This document discusses profit maximization and competitive supply. It begins by defining perfectly competitive markets and their key characteristics of price taking, product homogeneity, and free entry/exit. It then explains that firms seek to maximize profits in the long run. Using marginal revenue and marginal cost, it shows that firms maximize profits by producing at the quantity where marginal revenue equals marginal cost. In the short run, individual firms and industries will increase or decrease output in response to price changes until marginal cost again equals price at the new profit-maximizing quantity.

1. Chapter 8
Profit Maximization
and Competitive
Supply

2. Topics to be Discussed
 Perfectly Competitive Markets
 Profit Maximization
 Marginal Revenue, Marginal Cost, and
Profit Maximization
 Choosing Output in the Short-Run

3. Topics to be Discussed
 The Competitive Firm’s Short-Run
Supply Curve
 Short-Run Market Supply
 Choosing Output in the Long-Run
 The Industry’s Long-Run Supply Curve

4. Perfectly Competitive Markets
 Characteristics of Perfectly Competitive
Markets
1) Price taking
2) Product homogeneity
3) Free entry and exit

5. Perfectly Competitive Markets
 Price Taking
The individual firm sells a very small share
of the total market output and, therefore,
cannot influence market price.
The individual consumer buys too small a
share of industry output to have any impact
on market price.

6. Perfectly Competitive Markets
 Product Homogeneity
The products of all firms are perfect
substitutes.
Examples
 Agricultural products, oil, copper, iron,
lumber

7. Perfectly Competitive Markets
 Free Entry and Exit
Buyers can easily switch from one supplier
to another.
Suppliers can easily enter or exit a market.

8. Perfectly Competitive Markets
 Discussion Questions
What are some barriers to entry and exit?
Are all markets competitive?
When is a market highly competitive?

9. Profit Maximization
 Do firms maximize profits?
Possibility of other objectives
 Revenue maximization
 Dividend maximization
 Short-run profit maximization

10. Profit Maximization
 Do firms maximize profits?
Implications of non-profit objective
 Over the long-run investors would not
support the company
 Without profits, survival unlikely

11. Profit Maximization
 Do firms maximize profits?
Long-run profit maximization is valid and
does not exclude the possibility of
altruistic behavior.

12. Marginal Revenue, Marginal Cost,
and Profit Maximization
 Determining the profit maximizing level
of output
Profit ( ) = Total Revenue - Total Cost
Total Revenue (R) = Pq
Total Cost (C) = Cq
Therefore:
π
)()()( qCqRq −=π

13. Profit Maximization in the Short Run
0
Cost,
Revenue,
Profit
($s per year)
Output (units per year)
R(q)
Total Revenue
Slope of R(q) = MR

14. 0
Cost,
Revenue,
Profit
$ (per year)
Output (units per year)
Profit Maximization in the Short Run
C(q)
Total Cost
Slope of C(q) = MC
Why is cost positive when q is zero?

15.  Marginal revenue is the additional
revenue from producing one more unit
of output.
 Marginal cost is the additional cost from
producing one more unit of output.
Marginal Revenue, Marginal Cost,
and Profit Maximization

16.  Comparing R(q) and C(q)
 Output levels: 0- q0:
 C(q)> R(q)
 Negative profit
 FC + VC > R(q)
 MR > MC
 Indicates higher
profit at higher
output 0
Cost,
Revenue,
Profit
($s per year)
Output (units per year)
R(q)
C(q)
A
B
q0 q*
)(qπ
Marginal Revenue, Marginal Cost,
and Profit Maximization

17.  Comparing R(q) and C(q)
 Question: Why is profit
negative when output is
zero?
Marginal Revenue, Marginal Cost,
and Profit Maximization
R(q)
0
Cost,
Revenue,
Profit
$ (per year)
Output (units per year)
C(q)
A
B
q0 q*
)(qπ

18.  Comparing R(q) and C(q)
 Output levels: q0 - q*
 R(q)> C(q)
 MR > MC
 Indicates higher
profit at higher
output
 Profit is increasing
R(q)
0
Cost,
Revenue,
Profit
$ (per year)
Output (units per year)
C(q)
A
B
q0 q*
)(qπ
Marginal Revenue, Marginal Cost,
and Profit Maximization

19.  Comparing R(q) and C(q)
 Output level: q*
 R(q)= C(q)
 MR = MC
 Profit is maximized
R(q)
0
Cost,
Revenue,
Profit
$ (per year)
Output (units per year)
C(q)
A
B
q0 q*
)(qπ
Marginal Revenue, Marginal Cost,
and Profit Maximization

20.  Question
 Why is profit reduced
when producing more
or less than q*?
R(q)
0
Cost,
Revenue,
Profit
$ (per year)
Output (units per year)
C(q)
A
B
q0 q*
)(qπ
Marginal Revenue, Marginal Cost,
and Profit Maximization

21.  Comparing R(q) and C(q)
 Output levels beyond q*
:
 R(q)> C(q)
 MC > MR
 Profit is decreasing
Marginal Revenue, Marginal Cost,
and Profit Maximization
R(q)
0
Cost,
Revenue,
Profit
$ (per year)
Output (units per year)
C(q)
A
B
q0 q*
)(qπ

22.  Therefore, it can be
said:
 Profits are maximized
when MC = MR.
Marginal Revenue, Marginal Cost,
and Profit Maximization
R(q)
0
Cost,
Revenue,
Profit
$ (per year)
Output (units per year)
C(q)
A
B
q0 q*
)(qπ

23. C-R=π
Marginal Revenue, Marginal Cost,
and Profit Maximization
q
R
MR
∆
∆
=
q
C
MC
∆
∆
=

24. or
q
C
q
R
0
q
:whenmaximizedareProfits
=
∆
∆
−
∆
∆
=
∆
∆π
MC(q)MR(q)
MCMR
=
=− thatso0
Marginal Revenue, Marginal Cost,
and Profit Maximization

25.  The Competitive Firm
Price taker
Market output (Q) and firm output (q)
Market demand (D) and firm demand (d)
R(q) is a straight line
Marginal Revenue, Marginal Cost,
and Profit Maximization

26. Demand and Marginal Revenue Faced
by a Competitive Firm
Output
(bushels)
Price
$ per
bushel
Price
$ per
bushel
Output
(millions
of bushels)
d$4
100 200 100
Firm Industry
D
$4

27.  The Competitive Firm
The competitive firm’s demand
 Individual producer sells all units for $4
regardless of the producer’s level of
output.
 If the producer tries to raise price, sales
are zero.
Marginal Revenue, Marginal Cost,
and Profit Maximization

28.  The Competitive Firm
The competitive firm’s demand
 If the producers tries to lower price he
cannot increase sales
 P = D = MR = AR
Marginal Revenue, Marginal Cost,
and Profit Maximization

29.  The Competitive Firm
Profit Maximization
 MC(q) = MR = P
Marginal Revenue, Marginal Cost,
and Profit Maximization

30. Choosing Output in the Short Run
 We will combine production and cost
analysis with demand to determine
output and profitability.

31. q0
Lost profit for
qq < q*
Lost profit for
q2 > q*
q1 q2
A Competitive Firm
Making a Positive Profit
10
20
30
40
Price
($ per
unit)
0 1 2 3 4 5 6 7 8 9 10 11
50
60
MC
AVC
ATC
AR=MR=P
Outputq*
At q*
: MR = MC
and P > ATC
ABCDor
qxAC)-(P *
=π
D A
BC
q1 : MR > MC and
q2: MC > MR and
q0: MC = MR but
MC falling

32. Would this producer
continue to produce
with a loss?
A Competitive Firm
Incurring Losses
Price
($ per
unit)
Output
AVC
ATCMC
q*
P = MR
B
F
C
A
E
D
At q*
: MR = MC
and P < ATC
Losses = P- AC) x q*
or ABCD

33. Choosing Output in the Short Run
 Summary of Production Decisions
Profit is maximized when MC = MR
If P > ATC the firm is making profits.
If AVC < P < ATC the firm should produce
at a loss.
If P < AVC < ATC the firm should shut-
down.

34. The Short-Run Output of
an Aluminum Smelting Plant
Output
(tons per day)
Cost
(dollars per item)
300 600 9000
1100
1200
1300
1400
1140
P1
P2
Observations
•Price between $1140 & $1300: q = 600
•Price > $1300: q = 900
•Price < $1140: q = 0
Question
Should the firm stay in business
when P < $1140?

35. Some Cost Considerations for Managers
 Three guidelines for estimating
marginal cost:
1) Average variable cost should not be
used as a substitute for marginal
cost.

36. Some Cost Considerations for Managers
 Three guidelines for estimating
marginal cost:
2) A single item on a firm’s accounting
ledger may have two components,
only one of which involves marginal
cost.

37.  Three guidelines for estimating
marginal cost:
3) All opportunity cost should be
included in determining marginal
cost.
Some Cost Considerations for Managers

38. A Competitive Firm’s
Short-Run Supply Curve
Price
($ per
unit)
Output
MC
AVC
ATC
P = AVC
What happens
if P < AVC?
P2
q2
P1
q1
The firm chooses the
output level where MR = MC,
as long as the firm is able to
cover its variable cost of
production.

39.  Observations:
P = MR
MR = MC
P = MC
 Supply is the amount of output for every
possible price. Therefore:
If P = P1, then q = q1
If P = P2, then q = q2
A Competitive Firm’s
Short-Run Supply Curve

40. Price
($ per
unit)
MC
Output
AVC
ATC
P = AVC
P1
P2
q1 q2
S = MC above AVC
A Competitive Firm’s
Short-Run Supply Curve
Shut-down

41.  Observations:
Supply is upward sloping due to
diminishing returns.
Higher price compensates the firm for
higher cost of additional output and
increases total profit because it applies to
all units.
A Competitive Firm’s
Short-Run Supply Curve

42.  Firm’s Response to an Input Price
Change
When the price of a firm’s product
changes, the firm changes its output level,
so that the marginal cost of production
remains equal to the price.
A Competitive Firm’s
Short-Run Supply Curve

43. MC2
q2
Input cost increases
and MC shifts to MC2
and q falls to q2.
MC1
q1
The Response of a Firm to
a Change in Input Price
Price
($ per
unit)
Output
$5
Savings to the firm
from reducing output

44. The Short-Run Production
of Petroleum Products
Cost
($ per
barrel)
Output
(barrels/day)
8,000 9,000 10,000 11,000
23
24
25
26
27 SMC
How much would
be produced if
P = $23?
P = $24-$25?
The MC of producing
a mix of petroleum products
from crude oil increases
sharply at several levels
of output as the refinery
shifts from one processing
unit to another.

45.  Stepped SMC indicates a different
production (cost) process at various
capacity levels.
 Observation:
With a stepped MC function, small
changes in price may not trigger a change
in output.
The Short-Run Production
of Petroleum Products

46.  The short-run market supply curve
shows the amount of output that the
industry will produce in the short-run for
every possible price.
 Consider, for simplicity, a competitive
market with three firms:
The Short-Run Production
of Petroleum Products

47. MC3
Industry Supply in the Short Run
$ per
unit
0 2 4 8 105 7 15 21
MC1
SSThe short-run
industry supply curve
is the horizontal
summation of the supply
curves of the firms.
Quantity
MC2
P1
P3
P2
Question: If increasing
output raises input
costs, what impact
would it have on
market supply?

48. The Short-Run Market Supply Curve
 Elasticity of Market Supply
)//()/( PPQQEs ∆∆=

49.  Perfectly inelastic short-run supply
arises when the industry’s plant and
equipment are so fully utilized that new
plants must be built to achieve greater
output.
 Perfectly elastic short-run supply arises
when marginal costs are constant.
The Short-Run Market Supply Curve

50.  Questions
1) Give an example of a perfectly
inelastic supply.
2) If MC rises rapidly, would the supply
be more or less elastic?
The Short-Run Market Supply Curve

51. The World Copper Industry (1999)
Annual Production Marginal Cost
Country (thousand metric tons) (dollars/pound)
Australia 600 0.65
Canada 710 0.75
Chile 3660 0.50
Indonesia 750 0.55
Peru 450 0.70
Poland 420 0.80
Russia 450 0.50
United States 1850 0.70
Zambia 280 0.55

52. The Short-Run World Supply of Copper
Production (thousand metric tons)
Price
($ per pound)
0 2000 4000 6000 8000 10000
0.40
0.50
0.60
0.70
0.80
0.90
MCC,MCR
MCJ,MCZ
MCA
MCP,MCUS
MCCa
MCPo

53.  Producer Surplus in the Short Run
Firms earn a surplus on all but the last unit
of output.
The producer surplus is the sum over all
units produced of the difference between
the market price of the good and the
marginal cost of production.
The Short-Run Market Supply Curve

54. AA
DD
BB
CC
ProducerProducer
SurplusSurplus
Alternatively, VC is the
sum of MC or ODCq*
.
R is P x q*
or OABq*
.
Producer surplus =
R - VC or ABCD.
Producer Surplus for a Firm
Price
($ per
unit of
output)
Output
AVCAVCMCMC
00
PP
qq**
At q*
MC = MR.
Between 0 and q ,
MR > MC for all units.

55.  Producer Surplus in the Short-Run
The Short-Run Market Supply Curve
VC-RPSSurplusProducer ==
FC-VC-R-Profit π=

56.  Observation
Short-run with positive fixed cost
The Short-Run Market Supply Curve
πPS >

57. DD
PP**
QQ**
ProducerProducer
SurplusSurplus
Market producer surplus is
the difference between P*
and S from 0 to Q*
.
Producer Surplus for a Market
Price
($ per
unit of
output)
Output
SS

58. Choosing Output in the Long Run
 In the long run, a firm can alter all its
inputs, including the size of the plant.
 We assume free entry and free exit.

59. q1
A
B
C
D
In the short run, the
firm is faced with fixed
inputs. P = $40 > ATC.
Profit is equal to ABCD.
Output Choice in the Long Run
Price
($ per
unit of
output)
Output
P = MR$40
SAC
SMC
In the long run, the plant size will be
increased and output increased to q3.
Long-run profit, EFGD > short run
profit ABCD.
q3q2
G F
$30
LAC
E
LMC

60. q1
A
B
C
D
Output Choice in the Long Run
Price
($ per
unit of
output)
Output
P = MR$40
SAC
SMC
Question: Is the producer making
a profit after increased output
lowers the price to $30?
q3q2
G F
$30
LAC
E
LMC

61. Choosing Output in the Long Run
 Accounting Profit & Economic Profit
Accounting profit = R - wL
Economic profit = R = wL - rK
 wl = labor cost
 rk= opportunity cost of capital
)(π
)(π

62. Choosing Output in the Long Run
 Zero-Profit
If R > wL + rk, economic profits are positive
If R = wL + rk, zero economic profits, but
the firms is earning a normal rate of return;
indicating the industry is competitive
If R < wl + rk, consider going out of
business
Long-Run Competitive EquilibriumLong-Run Competitive Equilibrium

63. Choosing Output in the Long Run
 Entry and Exit
The long-run response to short-run profits
is to increase output and profits.
Profits will attract other producers.
More producers increase industry supply
which lowers the market price.
Long-Run Competitive EquilibriumLong-Run Competitive Equilibrium

64. S1
Long-Run Competitive Equilibrium
Output Output
$ per
unit of
output
$ per
unit of
output
$40
LAC
LMC
D
S2
P1
Q1q2
Firm Industry
$30
Q2
P2
•Profit attracts firms
•Supply increases until profit = 0

65. Choosing Output in the Long Run
 Long-Run Competitive Equilibrium
1) MC = MR
2) P = LAC
 No incentive to leave or enter
 Profit = 0
3) Equilibrium Market Price

66. Choosing Output in the Long Run
 Questions
1) Explain the market adjustment when
P < LAC and firms have identical
costs.
2) Explain the market adjustment when
firms have different costs.
3) What is the opportunity cost of land?

67. Choosing Output in the Long Run
 Economic Rent
Economic rent is the difference between
what firms are willing to pay for an input
less the minimum amount necessary to
obtain it.

68. Choosing Output in the Long Run
 An Example
Two firms A & B
Both own their land
A is located on a river which lowers A’s
shipping cost by $10,000 compared to B.
The demand for A’s river location will
increase the price of A’s land to $10,000

69. Choosing Output in the Long Run
 An Example
Economic rent = $10,000
 $10,000 - zero cost for the land
Economic rent increases
Economic profit of A = 0

70. Firms Earn Zero Profit in
Long-Run Equilibrium
Ticket
Price
Season Tickets
Sales (millions)
LAC
$7$7
1.01.0
A baseball team
in a moderate-sized city
sells enough
tickets so that price
is equal to marginal
and average cost
(profit = 0).
LMC

71. 1.31.3
$10$10
Economic Rent
Ticket
Price
$7$7
LAC
A team with the same
cost in a larger city
sells tickets for $10.
Firms Earn Zero Profit in
Long-Run Equilibrium
Season Tickets
Sales (millions)
LMC

72.  With a fixed input such as a unique
location, the difference between the
cost of production (LAC = 7) and price
($10) is the value or opportunity cost of
the input (location) and represents the
economic rent from the input.
Firms Earn Zero Profit in
Long-Run Equilibrium

73.  If the opportunity cost of the input (rent)
is not taken into consideration it may
appear that economic profits exist in the
long-run.
Firms Earn Zero Profit in
Long-Run Equilibrium

74.  The shape of the long-run supply curve
depends on the extent to which
changes in industry output affect the
prices the firms must pay for inputs.
The Industry’s Long-Run Supply Curve

75. The Industry’s Long-Run Supply Curve
 To determine long-run supply, we
assume:
All firms have access to the available
production technology.
Output is increased by using more inputs,
not by invention.

76. The Industry’s Long-Run Supply Curve
 To determine long-run supply, we
assume:
The market for inputs does not change with
expansions and contractions of the
industry.

77. A
P1
AC
P1
MC
q1
D1
S1
Q1
C
D2
P2P2
q2
B
S2
Q2
Economic profits attract new
firms. Supply increases to S2 and
the market returns to long-run
equilibrium.
Long-Run Supply in a
Constant-Cost Industry
Output Output
$ per
unit of
output
$ per
unit of
output
SL
Q1 increase to Q2.
Long-run supply = SL = LRAC.
Change in output has no impact on
input cost.

78.  In a constant-cost industry, long-run
supply is a horizontal line at a price that
is equal to the minimum average cost of
production.
Long-Run Supply in a
Constant-Cost Industry

79. Long-Run Supply in an
Increasing-Cost Industry
Output Output
$ per
unit of
output
$ per
unit of
output S1
D1
P1
LAC1
P1
SMC1
q1 Q1
A
SSLL
P3
SMC2
Due to the increase
in input prices, long-run
equilibrium occurs at
a higher price.
LAC2
B
S2
P3
Q3
q2
P2 P2
D1
Q2

80.  In a increasing-cost industry, long-run
supply curve is upward sloping.
Long-Run Supply in a
Increasing-Cost Industry

81. The Industry’s
Long-Run Supply Curve
 Questions
1) Explain how decreasing-cost is
possible.
2) Illustrate a decreasing cost industry.
3) What is the slope of the SL in a
decreasing-cost industry?

82. S2
B
SL
P3
Q3
SMC2
P3
LAC2
Due to the decrease
in input prices, long-run
equilibrium occurs at
a lower price.
Long-Run Supply in an
Decreasing-Cost Industry
Output Output
$ per
unit of
output
$ per
unit of
output
P1
P1
SMC1
A
D1
S1
Q1q1
LAC1
Q2q2
P2 P2
D2

83.  In a decreasing-cost industry, long-run
supply curve is downward sloping.
Long-Run Supply in a
Increasing-Cost Industry

84.  The Effects of a Tax
In an earlier chapter we studied how firms
respond to taxes on an input.
Now, we will consider how a firm responds
to a tax on its output.
The Industry’s
Long-Run Supply Curve

85. Effect of an Output Tax on a
Competitive Firm’s Output
Price
($ per
unit of
output)
Output
AVC1
MC1
P1
q1
The firm will
reduce output to
the point at which
the marginal cost
plus the tax equals
the price.
q2
tt
MC2 = MC1 + tax
AVC2
An output tax
raises the firm’s
marginal cost by the
amount of the tax.

86. Effect of an Output
Tax on Industry Output
Price
($ per
unit of
output)
Output
DD
P1
SS1
Q1
P2
Q2
SS2 = S1 + t
t
Tax shifts S1 to S2 and
output falls to Q2. Price
increases to P2.

87.  Long-Run Elasticity of Supply
1) Constant-cost industry
 Long-run supply is horizontal
 Small increase in price will induce an
extremely large output increase
The Industry’s
Long-Run Supply Curve

88.  Long-Run Elasticity of Supply
1) Constant-cost industry
 Long-run supply elasticity is infinitely
large
 Inputs would be readily available
The Industry’s
Long-Run Supply Curve

89.  Long-Run Elasticity of Supply
2) Increasing-cost industry
 Long-run supply is upward-sloping and
elasticity is positive
 The slope (elasticity) will depend on the
rate of increase in input cost
 Long-run elasticity will generally be
greater than short-run elasticity of supply
The Industry’s
Long-Run Supply Curve

90.  Question:
Describe the long-run elasticity of supply in
a decreasing -cost industry.
The Industry’s
Long-Run Supply Curve

91. The Long-Run Supply of Housing
 Scenario 1: Owner-occupied housing
Suburban or rural areas
National market for inputs

92. The Long-Run Supply of Housing
 Questions
Is this an increasing or a constant-cost
industry?
What would you predict about the elasticity
of supply?

93.  Scenario 2: Rental property
Zoning restrictions apply
Urban location
High-rise construction cost
The Long-Run Supply of Housing

94.  Questions
Is this an increasing or a constant-cost
industry?
What would you predict about the elasticity
of supply?
The Long-Run Supply of Housing

95. Summary
 The managers of firms can operate in
accordance with a complex set of
objectives and under various
constraints.
 A competitive market makes its output
choice under the assumption that the
demand for its own output is horizontal.

96. Summary
 In the short run, a competitive firm
maximizes its profit by choosing an
output at which price is equal to (short-
run) marginal cost.
 The short-run market supply curve is
the horizontal summation of the supply
curves of the firms in an industry.

97. Summary
 The producer surplus for a firm is the
difference between revenue of a firm
and the minimum cost that would be
necessary to produce the profit-
maximizing output.
 Economic rent is the payment for a
scarce resource of production less the
minimum amount necessary to hire that
factor.

98. Summary
 In the long-run, profit-maximizing
competitive firms choose the output at
which price is equal to long-run
marginal cost.
 The long-run supply curve for a firm can
be horizontal, upward sloping, or
downward sloping.

99. End of Chapter 8
Profit Maximization
and Competitive
Supply