ECON 221

CHAPTER 8
PROFIT MAXIMIZATION AND COMPETITIVE
SUPPLY
Mr. Tumelo Mmutle
1st Floor Block A: Office 138
(018) 389 2133
Tumelo. mmutle@nwu.ac.za
 LEARNING OUTCOMES

 Describe the concept of perfect competition

 List the characteristics of competitive markets
 Use the concepts of marginal cost and marginal revenue to conduct a marginal
analysis of the supply decisions of a profit-maximizing competitive firm
 Analyze the firm’s decision to shut down in the short run
 Derive a competitive firm’s short run supply curve
 INTRODUCTION
 Focus is still much on the supply of all firms.
 Previous chapter analysed the difference costs in production, attention now directed to
decision all firms face.
 Given the costs, at what level of output should be produced to maximize profit?
 Markets differ and these decisions are not uniform.
 This chapter addresses firms in competitive markets.
 Markets in which all firms produce identical products and that each has so small of market
fraction that it is unable to influence the market.
 8.1 PERFECTLY COMPETITIVE MARKETS

 Analyzing markets by means of supply and demand analysis depends on the perfectly competitive
behavior of firms.

 Examples of these types of markets?

 Built around three basic assumptions:

1. Product homogeneity:

 When the products of all of the firms in a market are perfectly substitutable with one another—that is,
when they are homogeneous—no firm can raise the price of its product above the price of other firms
without losing most or all of its business.

2. Free entry and exit:

 Condition under which there are no special costs that make it difficult for a firm to enter (or exit) an
industry

 With free entry and exit, buyers can easily switch from one supplier to another, and suppliers can easily
enter or exit a market.
 8.1 PERFECTLY COMPETITIVE MARKETS

3. Price taking:
 Because there are many firms in the market each firm faces a significant number of direct
competitors for its products.
 Price taker: Firm that has no influence over market price and thus takes the price as given.

When is a market highly competitive?

 Many markets are highly competitive in the sense that firms face highly elastic demand curves and
relatively easy entry and exit. But there is no simple rule of thumb to describe whether a market is close
to being perfectly competitive.

 Because firms can implicitly or explicitly collude in setting prices, the presence of many firms is not
sufficient for an industry to approximate perfect competition.

 Conversely, the presence of only a few firms in a market does not rule out competitive behavior.
 8.2 PROFIT MAXIMIZATION
Do Firms Maximize Profit?
 The assumption of profit maximization is frequently used in microeconomics because it predicts
business behavior reasonably accurately and avoids unnecessary analytical complications.

 For smaller firms managed by their owners, profit is likely to dominate almost all decisions. In larger
firms, however, managers who make day-to-day decisions usually have little contact with the
owners.

 Firms that do not come close to maximizing profit are not likely to survive. The firms that do survive
make long-run profit maximization one of their highest priorities.

 Not all firms strive for profit maximization other forms of organization.

 Cooperative: Association of businesses or people jointly owned and operated by members for
mutual benefit.

 Condominium: A housing unit that is individually owned but provides access to common facilities
that are paid for and controlled jointly by an association of owners.
 8.3 MARGINAL REVENUE, MARGINAL COST AND PROFIT MAXIMIZATION

 Start by analyzing the profit maximizing output of firm.

π(q) = R(q) − C(q)
 Profit: Difference between total revenue and total cost

 Firms choose to produce where the difference between revenue and cost is at it greatest.
Profit maximization output

 A firm chooses output q*, so that profit, the difference

AB between revenue R and cost C, is maximized.

 At that output, marginal revenue (the slope of the

revenue curve) is equal to marginal cost (the slope of
the cost curve).

 Cost is positive when output is zero based on fixed

costs.
Δπ/Δq = ΔR/Δq − ΔC/Δq = 0

MR(q) = MC(q)
 8.3 MARGINAL REVENUE, MARGINAL COST, AND PROFIT MAXIMIZATION

DEMAND AND MARGINAL REVUNUE FOR A COMPETITIVE FIRM

 Because each firm in a competitive industry sells only a small fraction of the entire industry output,
have little effect on the market price of the product.

 Market price solely determined by the market supply and demand curves, hence firms are price
takers.
 Market demand curve is downward sloping however for individual firms these are horizontal. Why?
 8.3 MARGINAL REVENUE, MARGINAL COST, AND PROFIT MAXIMIZATION

 The demand curve d facing an individual firm in a competitive market is both its average revenue
curve and its marginal revenue curve.

 Along this demand curve, marginal revenue, average revenue, and price are all equal.

 Firms therefore maximize profit where:

MC(q) = MR = P

 Note that because competitive firms take price as fixed this rule is set to determine output not the
price of the product.
 8.4 CHOOSING OUTPUT IN THE SHORT RUN

Short-Run Profit Maximization by a Competitive Firm

 In the short run the firm operates with a fixed amount of capital and must choose the level of its
variable inputs.

 So how much should firms produce to maximise profit in the short run?

 AR and MR = P and is horizontal

 Costs curves maintain the same shape as

in the previous chapter.

 Profit is maximised at point A where MC

= MR

 The profit of the firm is measured by the

rectangle ABCD.

 Any change in output, whether lower at

q1 or higher at q2, will lead to lower
profit.
 8.4 CHOOSING OUTPUT IN THE SHORT RUN

Short-Run Profit Maximization by a Competitive Firm

 Why is profit not maximised at q0?

 Increase beyond that point in output clearly increases the profit and hence we rewrite the output
rule as follows:

Output Rule: If a firm is producing any output, it should produce at the level at which
marginal revenue equals marginal cost.

 When do firms need to decide to shut down as opposed to continue production (shut down rule?)

 Firm is loosing money as long as its price is below its AC even when it is above AVC.

 But does it need to shut down at this point?

 Might operate at loss in the short run but in the long run firm retains flexibility to change capital and
hence reduce total costs.
8.4 CHOOSING OUTPUT IN THE SHORT RUN
FIGURE 8.4

A competitive firm should shut down if price is below AVC.

 8.5 THE COMPETITIVE FIRM’S SHORT RUN SUPPLY CURVE

 Competitive firms will increase output to the point at which price is equal to marginal cost but will
shut down if the price is below the AVC.

 The firms’ supply curve therefore is the portion of the MC curve that is above the AVC.

 Short run competitive supply curve slopes upward for the same reason as MC curve, which is?
 8.5 THE COMPETITIVE FIRM’S SHORT RUN SUPPLY CURVE

FIRMS RESPONSE TO AN INPUT PRICE CHANGE

 When the price of the product changes, firms

change their output level to ensure the that
marginal cost of production remains equal to
price.

 But what happens when the price of their inputs

(cost of production) changes?

 When the marginal cost of production for a firm

increases (from MC1 to MC2), the level of output
that maximizes profit falls (from q1 to q2).

 The higher input price causes the firm to reduce its

output.

 Shaded area gives the total lost profit associated

with reduction in output.
EXERCISES
A competitive firm has the following short-run cost functions:

C ( q ) =q 3 − 8 q 2 + 30 q + 5.

dC
MC = = 3q 2 − 16q + 30
dq

1. Find the average total cost (ATC) and Average Variable Cost (AVC).

2. At what range of prices will the firm supply zero output?

 8.6 THE SHORT RUN MARKET SUPPLY CURVE

 Short run market supply curve: shows the amount of output that the industry will produce in the
short run for every possible price.

 Industry output is the sum of the quantities supplied by all individual firms.

 Therefore to obtain the market supply curve we add all individual supply curves of the competitive
firms.
 8.6 THE SHORT RUN MARKET SUPPLY CURVE
PRODUCER SURPLUS IN THE SHORT RUN

 Producer surplus: Sum over all units produced by a firm of differences between the market price of a good and
the marginal cost of production.

 Producer surplus measures the area below the

market price and above the producers supply
curve.

 The producer surplus for a firm is measured by

the yellow area below the market price and above
the marginal cost curve, between outputs 0 and
q*, the profit-maximizing output.

 Alternatively, it is equal to rectangle ABCD because

the sum of all marginal costs up to q* is equal to
the variable costs of producing q*.
 8.6 THE SHORT RUN MARKET SUPPLY CURVE

PRODUCER SURPLUS IN THE SHORT RUN

 Producer surplus is closely related to profit but is not equal to it.

 In the short run, producer surplus is equal to revenue minus variable cost.

Producer surplus = PS = R − VC
 Total revenue is equal to revenue minus all costs.

Profit = π = R − VC − FC

PRODUCER SURPLUS FOR A MARKET

 Looks somewhat different.

 Is the area below the market price and above the

market supply curve between 0 and Q*.
 8.7 CHOOSING OUTPUT IN THE LONG RUN

LONG-RUN PROFIT MAXIMIZATION

 In the long run a firm can decide to alter inputs,

or shut down or enter the market.

 As in short run firm faces horizontal demand

curve maximises profit at P = SMC = MR

 LAC reflects economies of scale up to q2 and

diseconomies of scale beyond this point.

 Long run profit maximization point of a firm a q3

where LMC = P = MR.

 Increases profit from ABCD to EFGD.

 The question however is whether it is possible to

earn economic profit in the long run?
 8.7 CHOOSING OUTPUT IN THE LONG RUN
LONG RUN COMPETITIVE EQUILIBRIUM

 For equilibrium to arise in long run, certain economic conditions must prevail, firms must have no desire
to withdraw or enter the market.

 Important to distinguish between accounting and economic profit in the long run.

 Economic profit takes into account opportunity costs. One such opportunity cost is the return to the
firm’s owners if their capital were used elsewhere.

 Accounting profit equals revenues R minus labor cost wL, which is positive.

 Economic profit 𝜋𝜋, however, equals revenues R minus labor cost wL minus the capital cost, Rk.

π = R − wL − rK

 Firms in long run equilibrium will always earn zero economic profit.

 Zero economic profit: A firm is earning a normal return on its investment—i.e., it is doing as well as it
could by investing its money elsewhere.

 Signifies that not that firms are doing poorly but that the market is competitive.
 8.7 CHOOSING OUPUT IN THE LONG RUN

Long run competitive equilibrium occurs when three conditions hold:

1. All firms in the industry is are maximising profit.
2. No firm has an incentive to enter or exit the market (because all are earning zero
economic profit).
3. Quantity supplied by the industry is equal to quantity demanded.

In a market with free entry and exit, a firm enters when it can earn a positive long-run
profit and exits when it faces the prospect of a long-run loss.
 8.7 CHOOSING OUTPUT IN THE LONG RUN
 Initially the long-run equilibrium price of a product is R40 per unit, shown in (b).

 In (a) we see that firms earn positive profits.

 Positive profit encourages entry of new firms and causes a shift to the right in the supply curve to S2,
as shown in (b).

 The long-run equilibrium occurs at a price of R30, as shown in (a), where each firm earns zero profit
and there is no incentive to enter or exit the industry.
8.7 CHOOSING OUTPUT IN THE LONG RUN

 Some instances where firms can earn positive accounting profit with a zero economic profit.

 Consider the opportunity costs of owning land.

 Suppose, for example, that a clothing store happens to be located near a large shopping center.
The additional flow of customers can substantially increase the store’s accounting profit
because the cost of the land is based on its historical cost.

 When the opportunity cost of land is included, the profitability of the clothing store is no
higher than that of its competitors.

 In this instance the accounting profit is higher because certain firms have access to limited
supply of factors of production.

 These positive accounting profits referred to as economic rents.

 Economic rent: Amount that firms are willing to pay for an input less the minimum amount
necessary to obtain it.

 In competitive markets, in both the short and the long run, economic rent is often positive even
though profit is zero.
 8.7 CHOOSING OUTPUT IN THE LONG RUN

FIRMS EARN ZERO ECONOMIC PROFIT IN THE LONG RUN

 In long-run equilibrium, all firms earn zero economic

profit.

 Consider the example in 8.15.

 In (a), a baseball team in a moderate-sized city sells

enough tickets so that price (R7) is equal to marginal
and average cost.

 In (b), the demand is greater, so a R10 price can be

charged. The team increases sales to the point at
which the average cost of production plus the average
economic rent is equal to the ticket price.

 When the opportunity cost associated with owning

the franchise is taken into account, the team earns
zero economic profit.
8.8 INDUSTRY LONG RUN SUPPLY CURVE

 In the short run we obtain market supply curve by adding all individual supply
curves together.
 In the long run we are unable to achieve this, why?
 Shape of long run supply curve depends on the extent to which increases and
decreases in industry output affect the prices that firms must pay for inputs in
the production process.
 Useful to distinguish between constant, increasing and decreasing cost
industries.
 8.8 INDUSTRY LONG RUN SUPPLY CURVE
CONSTANT COST INDUSTRY
 Industry at equilibrium at A where D1 and S1 are equal.

 Suppose demand increases to D2, price is increased to P2 and subsequently profit.

 Stimulates entry into market shifting supply curve to S2 back to P1.

 In (b), the long-run supply curve in a constant-cost industry is a horizontal line SL, because input prices are
unaffected by the increased output of the industry, entry occurs until the original price is obtained (at point B in
(b)).
 8.8 INDUSTRY LONG RUN SUPPLY CURVE
INCREASING COST INDUSTRY

 Industry is characterised by increasing input prices as output increases (diseconomies of scale).

 If demand unexpectedly increases demand shifts to D2 causing increase to price of p2.

 As new firms enter price of inputs increase shifting LAC upwards, requiring higher price level of P3 to ensure
zero economic profit is still achieved.

 In (b), the long-run supply curve in an increasing-cost industry is an upward-sloping curve SL.

 Because input prices increase as a result, the new long-run equilibrium occurs at a higher price than the initial
equilibrium (opposite is true for decreasing cost industry).
8.8 INDUSTRY LONG RUN SUPPLY CURVE

How is the industry supply affected when output taxes are imposed?

 Due to each firm reducing its output at current

market price the total output supplied by the industry
will also fall.

 This causes the competitive market to shift the supply

curve for the industry upward by the amount of the
tax.

 This shift raises the market price of the product and

lowers the total output of the industry.
 8.8 INDUSTRY LONG RUN SUPPLY CURVE

How is the industry supply affected when output taxes are imposed?

 Suppose the tax is imposed only on the firm.

 Output taxes encourages firms to reduce output.

 Because the tax is imposed on each unit of output raises the

MC curve to MC2 and AVC.

 Chooses to produce where new MC is equal to the price and

thus reduces q to q2.

 Due to each firm reducing its output at current market price

the total output supplied by the industry will also fall.
8.8 INDUSTRY LONG RUN SUPPLY CURVE

LONG RUN ELASTICITY OF SUPPLY

 The long-run elasticity of industry supply is defined in the same way as the short-run elasticity: It is the
percentage change in output (∆Q/Q) that results from a percentage change in price (∆P/P).

 In a constant-cost industry, the long-run supply curve is horizontal, and the long-run supply elasticity is
infinitely large. (A small increase in price will induce an extremely large increase in output.) In an
increasing-cost industry, however, the long-run supply elasticity will be positive but finite.

 Because industries can adjust and expand in the long run, we would generally expect long-run
elasticities of supply to be larger than short-run elasticities.

 The magnitude of the elasticity will depend on the extent to which input costs increase as the market
expands.

 For example, an industry that depends on inputs that are widely available will have a more elastic long-
run supply than will an industry that uses inputs in short supply.
EXERCISE 5
Suppose that a competitive firm’s marginal cost of producing output q is given by MC(q) = 3 + 2q. Assume
that the market price of the firm’s product is R9.

a) What level of output will the firm produce to maximise profit?

b) Suppose that the average variable cost of the firm is given by AVC(q) = 3 + q. Suppose that the firm’s
fixed costs are known to be R3. Derive the total cost function of the firm.

c) What is the firm’s producer surplus when it maximizes profit?

d) What price should the firm charge in order for it to break even?
EXERCISE 4
Suppose you are the manager of a watchmaking firm operating in a competitive market. Your cost of
production is given by C = 200 + 2𝑞𝑞 2 , where q is the level of output and C is total cost. (The marginal cost
of production is 4q; the fixed cost is R200.)

a. If the price of watches is R100, how many watches should you produce to maximize profit?

b. What will the profit level be?

c. At what minimum price will the firm produce a positive output?

EXERCISE 11

Suppose that a competitive firm has a total cost function C(q) = 450 + 15q +2𝑞𝑞 2 and a marginal cost
function MC(q) = 15 + 4q.

A. If the market price is P = R115 per unit, find the level of output produced by the firm.

B. Find the level of profit and the level of producer surplus.