Profit Maximization, Supply,
Market Structures, and Resource
Allocation
Market Structure
• Firms are assumed to maximize economic profits
• Economic Profit = Revenue – Total Opportunity
Costs = Explicit and Implicit Costs
• Costs are dependent on technology and input
prices
• Revenue is dependent upon the market structure in
which a firm operates
• Therefore, the profit maximization decision must
be analyzed by market structures
Market Structures
•
•
•
•
Competitive Markets
Monopoly
Oligopoly
Monopolistic Competition
Quick Overview of Supply and Resource
Allocation in Competitive
Markets
• Marginal benefits from a firms perspective are marginal
revenue from selling output
• Marginal revenue equal the extra revenue from selling
another unit of output
• Assuming the firm produces (does not shutdown), the firm
will maximize profit (or minimize losses) where MR=MC
• The level of output will determine the costs of production
(measured by ATC)
• Comparing price to average costs show if the firm is
making profits, losses or will shutdown production
• All the buyers in the market combined form the market
demand curve and all the sellers for the market supply
curve
• Market demand and supply determine the price and along
with firms’ costs determine economic profits (hereafter
simply profits)
• Changes in demand and supply, cause market prices to
change, and thus cause profits to rise or fall
• In the short-run, existing firms in an industry change
production as price changes.
• In the transition to the long-run, firms enter or exit an
industry depending on whether profits are greater than or
less than zero.
• In the long-run, profits are driven to zero or to the level of
NORMAL profits (accounting profits that just cover all
opportunity costs).
• Resource allocation is determined by:
– Buyers and sellers follow their self-interest
• Buyers maximize utility
• Seller maximize profit
– Market demand reflects buyer behavior (and thus each
individual buyers behavior) and market supply reflect
seller behaviors (and thus individual firm behavior)
– Prices signal increases or decreases in quantity demand
and supply and profits signal resources to enter or exit
an industry causing market supply to change
– Long-run equilibrium occurs where:
• The price paid by the consumer, which is equal to
the marginal benefit of another unit, is just equal to
the marginal cost, which is equal to the opportunity
cost of another unit to society.
MB = MC
• From the videos,
– Resources dedicated to farming have decreased
– If rents are not controlled, the supply of
housing will respond to increased demand
without shortages
– The same is true of gasoline and water
– Also, in class, DVDs versus VCRs
• This is Adam Smith’s “Invisible Hand at work”.
– Every individual necessarily labours to render the annual revenue
of the society as great as he can. He generally neither intends to
promote the public interest, nor knows how much he is promoting
it...He intends only his own gain, and he is in this, as in many other
cases, led by an invisible hand to promote an end which was no
part of his intention. Nor is it always the worse for society that it
was no part of his intention. By pursuing his own interest he
frequently promotes that of the society more effectually than when
he really intends to promote it. I have never known much good
done by those who affected to trade for the public good. Wealth of
Nations, 1776)
Marginal Revenue and Market
Structure
• Competitive markets – sellers are price takers so
MR = Market Price, MR =P
• Monopoly – the seller is a price maker and faces
the entire market demand curve so MR < Price
• Oligopoly – the seller directly competes with a
few firms so MR depends on the actions of
competitors
• Monopolistic Competition – sellers possess some
market power and can set their own prices in the
short-run, so MR<P
Competitive Markets or Pure
Competition
• Assumptions revisited
– Many buyers and sellers
• Each buyer and seller is a price taker
– Homogenous or identical products
• Competition is based only on the price
– Perfect information or knowledge
• All firms have access to the same technology
• Competition is based upon price
– Firms can freely enter or exit
• Profits will be eliminated in the long-run
Revenue in Competitive Markets
• The market demand and supply curves determine
the equilibrium price and quantity and the price
that buyers will pay and sellers receive
• As with producer surplus, sellers are price takers
and the price they receive is their MR. The
marginal revenue and the price remain the same
no matter how much output is sold.
Table 1 Total, Average, and Marginal Revenue
for a Competitive Firm
Copyright©2004 South-Western
Competitive Firm in the
Short-run
• Short-run – at least one fixed factor = fixed costs.
Assume the plant size is fixed.
• Set MR=MC to find profit maximizing level of
output. Use the average cost curves to determine
whether one
–
–
–
–
Operates and earn profits
Operate and breakeven
Operates and make losses
Shutdowns and minimize losses
Table 2 Profit Maximization: A Numerical
Example
Copyright©2004 South-Western
Figure 1 Profit Maximization for a Competitive Firm
Costs
and
Revenue
The firm maximizes
profit by producing
the quantity at which
marginal cost equals
marginal revenue.
MC
MC2
ATC
P = MR1 = MR2
P = AR = MR
AVC
MC1
0
Q1
QMAX
Q2
Quantity
Copyright © 2004 South-Western
Conditions for Profits,
Breakeven, Losses and Shutdown
• Profits
– P > ATC
• Breakeven
– P = ATC
• Fixed Costs are sunk costs and irrelevant to decisionmaking. To operate you must cover variable costs!
• Losses but operate
– P > AVC but P < ATC or
– ATC < P < AVC
• Shutdown
– P > AVC
Figure 5 Profit as the Area between Price and Average
Total Cost
(a) A Firm with Profits
Price
MC
ATC
Profit
P
ATC
P = AR = MR
0
Quantity
Q
(profit-maximizing quantity)
Copyright © 2004 South-Western
Figure 5 Profit as the Area between Price and Average
Total Cost
(b) A Firm with Losses
Price
MC
ATC
ATC
P
P = AR = MR
Loss
0
Q
(loss-minimizing quantity)
Quantity
Copyright © 2004 South-Western
Short-run Losses
• Shutdown occurs when a firm cannot cover
its variable costs.
• If a firm operated with revenues that did not
cover variable costs, it would lose more
than their fixed costs.
• Therefore, a firm must cover its variable
costs first. If it can cover them it can pay
down some of the fixed costs.
Long-run Supply and Price
Determination
• Long-run – all factors are variable = no fixed costs
and plant size can be changed, ALSO firms can
enter and exit
• If economic profits are positive, new firms will
enter.
• If economic profits are negative, existing firms
will exit.
• Long-run equilibrium:
– Firms must chose the plant that minimizes LRATC or
they will suffer losses.
– Economic profits are reduced to zero.
• Therefore, supply is more elastic in the long-run.
Figure 7 Market Supply with Entry and Exit
(a) Firm’s Zero-Profit Condition
(b) Market Supply
Price
Price
LRMC
MC
LRATC
ATC
P = minimum
ATC
0
Supply
Quantity (firm)
0
Quantity (market)
Copyright © 2004 South-Western
Figure 8 An Increase in Demand in the Short Run and
Long Run
(a) Initial Condition
Market
Firm
Price
Price
MC
ATC
Short-run supply, S1
A
P1
Long-run
supply
P1
Demand, D1
0
Quantity (firm)
0
Q1
Quantity (market)
Figure 8 An Increase in Demand in the Short Run and
Long Run
(c) Long-Run Response
Market
Firm
Price
Price
MC
ATC
B
P2
S1
S2
C
A
P1
Long-run
supply
P1
D2
D1
0
Quantity (firm)
0
Q1
Q2
Q3 Quantity (market)
Copyright © 2004 South-Western
Long-run Supply Curve
• Constant cost industries – horizontal or perfectly
elastic supply
• Increasing cost industries – upward sloping supply
– Some resource may be available in limited quantities
(farm land)
– Some resources may increase in cost or be less
productive (skilled labor)
• Decreasing cost industries – downward sloping
supply
– Increased output may stimulate increased productivity
or technological change (computers)
Competitive Markets:
Short-run and Long-run
• Short-run supply response to changes in demand
are to increase or decrease the use of existing
capacity.
• Long-run supply response is to build efficient
plant size and increase or decrease capacity.
• In both the short-run and long-run, the profit
maximizing behavior of firms leads to supply
responses to accommodate changes in demand.
• In the short-run, prices act as signals and, in the
long-run,prices and profits act as signals to
increase or decrease output.
Efficiency Revisited
• Maximize human satisfaction from
resources = maximize total surplus =
maximize consumer surplus + producer
surplus.
• Two conditions:
– Produce what is most highly valued and the
amount that maximizes total surplus
– Produce it at the least possible cost.
• In the absence of market failures, competitive
markets are efficient in both the short-run and the
long-run:
– Supply responds to what consumers demand
– Goods are produced at least possible cost
• Price and profits are extremely important as
signals for the allocation of scarce resources.
– Examples of when prices and profits no longer act as
signal are rent controls and price supports
Market Structures: Monopoly
Monopoly
Assumptions
• One seller and many buyers
– Implication: The seller is a price maker and the buyers
are price takers.
• Barriers to Entry
– Ownership of a unique resource (Diamonds)
– Government granted rights for exclusive production
(e.g. patents, copyrights, licenses, concessions)
– Economies of scale and declining long-run average
costs
– Implication: Monopolist faces the entire market
demand curve and profits can persist in the short and
long-run.
Limits to Monopoly
• Size of the market (Pavarotti versus Joe,
uncongested bridge)
• Definition of market and close substitutes
(ornamental versus industrial diamonds,
bottled water).
• Potential competition
Production Decisions
• Monopolist versus competitive firm.
– CF is a price taker who faces a perfectly elastic demand
curve  MR=P
– M is a price maker who faces the entire market demand
curve  MR<P
• Intuitive proof – to sell another unit the monopolist must lower
the price. This means lowering the price not only on the extra
unit sold, but also all the other units the monopolist was
selling. So MR = Price of the additional unit – the sum of the
decreases in all the units previously sold ( e.g. selling 4 units
@$100, to sell the 5 unit the price must be lowered to $90, so
the monopolist’s MR = $90 – 4X$10=$50)
• Tabular proof – see next table and handout
• Graphical proof
A Monopoly’s Revenue
• Total Revenue
P  Q = TR
• Average Revenue
TR/Q = AR = P
• Marginal Revenue
DTR/DQ = MR
Table 1 A Monopoly’s Total, Average,
and Marginal Revenue
Copyright©2004 South-Western
Figure 2 Demand Curves for Competitive and
Monopoly Firms
(a) A Competitive Firm’s Demand Curve
Price
(b) A Monopolist’s Demand Curve
Price
Demand
Demand
0
Quantity of Output
0
Quantity of Output
Copyright © 2004 South-Western
Figure 3 Demand and Marginal-Revenue Curves for a
Monopoly
Price
$11
10
9
8
7
6
5
4
3
2
1
0
–1
–2
–3
–4
Demand
(average
revenue)
Marginal
revenue
1
2
3
4
5
6
7
8
Quantity of Water
Copyright © 2004 South-Western
Profit Maximization
• A monopoly maximizes profit by producing
the quantity at which marginal revenue
equals marginal cost.
• It then uses the demand curve to find the
price that will induce consumers to buy that
quantity.
• Profit Maximization –
– Set MR = MC to find Q that maximizes profits.
– Use the market demand curve to find the P that the Q
brings
– Find ATC and AVC cost to determine profits, losses, or
shutdown.
• Difference between the monopolist decision and
the competitive firms decision
– The monopolist does not have a supply curve like the
CF, rather they pick a single price and quantity
– Monopolists produce where P>MR and P>MCversus
CFs who produce where P=MR and P=MC.
Figure 4 Profit Maximization for a Monopoly
Costs and
Revenue
2. . . . and then the demand
curve shows the price
consistent with this quantity.
B
Monopoly
price
1. The intersection of the
marginal-revenue curve
and the marginal-cost
curve determines the
profit-maximizing
quantity . . .
Average total cost
A
Demand
Marginal
cost
Marginal revenue
0
Q
QMAX
Q
Quantity
Copyright © 2004 South-Western
Figure 5 The Monopolist’s Profit
Costs and
Revenue
Marginal cost
Monopoly E
price
B
Monopoly
profit
Average
total D
cost
Average total cost
C
Demand
Marginal revenue
0
QMAX
Quantity
Copyright © 2004 South-Western
Figure 6 The Market for Drugs
Costs and
Revenue
Price
during
patent life
Price after
patent
expires
Marginal
cost
Marginal
revenue
0
Monopoly
quantity
Competitive
quantity
Demand
Quantity
Copyright © 2004 South-Western
Welfare Costs of Monopoly
• In competitive markets, firms produce where
P=MC
And since
P=MB=willingness to bud
And
MC=willingness to sell
P=MC  MB=MC or
Maximum total surplus
• In monopoly,
P>MR so
P>MC
Or
MB>MC
Output falls short of the efficient amount 
Deadweight Welfare Loss
Figure 7 The Efficient Level of Output
Price
Marginal cost
Value
to
buyers
Cost
to
monopolist
Value
to
buyers
Cost
to
monopolist
Demand
(value to buyers)
Quantity
0
Value to buyers
is greater than
cost to seller.
Value to buyers
is less than
cost to seller.
Efficient
quantity
Copyright © 2004 South-Western
• Monopoly profit is not usually a social cost
but a transfer of surplus from consumer to
producer.
• Profit can be a social cost if extra costs are
incurred to maintain it, such as political
lobbying, or if the lack of competition leads
to costs not being minimized (Xinefficiency again!)
Public Policy and Monopolies
Working towards P=MC
• Attempts to increase competition through antitrust legislation
– Sherman Antitrust Act of 1890
– Examples: Breakup of Standard Oil and turning MA
Bell into Baby Bells
• Regulation – Natural Monopolies
– P=MC doesn’t work with extensive economies of scale
– Regulated forms have little incentive to minimize costs
• Public Ownership
– Public utilities and the Postal Service
• Hands-off Approach