Profit Maximization and the
Decision to Supply
Market Structure
• Firms are assumed to maximize economic profits
• Economic Profit = Revenue – Total Opportunity
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 structure
Market Structures
•
•
•
•
Competitive Markets
Monopoly
Oligopoly
Monopolistic Competition
Quick Overview
• 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
Marginal Revenue and Market
Structure
• Competitive markets – sellers are price takers so
MR = Market Price
• 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
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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
• 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 Supply
• Individual Firm: The short-run supply curve
is MC curve above minimum AVC.
• Market: The short-run supply curve is the
horizontal sum of all of the individual
firm’s MC curves above the minimum
AVC.
Figure 3 The Competitive Firm’s Short Run Supply
Curve
Costs
If P > ATC, the firm
will continue to
produce at a profit.
Firm’s short-run
supply curve
MC
ATC
If P > AVC, firm will
continue to produce
in the short run.
AVC
Firm
shuts
down if
P < AVC
0
Quantity
Copyright © 2004 South-Western
Figure 6 Market Supply with a Fixed Number of Firms
Assume 100 firms with identical plant sizes and horizontally
sum their marginal cost curves above minimum AVC
(a) Individual Firm Supply
(b) Market Supply
Price
Price
MC
Supply
$2.00
$2.00
1.00
1.00
0
100
200
Quantity (firm)
0
100,000
200,000 Quantity (market)
Copyright © 2004 South-Western
Price Determination in the
Short-run
• Fixed plant sizes implies a fixed number of firms.
• Market supply and demand curve determine the
price and the profit loss situations of existing
firms.
• If demand increase, firms increase the quantity
supplied by utilizing increasing capacity.
• The law of diminishing returns implies that supply
is upward sloping at that prices will rise.
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.
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