Profit Maximization
and Competitive Supply
Perfectly Competitive Markets
PRICE TAKING
Because each individual firm sells a sufficiently small proportion of total market
output, its decisions have no impact on market price.
Price taker: Firm that has no influence over market price and thus takes
the price as given.
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.
In contrast, when products are heterogeneous, each firm has the
opportunity to raise its price above that of its competitors without losing
all of its sales.
The assumption of product homogeneity is important because it ensures that there is a
single market price, consistent with supply-demand analysis.
Free entry (or 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.
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.
Marginal Revenue, Marginal Cost, and Profit Maximization
Profit: Difference between total revenue and total cost.
π(q) = R(q) − C(q)
Marginal revenue: Change in revenue resulting from a one-unit increase
in output.
PROFIT MAXIMIZATON IN THE SHORT RUN
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).
Δπ/Δq = ΔR/Δq − ΔC/Δq = 0
MR(q) = MC(q)
Demand and Marginal Revenue for a Competitive Firm
DEMAND CURVE FACED BY A COMPETITIVE FIRM
A competitive firm supplies only a small portion of the total output of all the
firms in an industry. Therefore, the firm takes the market price of the product
as given, choosing its output on the assumption that the price will be unaffected
by the output choice.
In (a) the demand curve facing the firm is perfectly elastic, even though the
market demand curve in (b) is downward sloping.
Because each firm in a competitive industry sells only a small fraction
of the entire industry output, how much output the firm decides to sell
will have no effect on the market price of the product.
Because it is a price taker, the demand curve d facing an individual competitive firm
is given by a horizontal line.
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.
P = MR = AR
Profit Maximization by a Competitive Firm
A perfectly competitive firm should choose its output so that marginal cost
equals price:
MC(q) = MR = P
Q P TR TC Profit MR MC
0 6 0 3 -3
1 6 6 5 1 6 2
2 6 12 8 4 6 3
3 6 18 12 6 6 4
4 6 24 17 7 6 5
5 6 30 23 7 6 6
6 6 36 30 6 6 7
7 6 42 38 4 6 8
8 6 48 47 1 6 9
Choosing Output in the Short Run
Short-Run Profit Maximization by a Competitive Firm
In the short run, the
competitive firm maximizes
its profit by choosing an
output q* at which its
marginal cost MC is equal to
the price P (or marginal
revenue MR) of its product.
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.
Output Rule: If a firm is producing any output, it
should produce at the level at which marginal revenue
equals marginal cost.
When Should the Firm Shut Down?
A COMPETITIVE FIRM INCURRING LOSSES
A competitive firm should
shut down if price is below
AVC.
The firm may produce in the
short run if price is greater
than average variable cost.
