Profit-Maximization and Output Decisions

Dr. Gong Jie

How Does a Firm Maximize Profit?

What is profit?
♦ Economic Profit instead of Accounting Profit
♦ Sales Revenue-Economic (opportunity) Cost
How to maximize profit?
♦ Step 1: How many units of the product to produce (Q*)
 Given cost C(Q) and revenue TR(Q)
♦ Step 2: How to minimize production cost
 Given Q*, the minimum cost of production is C(Q*)
Agenda

Principle of Profit Maximization

Profit Maximization in Competitive Markets
Short-Run Supply Curve
Long-Run Supply Curve
Long-Run Market Equilibrium
Producer Surplus
The General Principle of Profit Maximization

Max π(Q) =TR(Q) - TC(Q)

Q
Additional production (Q) induces additional revenue
and additional cost. What is the optimal level?
The principle for profit maximization:
MR(Q) = MC(Q)
 What is the MR in a competitive market?
Price
TR(Q)=P*Q=(a-bQ)Q=aQ-bQ2
MR(Q)=ΔTR(Q)/ΔQ=a-2bQ?
Wrong!

Market Demand
P = a-bQ

Quantity
In perfectly competitive markets, everyone
is a price-taker!
Price

The demand facing an individual

seller is a horizontal line!
Individual firm sells every unit at
market price.

Quantity
Demand curve facing an individual firm in
competitive market

$ $
S

Pe Df

QM Qf
Market Firm
Managing in Perfectly Competitive Market

When the market price is Pe, what is the marginal

revenue for a competitive seller?
♦ Pe does not depend on each individual firm’s output
choice Q.
♦ The marginal revenue is the same as the market price.
 MR=ΔTR(Q)/ΔQ= Δ (PeQ)/ΔQ =Pe
♦ Therefore, the profit maximization condition for a
price-taking firm is Pe = MC.
A Firm’s Output Decision

Profit = (Pe - ATC) * Qf*

MC
$
SAC
SAVC
Pe Pe = Df = MR

ATC

Qf* Qf
A Numerical Example

Given
♦ P=$10
♦ TC(Q) = 5 + Q2
Optimal Output?
♦ MR = P = $10, MC(Q) = 2Q
♦ 10 = 2Q
♦ Q* = 5 units
Maximum Profits?
♦ PQ* - C(Q*) = (10)(5) - (5 + 25) = $20
What if the price line and the MC curve
have two intersections?
MC

Pe Pe = Df = MR

Q1 Q2 Qf
At Q1, the firm should not stop the production because
the marginal cost is decreasing, such that the additional
revenue from the next unit exceeds the additional cost.
Q1 is not optimal. MC

Pe Pe = Df = MR

Q1 Q2 Qf
At Q2, the firm has to stop production because the marginal
cost is increasing, such that the additional revenue from the
next unit is less than what offsets the additional cost.
Profit-maximization Conditions

MR=MC is the necessary but not the sufficient

condition for optimization!
Firms should not produce a quantity where marginal
cost is decreasing.
Profit-maximization conditions for a price-taking
firm:
♦ P=MC
♦ MC must be increasing.
Short-Run Supply Curve

A firm’s individual supply tells us the quantity of

product the firm is willing to offer for each possible
price.
A firm’s optimal output for a given market price is
determined by P=MC(Q).
Thus, a firm’s supply curve is the same as its
marginal cost curve. True or False?
A firm’s supply curve is the same as its
marginal cost curve. True or False?

MC
$
Pe = Df = MR
Pe SAVC

Qf* Qf
 Should this firm produce at all?

MC SAC
$

SAVC
ATC

Fixed cost

Pe

Qf* Qf

Profit = (Pe - ATC) * Qf* < 0

 Should this firm sustain short run losses
or shut down?
Profit = (Pe - ATC) * Qf* < 0, but Pe > min AVC
MC SAC
$

SAVC

ATC
Loss Pe = Df = MR
Pe

Fixed Costs

Qf* Qf
 When should the firm shut down? P<minAVC

 The firm should shut down if: MC

payoff of shutdown>payoff of production
0-FC > PQ* - TC(Q*)
$ SAC

 PQ* < TC(Q*) – FC = VC(Q*)

 P < AVC(Q*)
SAVC
 MC(Q*) < AVC(Q*)
 Recall MC crosses AVC at min AVC.
 When P>min AVC, P=MC yields Q* in min AVC
AVC
the area where MC(Q*)>AVC(Q*). Pe
When P<min AVC, P=MC yields Q* in Qf
Qf*
the area where MC(Q*)<AVC(Q*).
 P<min AVC: production always involves
extra loss.
Short-run Output Choice

When P < min AVC, the firm should set Q = 0.

♦ Supply curve is the vertical axis.

When P ≥ min AVC, the firm should choose a level

of Q* such that:
♦ P = MC (Q*)
♦ MC is not decreasing at Q*
 Firm’s Short-Run Supply Curve: MC
Above min AVC

MC SAC
$

SAVC

P = min AVC

Qf
 Short-Run Market Supply Curve

The market supply curve is the summation of each

individual firm’s supply at each price.

P Firm 1 Firm 2 Market

P P

S1 S2
SM
15

10 18 Q 20 25 Q 30 43Q
Long Run Supply Curve

In the long run, firms have the flexibility to adjust all
the inputs they use.
♦ They evaluate output decision using long run cost function.
In the long run, firms also decide whether to enter or
exit the market.
♦ If firms are price takers but there are barriers to entry,
profits will persist.
♦ In perfectly competitive market, there is free entry. Other
“greedy capitalists” enter the market.
 Firm’s Long-Run Supply Curve: MC
Above Min AC

MC
$

AC

P = min AC

Qf
 Effect of Entry on Price

$ $
S
Entry S*
Pe Df
Pe* Df*

QM Qf
Market Firm
Effect of Entry on the Firm’s Output
and Profits
MC
$
AC

Pe Df

Pe* Df*

Q L Q f* Q
Summary of Logic

Short-run profits lead to entry.

Entry increases market supply, drives down the
market price, increases the market quantity.
Demand for individual firm’s product shifts down.
Firm reduces output to maximize profit.
Long run profits must be zero for a competitive
firm.
Long-run Dynamics: Entry and Exit

Short-run Profit Short-run Loss

Entry Exit

Supply curve shifts rightward Supply curve shifts leftward

Price falls Price rises

No more incentive for entry No more incentive for exit

Entry stops Exit stops

Example: Calculating a Long Run Equilibrium

TC(q) = 40q - q2 + .01q3

AC(q) = 40 – q + .01q2
MC(q) = 40 – 2q + .03q2

Qd(P) = 25000-1000P

Assuming the number of firms in the market is n, the long run

equilibrium satisfies the following:

a. P* = 40 – 2q* - .03q*2 (P=MC)

b. P* = 40 – q* + .01q*2 (Profit=0, P=AC)
c. 25000-1000P* = q*n* (Market demand=Market Supply)
Using (a) and (b), we have:

40 – 2q* + .03q*2 = 40-q*+.01q*2

q* = 50
P* = 15
 Qd(P*) = 10000

Using (c ) we have:

n* = 10000/50 = 200
How to Understand Zero Profit?

Why do firms continue to produce in the long run

even though their economic profits are zero?
Economic profits=0 does not imply accounting
profits=0. Accounting profits are just enough to offset
any implicit costs of production.
All resources are getting a return equivalent to the
best returns they could get elsewhere.
The firm earns no more, and no less, than it could
earn by using the resources in some other capacity.
Producer Surplus

Producer Surplus is the net benefit to the producer

from supplying a product, i.e., the amount that a firm
receives from selling a good net of the minimum
amount the firm must receive to be willing to supply.
P ♦ The area under an ordinary
S supply curve: the cost from
P* certain production
♦ The area under the market
price and above an ordinary
supply curve provides a
measure of producer surplus.

Q
Q*
 The Discrete Case
Price Supply

Suppose there are 4 types of

construction firms with different
technology to build houses and each
1.2 can build only 1 house a year:

1.0 Type 1 has MC=0.6 million

Type 2 has MC=0.8 million
0.8 Type 3 has MC=1.0 million
Type 4 has MC=1.2 million
0.6

1 2 3 4 Quantity
 The Discrete Case
Price Supply

2.0

1.2 Suppose the market price is 2 million.

1.0
Total Producer Surplus is the value
received net of the cost.
0.8 PS= (2-0.6) + (2-0.8) + (2-1.0) + (2-1.2)
= 4.4 million
0.6

1 2 3 4 Quantity
 The Continuous Case Revenue
from 4
units
=2x4
= 8 million
Price $
Producer
Surplus
2.0
= 8 - 5.2
= 2.8
1.2

1.0

0.8 Cost of 4 units

= (0.6+2)*4/2
=5.2 million
0.6

1 2 3 4 Quantity
Takeaway

The general principle for a seller to maximize profit is

to set MR=MC.
In competitive markets, a seller faces a perfectly
elastic demand.
In the short run, it is optimal for a firm to shut down
if the loss is lower than the loss of operating.
In the long run, sellers in competitive markets can
only earn zero economic profit.