Principles of Econ: Profit Maximization Under Different Market Structures
Prof. H.Grob, Spring 2006
Profit Maximization
Profits = Total Revenue - Total Costs
Total Revenue = Price x Quantity
Total Cost = Average Total Cost x Quantity
Therefore:
Profit = (Price x Quantity) – (Average Cost x Quantity)
Profit= (Price – Average Cost) * Quantity
* There is a difference between economic profit and accounting profit.
Average Total Cost, Average Variable Cost, Average Fixed Cost
Total Cost = Total Fixed Cost + Total Variable Cost
Average variable cost = Total cost / quantity
Average fixed costs = Total fixed cost / quantity
Average Total Cost = Average Fixed Cost + Average Variable Cost
Average Total Cost = (Total Fixed Cost/ Q) + (Total Variable Cost / Q)
* A firm should shut down when the total variable cost exceeds total revenue
Marginal cost, marginal revenue
Marginal cost = Change in Total cost / Change in quantity
* Marginal cost intersects average total cost and average variable cost curves at
the minimum points because for each additional change in cost, there will be a
corresponding (but not necessarily equal) change in average variable costs.
Marginal Revenue = Change in total revenue / change in quantity sold
* All efficient firms, whether monopoly or competitive, will set quantity where
marginal revenue equals marginal cost.
Profit maximization under conditions of perfect competition
A perfectly competitive market is characterized by many sellers, many buyers,
relatively easy entry into and from a market, standardized products, and perfect
information. Perfectly competitive firms operate at lowest cost, lowest price.
Perfectly competitive firms are price TAKERS. Therefore, the demand curve
facing the individual firm is horizontal. Because price does not change, and
because TR=P x Q and MR=dTR/dQ, then P=MR.
Perfectly competitive firms will operate or produce where P=MR=MC. At this
point, the firm maximizes profits and minimizes losses.
P
MC
D=MR
Q
Conditions necessary for optimal allocation of resources
1.
Market goods are marketable, divisible
2.
Distribution is not a problem
3.
Goods and services are perfect substitutes
4.
Perfect information
5.
Perfect competition
Absence of any of these conditions can cause market failure.
Profit maximization under conditions of monopoly
Monopoly markets are characterized by one seller. Barriers to entry and exit,
patents, control over resources or economies of scale can result in monopolistic
conditions.
Economies of scale mean that the more the firm produces, the less costly the
production becomes. Economies of scale often benefit consumers.
Monopolies are price MAKERS. This means that the monopoly faces the market
demand curve. A monopoly can command any price or set any level of quantity
so long as it meets demand, but the most efficient point of operation will be at the
point where MR=MC. Price will generally be set higher, however.
The monopolist will restrict output in order to maximize profit. By keeping prices
high and quantity low, the monopolist disturbs the balance of conditions
necessary for market clearing to occur. Allocation is therefore sub-optimal.
“Natural monopolies” are able to supply the entire market at a lower cost per unit
than would be achieved by two or more firms supplying it. They often experience
economies of scale.
P
MC
D
MR
Q
PRACTICE:
1.
2.
What is the equation for each of the following?
a.
Total Revenue
=
b.
Profit
=
c.
Marginal Cost
=
Using the following information, calculate average and marginal costs.
TC
Q
Marginal cost
Average Cost
700
0
_______
_______
1300
1
_______
_______
2500
2
_______
_______
3300
3
_______
_______
2.
Fill in the following table. It might help to write the equation above each
column.
(A)
(B)
(C.)
(D)
(E)
(F)
(G)
(H)
Output
Total
cost
Total
fixed
cost
Total
variable
cost
Average
total
cost
Average
variable
cost
Average
fixed
cost
Marginal
cost
0
400
400
0
-x-
-x-
-x-
-x-
1
800
400
400
800
400
400
400
2
1000
400
600
500
300
200
200
3
1,200
400
800
400
_____
133
_____
4
1,600
400
1200
400
_____
_____
_____
5
1,700
400
1300
______
__
_____
_____
_____
3.
Using this information answer the questions below
Output
P=MR
ATC
MC
10
$10
$20.80
--x--
20
10
12.40
$4.00
30
10
9.92
5.00
40
10
9.00
6.20
50
10
8.80
8.00
60
10
9.00
10.00
70
10
9.56
13.00
80
10
10.50
17.00
Source: Carbaugh, Contemporary Economics, 2005
a.
Sketch a graph of the MR, ATC and MC curves, putting price on the
vertical axis and quantity on the horizontal axis.
b.
In what market structure does this firm operate and how do you know?
c.
What level of output maximizes the firm’s profits? What price will be
charged?
d.
What is the firm’s maximum total profit?