Profit-Maximizing Level of
Output
Perfect
Competition
Chapter 14-2.
Profit Maximizing and
Shutting Down
Profit-Maximizing Level of
Output
What happens to profit in response to a
change in output is determined by
marginal revenue (MR) and marginal
cost (MC).
A firm maximizes profit when MC = MR.
Marginal Revenue
A perfect competitor accepts the
market price as given.
As a result, marginal revenue equals
price (MR = P).
The goal of the firm is to maximize
profits.
Profit is the difference between total
revenue and total cost.
Profit-Maximizing Level of
Output
Marginal revenue (MR) the change
in total revenue associated with a
change in quantity.
Marginal cost (MC) the change in total
cost associated with a change in quantity.
Marginal Cost
Initially, marginal cost falls and then
begins to rise.
Marginal concepts are best defined
between the numbers.
1
 Profit Maximization: MC = MR How to Maximize Profit
To maximize profits, a firm should If marginal revenue does not equal
produce where marginal cost equals marginal cost, a firm can increase profit
marginal revenue. by changing output.
The supplier will continue to produce as
long as marginal cost is less than
marginal revenue.

How to Maximize Profit Again! MR=MC

The supplier will cut back on production Profit is maximized when MR=MC.
if marginal cost is greater than marginal If the cost of producing one more unit is
revenue. less than the revenue it generates, then a
profit is available for the firm that
Thus, the profit-maximizing condition of a increases production by one unit.
competitive firm is MC = MR = P. If the cost of producing one more unit is
more than the revenue it generates, then
increasing production reduces profit.

Profit Maximization:
Marginal Cost, Marginal Graphical Analysis
Revenue, and Price
Costs MC
Price = MR Quantity Marginal
Produced Cost
$35.00 0 60
$28.00
35.00 1
20.00 50
35.00 2 16.00
35.00 3 40 A C
35.00 4
14.00 P = D = MR
12.00 30 B
35.00 5 A
17.00
35.00 6 22.00 20
35.00 7 30.00
35.00 8 10
40.00
35.00 9 54.00 0
35.00 10 68.00 1 2 3 4 5 6 7 8 9 10 Quantity

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2
Profit Maximization: The
Numbers
MR=MC The Marginal Cost Curve Is
Q
0
P
$1
TR
$0
TC
$1.00
TR-TC
-$1.00
MR
$1
MC ATC
the Supply Curve
1 $1 $1 $2.00 -$1.00 $1 $1.00 $2.00
The marginal cost curve is the firm's
2 $1 $2 $2.80 -$0.80 $1 $0.80 $1.40
3 $1 $3 $3.50 -$0.50 $1 $0.70 $1.17 supply curve above the point where
4 $1 $4 $4.00 $0.00 $1 $0.50 $1.00 price exceeds average variable cost.
5 $1 $5 $4.50 $0.50 $1 $0.50 $0.90
6 $1 $6 $5.20 $0.80 $1 $0.70 $0.87
7 $1 $7 $6.00 $1.00 $1 $0.80 $0.86
8 $1 $8 $6.86 $1.14 $1 $0.86 $0.86
9 $1 $9 $7.86 $1.14 $1 $1.00 $0.87
10 $1 $10 $9.36 $0.64 $1 $1.50 $0.94
11 $1 $11 $12.00 -$1.00 $1 $2.64 $1.09

The Marginal Cost Curve Is The Marginal Cost Curve Is

the Supply Curve the Firms Supply Curve
Marginal cost
$70 C
The MC curve tells the competitive firm
60
how much it should produce at a given
50
Cost, Price

price. A
40
The firm can do no better than produce the 30 B
quantity at which marginal cost equals 20
marginal revenue which in turn equals 10
price. 0 1 2 3 4 5 6 7 8 9 10 Quantity

Firms Maximize Total Profit Maximization Using

Profit
Firms seek to maximize total profit, not
profit per unit.
Firms do not care about profit per unit.
As long as increasing output increases
total profits, a profit-maximizing firm
should produce more.
Total Revenue and Total Cost
Profit is maximized where the vertical
distance between total revenue and
total cost is greatest.
At that output, MR (the slope of the
total revenue curve) and MC (the slope
of the total cost curve) are equal.

3
 Profit Determination Using Total
Cost and Revenue Curves Total Profit at the Profit-
TC TR
Maximizing Level of Output
$385 Loss The P = MR = MC condition tells us
Total cost, revenue

350
315 Maximum profit =$81 Profit how much output a competitive firm
280
245 should produce to maximize profit.
210 $130
175 It does not tell us how much profit the
140 firm makes.
105 Profit =$45
70
35 Loss
0
1 2 3 4 5 6 7 8 9 Quantity
McGraw-Hill/Irwin 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Determining Profit and Loss

Costs Relevant to a Firm
From a Table of Costs
P = MR Output Total Cost Marginal Average Total Profit
Profit can be calculated from a table of Cost Total Cost Revenue TR-TC
costs and revenues. 0 40.00 0 40.00
35.00 1 68.00 28.00 68.00 35.00 33.00
Profit is determined by total revenue
35.00 2 88.00 20.00 44.00 70.00 18.00
minus total cost. 35.00 3 104.00 16.00 34.67 105.00 1.00
35.00 4 118.00 14.00 29.50 140.00 22.00
35.00 5 130.00 12.00 26.00 175.00 45.00
35.00 6 147.00 17.00 24.50 210.00 63.00

McGraw-Hill/Irwin 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Determining Profit and

Costs Relevant to a Firm
Loss From a Graph
P = MR Output Total Cost Marginal Average Total Profit
Cost Total Cost Revenue TR-TC Find output where MC = MR.
35.00 4 118.00 14.00 29.50 140.00 22.00 The intersection of MC = MR (P)
35.00 5 130.00 12.00 26.00 175.00 45.00 determines the quantity the firm will
35.00 6 147.00 17.00 24.50 210.00 63.00 produce if it wishes to maximize profits.
35.00 7 169.00 22.00 24.14 245.00 76.00
35.00 8 199.00 30.00 24.88 280.00 81.00
35.00 9 239.00 40.00 26.56 315.00 76.00
35.00 10 293.00 54.00 29.30 350.00 57.00

McGraw-Hill/Irwin 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

4
 Determining Profit and Determining Profit and
Loss From a Graph Loss From a Graph
Find profit per unit where MC = MR. The firm makes a profit when the ATC
curve is below the MR curve.
Drop a line down from where MC equals MR,
and then to the ATC curve.
This is the profit per unit. The firm incurs a loss when the ATC curve
Extend a line back to the vertical axis to is above the MR curve.
identify total profit.

Determining Profit and Loss Determining Profits Graphically

From a Graph Price MC Price MC Price MC
65 65 65
60 60 60
Zero profit or loss where MC=MR. 55 55 55
50 50 50 ATC
Firms can earn zero profit or even a loss 45 45 ATC 45
40 D A P = MR 40 40 Loss P = MR
where MC = MR. 35 35 35
P = MR
30 Profit B ATC 30 30 AVC
Even though economic profit is zero, all 25 C AVC 25 AVC 25
20 E 20 20
resources, including entrepreneurs, are being 15 15 15
paid their opportunity costs. 10 10 10
5 5 5
0 0 0
1 2 3 4 5 6 7 8 9 10 12 1 2 3 4 5 6 7 8 9 10 12 1 2 3 4 5 6 7 8 910 12
Quantity Quantity Quantity
(a) Profit case (b) Zero profit case (c) Loss case

Irwin/McGraw-Hill The McGraw-Hill Companies, Inc., 2000

Loss Minimization
Average cost of a unit of output

The Shutdown Point

The firm will shut down if it cannot
cover average variable costs.
A firm should continue to produce as long
Market as price is greater than average variable
price
falls cost.
Revenue If price falls below that point it makes
generated by a sense to shut down temporarily and save
unit of output
the variable costs.

5
 The Shutdown Point The Shutdown Point
The shutdown point is the point at If total revenue is more than total
which the firm will be better off it it variable cost, the firms best strategy is
shuts down than it will if it stays in to temporarily produce at a loss.
business. It is taking less of a loss than it would by
shutting down.

Minimizing Loss
The Shutdown Decision
MC
Price
60
Shutdown price: the minimum point of
50 ATC
the average-variable-cost (AVC) curve.
40 Loss
P = MR
30 Break-even price: A price that is equal to
AVC
20 the minimum point of the average-total-
$17.80 A
10 cost (ATC) curve.
0
2 4 6 8 Quantity At this price, economic profit is zero.

Profit Maximizing Level of

Output Profit Maximizing Level of
The goal of the firm is to maximize profits, the difference Output
between total revenue and total cost
The profit-maximizing condition of a competitive firm is:
MR = MC
A firm maximizes profit when marginal revenue equals
marginal cost For a competitive firm, MR = P

Marginal revenue (MR) is the change in A firm maximizes total profit, not profit per unit
total revenue associated with a change in If MR > MC,
quantity a firm can increase profit by increasing output
Marginal cost (MC) is the change in total cost associated
with a change in quantity If MR < MC,
a firm can increase profit by decreasing
14-35 its output 14-36

6
 Marginal Cost, Marginal The Marginal Cost Curve is
Revenue, and Price Graph the Supply Curve
P Marginal
Cost Marginal Firms Supply
P Cost = Curve

MC > P,
MC = P decrease output to $61
Because the marginal cost
increase total profit
curve tells us how much of
$35 P = D = MR a good a firm will supply at
MC < P, $35 a given price, the
increase output to marginal cost curve is the
increase total profit $19.50 firms supply curve

Q
MC = P at 8 units,
total profit is
Q
6 8 10
maximized

14-37 14-38

Profit Maximization using Total Total Revenue and Total

Revenue and Total Cost Cost Table
An alternative method to determine the profit-maximizing Total Cost,
level of output is to look at the total and total cost curves Total Revenue TC The total revenue curve
TR
Max profit = $81 is a straight line
at 8 units of
output The total cost curve is
$280 bowed upward at most
Total cost is the cumulative sum
Total profit is the difference between total
quantities reflecting
increasing marginal cost
$175
of theand
revenue marginal
total costcosts,
curves plus the
$130
fixed costs Profits are maximized
when the vertical
Losses Profits Losses distance between TR
and TC is greatest
Q
3 5 8

14-39 14-40

Determining Profits Graphically: Determining Profits Graphically:

A Firm with Profit A Firm with Zero Profit or Losses
P Find output where P
MC Find output where MC
MC = MR, this is the
MC = MR, this is the
profit maximizing Q
profit maximizing Q
MC = MR
ATC ATC
Find profit per unit
P P = D = MR Find profit per unit MC = MR
Profits where the profit max Q
AVC where the profit max Q AVC
ATC intersects ATC
intersects ATC P P = D = MR
ATC at Qprofit max =ATC
Since P>ATC at the ATC at Qprofit max
Since P=ATC at the
profit maximizing quantity,
profit maximizing quantity,
this firm is earning profits
Q this firm is earning Q
Qprofit max zero profit or loss Qprofit max

14-41 14-42

7
 Determining Profits Graphically: Determining Profits Graphically:
A Firm with Losses The Shutdown Decision
P Find output where P
The shutdown point is the
MC MC = MR, this is the point below which the firm MC
profit maximizing Q will be better off if it shuts
ATC at Qprofit max ATC down than it will if it stays
in business ATC
Find profit per unit
where the profit max Q If P>min of AVC, then the
AVC
ATC intersects ATC firm will still produce, but
Losses P = D = MR AVC
earn a loss
P
Since P<ATC at the If P<min of AVC, the firm
MC = MR PShut P = D = MR
profit maximizing quantity, will shut down down
this firm is earning losses If a firm shuts down, it still
Q Q
Qprofit max has to pay its fixed costs Qprofit max

14-43 14-44

Short-Run Market Supply Short-Run Market Supply and

and Demand Demand Graph
P Market P Firm
While the firms demand curve is perfectly elastic,
the industrys demand curve is downward sloping Market MC
Supply

ATC
The market supply curve takes into account any
P P P = D = MR
changes in input prices that might occur Profits
ATC

Market
The market (industry) supply curve is Demand

the horizontal sum of all the firms Q

Qprofit max
Q
marginal cost curves
14-45 14-46