until the original price is obtained (at point B in
(b)).

The long-run supply curve SL. for a constantcost industry is, therefore, a horizontal line at
a price that is equal to the long-run minimum
average cost of production.

Increasing-Cost Industry
Industry whose long-run supply curve is upward sloping.
Long-Run Supply in an Increasing-Cost Industry

When demand increases,

initially causing a price rise,
the firms increase their
output from q1 to q2 in (a).
In that case, the entry of new
firms causes a shift to the
right in supply from S1 to S2.
Because input prices
increase as a result, the new
long-run equilibrium occurs
at a higher price than the
initial equilibrium.

In an increasing-cost industry, the long-run

industry supply curve SL. is upward sloping.

Decreasing-Cost Industry
decreasing-cost industry
downward sloping.

Industry whose long-run supply curve is

EXAMPLE 8.6 CONSTANT-, INCREASING-, AND DECREASING-COST

INDUSTRIES: COFFEE, OIL, AND AUTOMOBILES
We saw that the supply of coffee is extremely elastic in the long run. The reason is that land for growing coffee is widely available and the costs of planting
and caring for trees remains constant as the volume grows. Thus, coffee is a constant-cost industry.
The oil industry is an increasing cost industry because there is a limited availability of easily accessible, large-volume oil fields.
Finally, a decreasing-cost industry. In the automobile industry, certain cost advantages arise because inputs can be acquired more cheaply as the volume of
production increases.

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Effect of an Output Tax on a Competitive Firms Output

An output tax raises the

firms marginal cost curve
by the amount of the tax.
The firm will reduce its
output to the point at
which the marginal cost
plus the tax is equal to the
price of the product.

The Effects of a Tax

An output tax placed on all
firms in a competitive
market shifts the supply
curve for the industry
upward by the amount of
the tax.
This shift raises the market
price of the product and
lowers the total output of the
industry.

Long-Run Elasticity of Supply

It is the percentage change in output (Q/Q) that results from a percentage

change in price (P/P).

In a constant-cost industry, the long-run supply curve is horizontal, and the long-run supply elasticity is infinitely large. (A small increase in price will
induce an extremely large increase in output.)

In an increasing-cost industry, the long-run supply elasticity will be positive but finite.

Because industries can adjust and expand in the long run, we would generally expect long-run elasticities of supply to be larger than short-run
elasticities.

The magnitude of the elasticity will depend on the extent to which input costs increase as the market expands. e.g., an industry that depends on inputs
that are widely available will have a more elastic long-run supply than will an industry that uses inputs in short supply.

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Practice Questions
In the long-run equilibrium of a competitive market,
the market supply and demand are:
Supply: P = 30 + 0.50Q
Demand: P = 100 1.5Q,
where P is dollars per unit and Q is rate of production
and sales in hundreds of units per day. A typical firm in
this market has a marginal cost of production
expressed as: MC = 3.0 + 15q.
a. Determine the market equilibrium rate of sales and price.
Demand=supply
100-1.5Q=30+0.5Q
70=2Q, Q=35
Sub Q into supply function
P=100-1.5*35=47.5

b. Determine the rate of sales by the typical firm.

Output rule(or profit-max rule)
P=MC
47.5=3+15q, q=2.967 hundred per day

C. Determine the economic rent that the typical firm enjoys.

(Hint: Note that the marginal cost function is linear.)
The economic rent that the firm earn in the LR is equal
to the producer surplus that it generate
P=47.5 q=2.967
P=MR=AR
PS=0.5*(47.5-3)*2.967=66.016

d. If an output tax is imposed on ONE firm's output such that

the ONE firm has a new marginal cost (including the tax) of:
MCt = 5 + 15q,
what will the firm's new rate of production be after the tax is
imposed? How does this new production rate compare with
the pre-tax rate? Is it as expected? Explain. Would the effect
have been the same if the tax had been imposed on all firms
equally? Explain.

P=mc
47.5=5+15q q*=2.833 is less than 2.967(pre-tax output)
The effect would not have been the same if the tax had
been imposed on all firms. The equilibrium market price
would have increased. The industry supply would shift
upward and total industry output would decrease