The objectives of firms
Professional Development Course in Knowledge Enrichment for
Senior Secondary Economics Teachers
Outline of Lecture 2 –Microeconomics: The objectives of firms
Topics covered:
I.
Consumers and producers surplus
II.
Pareto efficiency - Externality with graph analysis
III. Profit maximizing output decision of perfect competitive firms
IV. Profit maximizing output decision of monopoly
V.
I.
Price discrimination
Consumers and producers surplus
Consumer Surplus
Teaching advice

Students will understand consumer surplus if you take the time to work through the
example. If you start with this simple example, students will have no trouble understanding
how to find consumer surplus on a graph.

It is important to stress that consumer surplus is measured in monetary terms. Consumer
surplus gives us a way to place a monetary cost on inefficient market outcomes (due to
government involvement or market failure).

Marginal benefit to consumers, willingness to pay, consumer surplus, demand curve,
law of demand and relative price (Alchian Generalization) and their relationship

Definition of willingness to pay: the maximum amount that a buyer will pay for a
good.

Definition of consumer surplus: a buyers’ willingness to pay minus the amount the
buyer actually pays.
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The objectives of firms

Using the Demand Curve to Measure Consumer Surplus
-

Consumer surplus can be measured as the area below the demand curve and above
the price.
How a Lower Price Raises Consumer Surplus
-
As price falls, consumer surplus increases.
(a) Consumer Surplus at Price P0
Price
A
Consumer
surplus
P0
B
C
Demand
0
Quantity
Q0
(b) Consumer Surplus at Price P1
Price
A
Additional consumer
surplus to initial consumers
Initial
consumer surplus
C
P0
B
P1
D
Consumer surplus
to new consumers
F
E
Demand
0

Q0
Q1
Quantity
Consumer surplus measures the benefit that consumers receive from the good as the
buyers themselves perceive it.
2
The objectives of firms
Producer Surplus
Teaching advice

You will need to take some time explaining the relationship between the producers’
willingness to sell and the cost of producing the good.

The relationship between cost and the supply curve is not as apparent as the relationship
between the demand curve and willingness to pay.

Marginal cost of firms, minimum supply-price, producer surplus, supply curve and
their relationship
-
Definition of cost: the value of everything a seller must give up to produce a good.
-
Definition of producer surplus: the amount a seller is paid for a good minus the
seller’s cost.

Using the Supply Curve to Measure Producer Surplus
-
Producer surplus can be measured as the area above the supply curve and below the
price.

How a Higher Price Raises Producer Surplus
-
As price rises, producer surplus increases.
(a) Producer Surplus at Price P0
Price
Supply
P0
B
Producer
surplus
C
A
0
Q0
Quantity
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The objectives of firms
(b) Producer Surplus at Price P1
Price
Supply
Additional producer
surplus to initial
producers
D
P1
E
F
B
P0
Initial
producer
surplus
C
Producer surplus
to new producers
A
0

II.
Q0
Q1
Quantity
Illustrate consumer surplus and producer surplus in a demand-supply diagram
Pareto efficiency
Teaching advice

It would be a good idea to remind students that there are circumstances when the market
process does not lead to the most efficient outcome.

Examples include situations such as when a firm (or buyer) has market power over price or
when there are externalities present.

Pareto condition - An outcome is Pareto efficiency if it is not possible to improve the
benefit of one without lowering the benefit of another.

Conditions for efficiency: Maximization of total surplus; marginal benefit equals
marginal cost

Total Surplus = Consumer Surplus + Producer Surplus

Total Surplus = (Value to Buyers – Amount Paid by Buyers) + (Amount Received
by Sellers – Costs of Sellers)
= Value to Buyers – Costs of sellers
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The objectives of firms
Consumer and Producer Surplus in the Market Equilibrium
Price
A
D
Supply
Consumer
surplus
Equilibrium
price
E
Producer
surplus
B
Demand
C
0

Quantity
Equilibrium
quantity
Evaluating the market equilibrium: discussion about how the equilibrium of supply and
demand maximizes total surplus in a market.
-
Total surplus is maximized at the market equilibrium.
Price
Supply
Cost to
sellers
Value to
buyers
Value to
buyers
Cost to
sellers
0
Equilibrium
quantity
Value to buyers is greater
than cost to sellers.
Value to buyers is less
than cost to sellers.
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Demand
Quantity
The objectives of firms

The Deadweight Loss of Taxation
Teaching advice

Show the students that the nature of this deadweight loss stems from the reduction in
the quantity of the output exchanged.

Stress the idea that goods that are not produced, consumed, or taxed do not generate
benefits for anyone.
Tax Revenue
Price
Supply
Price buyers
pay
Size of tax (T)
Tax
revenue
(T × Q)
Price sellers
receive
Demand
Quantity
sold (Q)
0
Quantity
with tax
Quantity
Quantity
without tax
How a Tax Affects Welfare
Price
Price
buyers = PB
pay
Supply
A
B
C
Price
without tax = P1
Price
sellers = PS
receive
E
D
F
Demand
0
Q2
Quantity
Q1
Without Tax
With Tax
Change
Consumer Surplus
A+ B + C
A
- (B + C)
Producer Surplus
D+E+F
F
- (D + E)
Tax Revenue
None
B+D
+ (B + D)
Total Surplus
A+ B + C+ D+ E+ F
A+ B + D+ F
- (C + E)
The area C + E shows the fall in total surplus and is the deadweight loss of the tax.
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The objectives of firms

Definition of deadweight loss: the net reduction in welfare from a loss of surplus
by one group that is not offset by a gain to another group from an action that alters
a market equilibrium.

Divergence between private and social costs (benefits): market versus government
solutions

Definition of externality: the uncompensated impact of one person’s actions on the
well-being of a bystander.

Externalities and Market Inefficiency

Definition of internalizing an externality: altering incentives so that people take
account of the external effects of their actions.
III.
Profit maximizing output decision of perfect competitive firms
Teaching advice

Students have a difficult time understanding what a competitive market is.

The use of the word “competition” in economics is much different than that in sports. This
will lead students to often forget that these firms are generally unconcerned with the actions
of their rivals.

To help students understand price-taking behavior, use the example of common stock.
Have your students assume that they inherited 1,000 shares of stock in a company well
known in your area. Point out that these 1,000 shares may seem like a lot, but it is a very
small proportion of the total number of shares outstanding.

If the student wanted to know the value of a share, it could be obtained from a broker.

At this market-determined price, the student could sell as few or as many shares as he
wishes.

At a price above this, no one would be willing to buy any. There is also no reason to charge
a price below the current market price, because the student can sell any number of shares
that he wishes at the current price.
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The objectives of firms
Definition of competitive market: a market with many buyers and sellers trading identical
products so that each buyer and seller is a price taker.

The Revenue of a Competitive Firm
- Definition of average revenue: total revenue divided by the quantity sold.
Total Revenue
Average Revenue =
Quantity
- Definition of marginal revenue: the change in total revenue from an additional unit
sold. (For competitive firms, marginal revenue equals the price of the good.)
change in Total Revenue
Marginal Revenue =

change in Quantity
Profit maximizing output decision of perfectly competitive firms
Teaching advice

Make sure that students realize that firms in perfect competition can only change their level
of total revenue by varying their level of output because they have no ability to change the
price.

You may want to make it clear that, by definition, average revenue is always equal to price.
But marginal revenue is equal to price only for firms who operate in perfectly competitive
markets.
Profit Maximization of a Competitive Firm
Costs and
Revenue
The firm maximizes profit by
producing the quantity at which
marginal cost equals marginal revenue.
MC
MC 2
ATC
P = MR 1 = MR 2
P = AR = MR
AVC
MC 1
0
Q1
Q MAX
Q2
Quantity
(The cost curves are required in the elective part, but not in the core part.)
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The objectives of firms

Meaning of profit as the difference between total revenue and total cost

Profit maximizing choice of output for individual firms with given prices and
marginal cost schedule


The marginal cost schedule as the supply schedule of individual firms
If:
The Firm Will:
P ≥ AVC
Produce output level where MR = MC
P < AVC
Shut down and produce zero output
Why perfectly competitive market is efficient? Explain in terms of consumer
surplus and producer surplus
Teaching advice - Market Structure elective only

The graphs in this chapter often confuse students because they contain many different
curves at the same time. Thus, the first time you draw the profit-maximizing decision of the
firm, use only the marginal cost curve and the marginal revenue line.

Then, after students feel comfortable with this, add average total cost (to teach students how
to measure profit or loss). Last, add average variable cost to teach students about the
short-run shutdown decision of a firm earning an economic loss.
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The objectives of firms
IV.
Profit maximizing output decision of monopoly
Teaching advice

After having seen profit-maximization for a perfectly competitive firm, students generally
do not have difficulty understanding that a monopolist will maximize profit where marginal
revenue equals marginal cost.

However, students do have trouble remembering to use the demand curve to find the
monopolist’s price. Thus, be careful to review this point several times.
Definition of monopoly: a firm that is the sole seller of a product without close substitutes.

Compare monopoly versus perfectly competitive firm
Monopoly Versus Competition



Monopoly

Is the sole producer

Faces a downward-sloping demand curve

Is a price searcher

Reduces price to increase sales
Competitive Firm

Is one of many producers

Faces a horizontal demand curve

Is a price taker

Sells as much or as little at same price
A monopoly’s revenue

A monopoly’s marginal revenue will always be less than the price of the good
(other than at the first unit sold).
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The objectives of firms

Determination of price and output for individual firms with monopoly power

The monopolist’s profit-maximizing quantity of output occurs where marginal revenue
is equal to marginal cost.
Profit Maximization for a Monopoly
Costs and
Revenue
`
2. . . . and then the demand
curve shows the price
consistent with this quantity.
1. The intersection of the
MR curve and the MC
curve determines the
profit-maximizing
quantity . . .
B
Monopoly
price
ATC
A
A
D
MC
MR
0

Q
QMAX
Quantity
Q
Why a monopoly does not have a supply curve

A supply curve tells us the quantity that a firm chooses to supply at any given
price.

But a monopoly firm is a price searcher; the firm sets the price at the same time it
chooses the quantity to supply.

It is the market demand curve that tells us how much the monopolist will supply
because the shape of the demand curve determines the shape of the marginal
revenue curve (which in turn determines the profit-maximizing level of output).
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The objectives of firms

A Monopoly’s Profit
Profit = (P – ATC) x Q
The Monopolist’s Profit
Costs and
Revenue
MC
Monopoly
price
A
B
Profit = (P – ATC) x Q
Monopoly
profit
Average
total cost
ATC
D
C
D
MR
0

QMAX
Quantity
Efficiency implications: Deadweight loss (Illustrate in terms of consumer surplus and
producer surplus)
Teaching advice

Remind students that total surplus is the area between the demand curve and the marginal
cost curve. It should be clear that surplus is not realized for quantities of output between the
monopoly output and the socially efficient output.

Here, the monopolist places a wedge between price and marginal cost and the quantity sold
ends up being short of the optimum level.
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The objectives of firms
The Inefficiency of Monopoly
Price
MC
Deadweight loss
Monopoly
price
D
MR
0
V.
Monopoly Efficient
quantity quantity
Quantity
Price discrimination
Note: The Economics Curriculum (S4-S6) only requires students to know (i) the meaning of
price discrimination, (ii) types of price discrimination: first, second and third degree, and
(iii) the conditions for different types of price discrimination. Students are not required to
know the price and output determination (and hence efficiency implications.)

Meaning of price discrimination
Price discrimination is the practice of charging different prices to different consumers
for the same good.

First degree price discrimination
First-degree price discrimination / Perfect price discrimination describes a
situation where a monopolist knows exactly the willingness to pay of each customer
and can charge each customer a different price.
-
There is no deadweight loss in this situation.
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The objectives of firms
First Degree Price Discrimination
$/Q
Pmax
MC
C
P1
Under uniform pricing:
- Profit is the area between MC & MR
- Consumer surplus is the area of PmaxP1C
PC
D = AR
Under perfect price discrimination:
- Profit increases to include the shaded area
MR
0

Q1
Quantity
QC
Second degree price discrimination
Practice of charging different prices per unit for different quantities of the same good or
service.
Second-Degree Price Discrimination
* Different prices are charged for different quantities or ‘blocks’ of the same good.
Under uniform pricing:
- Price = P0
- Quantity = Q0
* Different prices are charged
for different quantities or
“blocks” of same good.
$/Q
P1
P0
Under perfect discrimination:
- Without
Three discrimination:
blocks with different prices
PP=1P
Q =PQ
, 0Pand
2, &
3 0. With
second-degree discrimination
there are three blocks with
prices P1, P2, & P3.
P2
AC
MC
P3
D
MR
Q1
1st Block
Q0
2nd Block
Q2
Q3
3rd Block
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Quantity
The objectives of firms

Third degree price discrimination
Practice of dividing consumers into two or more groups with separate demand curves
and charging different prices to each group
Third-Degree Price Discrimination
* Consumers are divided into two groups, with separate demand curves for each group.
Consumers are divided into two groups, with
separate demand curves for each group.
$/Q
MRT = MR1 + MR2
P1
MC = MR1 at Q1 and P1
•QT: MC = MRT
•Group 1: more inelastic
•Group 2: more elastic
•MR1 = MR2 = MCT
•QT control MC
MC
P2
D2 = AR2
MCT
MRT
MR2
D1 = AR1
MR1
Q1
-
Q2
QT
Quantity
MRT = MR1 + MR2
QT: MC = MRT
Group 1 is more inelastic (P1, Q1)
Group 2 is more elastic (P2, Q2)
MR1 = MR2 = MCT
QT control MC

Conditions for different types of price discrimination

Examples of price discrimination: Movie tickets; Airline prices; Discount coupons;
Financial aid; Quantity discounts
15