Chapter 11
Costs and Profit
Maximization Under
Competition
MODERN PRINCIPLES OF ECONOMICS
Third Edition
Outline





What price to set?
What quantity to produce?
Profits and the average cost curve
Entry, exit, and shutdown decisions
Entry, exit, and industry supply curves
2
The Big Questions
How do firms behave?
The assumption:
Profit is the main motivation for
firms’ actions.
How do firms maximize profit?
By controlling their variables:
Price (if possible)
Quantity
Cost
3
The Big Questions
 Every producer must answer three questions:
• What price to set?
• What quantity to produce?
• When to enter and exit the industry?
 This chapter will look at the answers for a
competitive industry.
4
What Price to Set?
 In a competitive market, producers are “price
takers”:
• The firm accepts the price that is determined
by the market.
• A firm can sell all its output at market price.
• A firm can’t sell any output at a higher price.
• The firm’s demand is perfectly elastic at
market price.
• Exist mostly in agriculture/commodities
5
What Price to Set?
World Market For Oil
Price
Price
Individual Firm’s Demand
Market
supply
Demand
for one
firm’s oil
$50
Market
demand
82,000,000
Quantity
(barrels)
2
5
10 Quantity
(barrels)
6
What Price to Set?
 An industry is competitive when firms don’t have
much influence over the price of their product.
 This is a reasonable assumption when:
• The product being sold is similar across
sellers.
• There are many buyers and sellers, each
small relative to the total market.
• There are many potential sellers.
 Demand is most elastic in the long run.
7
Definition
Long run:
the time after all exit or entry has
occurred.
Short run:
the time period before exit or entry can
occur.
8
Self-Check
In a perfectly competitive market, a firm will set
its price:
a. Equal to its cost of production.
b. Equal to its costs plus a normal markup.
c. Equal to market price.
Answer: c – Firms in a competitive industry are
price takers, and must accept market price.
9
What Quantity to Produce?
 It depends on the objective.
 We assume the objective is to maximize profit.
Profit = π = Total Revenue – Total Cost
 Maximizing profit means maximizing the
difference between total revenue and total costs.
• Total revenue is Price x Quantity.
• Total costs include opportunity costs.
• Must distinguish between many different kinds
of cost (average, marginal, fixed, and so on).
10
Definition
Total revenue:
price times quantity sold.
TR = P x Q
Total cost:
(market value of the inputs or
opportunity) cost of producing a given
quantity of output.
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Economic Costs Defined
•
•
•
•
•
•
Firms incur costs in the production process
Land, labor, capital costs
Accounting costs versus economic costs
Accounting costs do not include opportunity costs
Costs can be defined as either explicit and implicit
Economic costs are what matter most
•
•
•
Accounting costs = explicit costs
Economic costs = explicit + implicit costs
Difference is opportunity costs
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Opportunity Costs
 Total costs include:
• Explicit money costs and
• Implicit opportunity costs, or the costs of foregone
alternatives.
 Output decisions should be based on all costs,
including opportunity costs.
• Opportunity Costs The cost of something is what you give up to get it.
• This is true whether the costs are implicit or
explicit. Both matter for firms’ decisions.
13
Definition
Explicit cost:
a cost that requires a money outlay.
Implicit cost:
a cost that does not require an outlay of
money.
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Definition
Accounting profit:
total revenue minus explicit costs.
Economic profit:
total revenue minus total costs including
implicit costs.
15
Explicit vs Implicit Costs
Example:
You need $100,000 to start your business.
The interest rate is 5%.
• Case 1: borrow $100,000
 explicit cost = $5000 interest on loan
• Case 2: use $40,000 of your savings,
borrow the other $60,000
 explicit cost = $3000 (5%) interest on the loan
 implicit cost = $2000 (5%) foregone interest you could
have earned on your $40,000.
• In both cases, total (exp + imp) costs are $5000.
16
Explicit vs Implicit Costs
Example:
Assume the firm’s revenues are $10,000
What are the firm’s accounting and economic profits?
Accounting profits (explicit costs only):
Case 1: $10,000 - $5,000 = $5,000 profit
Case 2: $10,000 - $3,000 = $7,000
Economic profits (expl + impl costs):
Case 1: $10,000 - $5,000 = $5,000 profit
Case 2: $10,000 - $5,000 = $5,000
Accounting profits do not reflect implicit costs or
opportunity costs
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Explicit vs Implicit Costs
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Self-Check
Economic profit is total revenue minus:
a. Explicit costs.
b. Implicit costs.
c. Both explicit and implicit costs.
Answer: c – Economic profit equals total revenue
minus both explicit and implicit costs.
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Costs of Production - Definition
Fixed costs:
costs that do not vary with output.
Variable costs:
costs that do vary with output.
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Costs of Production
 Total costs = Fixed Costs + Variable Costs
 TC = FC + VC
 Fixed costs are those costs incurred when output (Q)
is zero
• Consists of factors of production that are fixed for the short
run, i.e. land, buildings, machinery, insurance, etc
• Fixed costs do not vary with output
• The firm faces fixed costs no matter what
 Variable costs are those costs that vary with output
(Q)
• Labor costs, materials costs, energy costs, etc
• Variable costs equal zero when output is zero
• As output increases, variable costs increase
21
Costs of Production - Example
• Example: Airline Costs
• What is the airline’s product (Q)?
 Passenger miles
 Note: Revenues = Price * Q
• Fixed costs – airplanes, buildings, maintenance
facilities, land, insurance, etc.
• Variable costs - aviation fuel, pilot costs, other
expenses related to actually flying the planes,
producing passenger miles
 To spread fixed costs, must keep airplanes in the
air as much as possible (Southwest)
22
Maximizing Profit

 Profit is the difference between total revenue and
total cost.
 To find the maximum profit, one method is to find
the quantity that maximizes TR − TC.
 But first a discussion of “evil” profits
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And Now a Word About Profits
 “Capitalism without losses is like Religion
without Hell.” – Frank Borman
 "I don't tell my grocery when I am coming. I
don't tell the grocery what I am going to buy. I
don't tell my grocery how much I am going to
buy, but if they don't have what I want when I
get there, I fire them.” - Walter Williams
 https://www.youtube.com/watch?v=tdHwewUuXBg
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And Now a Word About Profits
 Markets require Profits and Losses as a signal to
producers
 Without profits/losses massive waste and inefficiency
will result
 Why are profits considered evil?
•
•
•
•
Consumers pay prices that are too high?
Profits are “unfairly” high?
Profits lead to income inequality?
Marx’s contention that “surplus value” should go to
labor?
 Profits from “Krony Kapitalism” most likely “evil”
25
And Now a Word About Profits
 Profits/losses exist in any type of economy,
 Even for Cuba, N. Korea, Venezuela, whether
they realize it or not (or care to admit it)
 Profits are signals to entrepreneurs or owners as to
the viability of their investments and their skill as
owners/managers
 Consumers are “sovereign” – their buying choices
ultimately determine success/failure of firms
 For Competitive Industries:
 “Market Discipline” – inefficient firms are ruthlessly
squashed by competition
 “Mr. Market” always wins…..
26
And Now a Word About Profits
 Firms must be allowed to fail in order to
“educate” themselves and the market, so as to
allocate scarce resources to their highest valued
use
 Profits are a “learning experience” as well
 Markets reward innovation, good customer
service
 Higher than normal profit levels will attract new
firms, eventually causing prices, revenues, and
profits to fall – solves the problem of excess
profits
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
And Now a Word About Profits
 Implication: wherever possible, promote
competitive markets rather than enacting
“windfall” profit taxes or government regulation
 No surprise - business owners hate competition
 Consumers love competition between firms
 Crony Capitalism – legislation designed to
reduce competition and enhance profits
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Maximizing Profit
 Rather than use:
 We can use another method of finding the
maximum profit.
 We can compare the increase in revenue from
selling an additional unit (MR) to the increase in
cost from selling an additional unit (MC).
 A firm should keep producing as long
Marginal Revenue (MR) > Marginal Cost (MC)
 The last unit produced should be the one where
MR = MC.
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Definition
Marginal revenue (MR):
the change in total revenue from selling
an additional unit.
MR = TR / Q
30
Maximizing Profit
 For a firm in a competitive industry, the demand
curve is perfectly elastic.
 The firm doesn’t need to drop the price to sell
more units.
 Each additional unit can be sold at market price.
 For a firm in a competitive industry,
• MR = MR = Price.
31
Self-Check
A competitive firm will maximize its profit at the
quantity:
a. Where MR = Price.
b. Where MR = MC.
c. Where MC = 0.
Answer: b – a competitive firm will maximize its
profit by producing at the quantity where
marginal revenue (MR) = marginal cost (MC).
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Definition
Marginal cost (MC):
the change in total cost from producing
an additional unit.
33
Maximizing Profit
=
Maximizing Profit
P
($/barrel)
$150
At a Quantity of 8,
MR = MC
Profits are maximized
Marginal
cost
100
World
Market
price 50
More profit
More profit
MR = P
0
0
1
2
3
4
5
6
7
8
9
Quantity
10 (barrels)
35
Maximizing Profit
 As the price changes, so does the profitmaximizing quantity.
 If price increases, the firm will expand
production.
 Will continue to expand until it is once again
maximizing profit where P = MC.
36
Maximizing Profit
P
($/barrel)
$150
As Price increases, the
firm expands production
along its MC curve
Marginal
cost
$100
MR = P
World
Market
price $50
MR = P
0
0
1
2
3
4
5
6
7
8
9
Quantity
10 (barrels)
37
Self-Check
If price increases, a firm will:
a. Expand production.
b. Decrease production.
c. Price does not affect how much a firm
produces.
Answer: a – if price increases, a firm will expand
production.
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Definition
Average Cost of Production:
the cost per unit, or the total cost of
producing Q units divided by Q.
AC = TC / Q
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Cost Concepts - Equations
 Starting with TC = FC + VC
 Divide by Q to get averages:
•
•
•
•
AC = AFC + AVC
AFC = FC/Q
AVC = VC/Q
AC = TC/Q
 Average cost concepts much easier to
interpret in graphical format
 Much easier to understand profit
maximization conditions graphically
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Cost Concepts - Equations
41
Cost Concepts - Equations
42
Cost Concepts - Equations
43
Cost Concepts - Equations
44
Cost Concepts - Equations
45
Profits and the Average Cost Curve
 A firm can maximize profits and still have low
profits or even losses.
 It can be useful to show profits in a diagram.
 To do this, we need average cost (cost per unit).
 We can then calculate profitability.
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Profits and the Average Cost Curve
Profit = TR – TC
we can also write
(
Profit =
We then substitute:
TR
Q
– TC
Q
) xQ
TR = P x Q
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Profits and the Average Cost Curve
Profit = TR – TC
we can also write
Profit = P x Q – TC
Q
Q
(
We can also substitute:
) xQ
AC = TC / Q
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Profits and the Average Cost Curve
Profit = TR – TC
we can also write
Profit = P x Q – AC
Q
(
We end up with:
) xQ
Profit = (P – AC) x Q
49
Profits and the Average Cost Curve
This formula tells us that Profit is equal to
the average profit per unit (P − AC)
times the number of units sold (Q).
Profit = (P – AC) x Q
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Profits and the Average Cost Curve
 Profit = Q * (P – ATC)  is the most useful
form of profit equation

When P >ATC  profits are positive

When P < ATC  losses occur (profits < 0)

and if P = ATC  profits are zero
Since a firm in a competitive market must sell its
output at the market price, profit maximization
depends only on the firm’s output decision
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Profits and the Average Cost Curve
With an average cost curve, we can show profits on a graph.
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Maximizing Profit
Price
• Profits are maximized at
MR = MC, where Q = 8
• At Q = 8, AC = $25.75
• Profit = (P – AC) x Q
$100
Marginal
cost
Average
Cost (AC)
MR = P
50
Profit = (50-25.75) x 8 = $194
25.75
0
0
1
2
3
4
5
6
7
8
9
10 Quantity
53
Maximizing Profit
Price
• MR = MC doesn’t mean
the firm makes a profit
• Minimum AC is $17
• At any price below $17,
P < AC → Losses
$100
Marginal
cost
Average
Cost (AC)
MR = P
50
Cost = 20
17
Price = 10
0
Loss
0
1
2
3
4
5
6
7
8
9
10 Quantity
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Maximizing Profit
Price
Marginal
cost
$100
The MC curve
crosses the AC curve
at its minimum point
Average
Cost (AC)
50
P = MC < AC
is a loss
P = MC > AC
is a profit
17
0
0
1
2
3
4
5
6
7
8
9
10 Quantity
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Profit Maximization Method
1. Find that Q (output) where MC = MR
2. Determine value of AC at that Q
3. Calculate profits using the formula:
Profit = Q * (P – ATC)
56
Self-Check
If a firm produces at the output where MR = MC,
it will always make a profit.
a. True.
b. False.
Answer: b – False; if average cost is greater
than price, the firm will have a loss.
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Entry, Exit, and Shutdown
 Firms seek profits so in the long run:
• Firms will enter the industry when P > AC.
• Firms will exit the industry when P < AC.
 When P = AC, economic profits are zero and
there is no incentive to enter or exit.
 Zero profits means that the price is just enough
to pay labor and capital their opportunity costs.
 Zero profits really means normal profits.
• If firms in the industry average 5%, that would be
normal profits
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Entry, Exit, and Shutdown
 Typically, exit cannot occur immediately.
TC = VC + FC
 In the short run, a firm must pay its fixed costs
whether it is operating or not.
 Fixed costs therefore do not influence decisions
in the short run.
 The firm should shut down immediately only if
TR < VC, i.e. if the firm cannot cover its variable
costs
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Entry, Exit, and Shutdown
 If Price is below the minimum of AVC, then the
firm should shut down immediately.
 If Price is above AVC but below AC, then the firm
should continue producing but exit (long run) as
soon as possible.
 If Price is at or above AC, the firm should
continue producing where P = MC, or enter if it is
not already in the industry.
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Entry, Exit, and Shutdown
The firm’s entry, exit, and shutdown decisions.
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Entry, Exit, and Industry Supply
 Entry of firms – shifts the industry supply curve
outwards
 Exit of firms – shifts the industry supply curve
inwards
 The slope of the supply curve can be explained
by how costs change as industry output changes.
 Supply curves can slope upward, be flat, or in
rare circumstances even slope downward.
62
Definition
Increasing Cost Industry:
An industry in which industry costs
increase with greater output; shown with
an upward sloped supply curve.
63
Increasing Cost Industry
 Costs rise as industry output increases.
 Greater quantities can only be obtained by using
more expensive methods.
 Any industry that buys a large fraction of the
output of and increasing cost industry will also be
an increasing cost industry.
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Increasing Cost Industry
 Firm 1 – oil is near the surface; lower costs
 Firm2 – oil is located deeper; higher costs
P
Firm 1
MC1
P
$50
Firm 2 MC
2
AC2
P
Industry
SIndustry
AC1
$29
$17
4
q2
6 8 q1
5 7
P < $17 → Q = 0
P = $17 → Q = q1 + q2 = 4
P = $29 → Q = q1 + q2 = 11
P = $50 → Q = q1 + q2 = 15
4
Q
11 15
65
Definition
Constant Cost Industry:
An industry in which industry costs do
not change with greater output; shown
with a flat supply curve.
66
Constant Cost Industry
A constant cost industry has two characteristics:
1. It meets the conditions for a competitive industry.
• The product is similar across sellers.
• There are many buyers and sellers, each small relative
to the total market.
• There are many potential sellers.
2. It demands only a small share of its major inputs.
• The industry can expand or contract without changing
the prices of its inputs.
67
Constant Cost Industry
P
P
Market
Firm
MC
SSA
SSB
B
B
$7.99
$6.99
AC
C LRS
A
C
A
DB
DA
QA QB Q C
Q
qA qB
↑ Market demand → ↑ market price → ↑ profits
↑ profits → Existing firms ↑ q → ↑ Q
↑ profits → Firms enter → Short-run supply shifts right → ↓ P, ↑Q
Profits return to normal
q
68
Constant Cost Industry
Implications of a constant cost industry:
 Price is driven down to AC, so profits are driven
down to normal levels.
 Price doesn’t change much because AC doesn’t
change much when the industry expands or
contracts.
69
Definition
Decreasing Cost Industry:
An industry in which industry costs
decrease with greater output; shown
with a downward sloped supply curve.
70
Decreasing Cost Industry
 Industry clusters can create decreasing cost
industries.
 As the industry grows, suppliers of inputs move
into the area, decreasing costs.
 Dalton Georgia – “Carpet Capital of the World”
 Silicon Valley – Computer technology
 Cost reductions are temporary.
 Once the cluster is established, constant or
increasing costs are the norm.
71
Industry Supply Curves
72
Self-Check
An industry where the industry costs do not
change with greater output is called a(n):
a. Increasing cost industry.
b. Constant cost industry.
c. Decreasing cost industry.
Answer: b – constant cost industry.
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Takeaway
1. What price to set?
• In a competitive industry, a firm sets its price
at the market price.
2. What quantity to produce?
• To maximize profit, a competitive firm should
produce the quantity that makes P = MC.
74
Takeaway
3. When to exit and enter?
• In the short run, the firm should shut down
only if price is less than average variable
cost.
• In the long run, a firm should enter if P > AC
and exit if P < AC.
75
Takeaway
 Profit maximization and entry and exit decisions
are the foundation of supply curves.
 In an increasing cost industry, costs rise so
supply curves are upward-sloping.
 In a constant cost industry, costs remain the
same so the long-run supply curve is flat.
 In the rare case of a decreasing cost industry,
costs fall so supply curves are downwardsloping.
76