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Perfectly Competitive Markets Profit Maximization Choosing Output in the Short Run The Competitive Firms Short-Run Supply
Curve
Competitive Market?
Profit Maximization
Do firms maximize profits? Managers in firms may be concerned with other objectives
Revenue maximization Revenue growth Dividend maximization Short-run profit maximization (due to bonus
or share options) could be at expense of long run profits
Profit Maximization
We can study profit maximizing output for any firm, whether perfectly competitive or not
Profit () = Total Revenue - Total Cost If q is output of the firm, then total revenue is price
of the good times quantity
Total Revenue (R) = P*q Note: If the firm is not a price taker, then
(R)=P(q)*q
Output
Revenue is a curve, showing that a firm can only sell more if it lowers its price
Slope of the revenue curve is the marginal revenue
Firm
Industry
100
200
Output (bushels)
100
MR = P with the horizontal demand curve For a perfectly competitive firm, profit maximizing
output occurs when
A Competitive Firm
Price 50
40 30
20 10 0 1 2 3 4 5 6 7 8 9 10 11
Output
MC
40
A
ATC
AR=MR=P
B AVC Profits are determined by output per unit times quantity
30 C
20 10 0 1 2 3 4 5 6 7 8
q1
q*
10
11
q2
Output
A firm does not have to make profits It is possible a firm will incur losses if
the P < AC for the profit maximizing quantity
MC
B
ATC
P = MR AVC
q*
Output
Short-Run Production
Might think price will increase in near future Shutting down and starting up could be costly
(1) Continue producing (2) Shut down temporarily Will compare profitability of both choices
If AVC > P < ATC, the firm should shut down Cannot cover its variable costs or any of its
fixed costs
MC
B
ATC
C D
P < ATC but AVC so firm will continue to produce in short run
P = MR AVC
q*
Output
Supply curve tells how much output will be produced at different prices
Competitive firms determine quantity to produce where P = MC
MC
P2 P1
S ATC AVC
P = AVC
q1
q2 Output
MC2
Savings to the firm from reducing output
MC1 $5
q2
q1
Output
Shows the amount of product the whole market will produce at given prices
Is the sum of all the individual producers in the market We can show graphically how we can sum the supply curves of individual producers
P3
P2 P1
Q
2 4
5
7 8
10
15
21
E s ( Q / Q ) /( P / P )
When MC increases rapidly in response to increases in output, elasticity is low When MC increases slowly, supply is relatively elastic 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
Price is greater than MC on all but the last unit of output
Therefore, surplus is earned on all but the last unit 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 Area above supply curve to the market price
MC B
AVC
P
At q* MC = MR. Between 0 and q, MR > MC for all units.
q*
Output
P*
Producer Surplus
D
Output
Q*
Profits will attract other producers More producers increase industry supply,
which lowers the market price
Firm
Industry S1
$40
LAC
P1
S2
$30
P2
D q2
Output
Q1
Q2
Output
MR = MC
2. Market is in equilibrium
QD = QS
3. No firm has incentive to enter or exit industry
Summary
Perfect competition Profit maximizing firms Supply curve Elasticity of supply Producer surplus
Required Reading