Profit Maximization

and Competitive
Supply
Perfectly Competitive Markets
Profit Maximization
Choosing Output in Short Run
Competitive Firms Short Run Supply Curve
 Competitive

?
What is

Market
 1PERFECTLY COMPETITIVE MARKETS

Perfectly Competitive Markets:

A large number of buyer and seller
Identical products sold by all firms
Freedom of entry into and exit out of the industry
Perfect knowledge of prices and technology

Each firm in a perfectly competitive market

sells an identical product, which is also
commonly termed "homogeneous goods." The
essential feature of this characteristic is that the
goods themselves are exactly, perfectly the same,
but that buyers are unable to discern any difference.
There are no brand names or distinguishing features
In perfect
that competition,
differentiate products buyers
by firm. are completely
aware of sellers' prices, such that one firm
cannot sell its good at a higher price than
other firms. Each seller also has complete
information about the prices charged by other
sellers. Perfect knowledge also extends to
technology. No firm can produce its output faster,
better, or cheaper because of special knowledge of
 1PERFECTLY COMPETITIVE MARKETS

Large number of buyer and seller each of which is

relatively small compared to the overall size of the
market. This ensures that no single entities can
exert market control over price or quantity. If one
firm decides to change the price or even stop
producing, the market is unaffected. The price overall
Perfectly
does competitive firms are free to enter
not change.
and exit an industry They are not restricted by
government rules and regulations, start-up cost, or
other barriers to entry. They can acquire whatever
labor, capital, and other resources that they need
without delay and without restrictions.

A large number of small firms

Identical products sold by all firms Price Taker!
Firm that has no influence
Perfect knowledge of prices and technology over market price and thus
takes the price as given
Freedom of entry into and exit out of the industry
1PERFECTLY COMPETITIVE MARKETS

Agricultural Marke
 1PERFECTLY COMPETITIVE MARKETS

Internet-Related Mark
 1PERFECTLY COMPETITIVE MARKETS

oreign Exchange Mark

 Why study the theory of

perfect competition
if no real-world market completely satisfies
all of the theory's assumptions?

The model of perfect competition acts as a

guideline where in an economy competition
increases efficiency in allocation of scarce
resources
 1PERFECTLY COMPETITIVE MARKETS

When is a market highly 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.
Concentration Ratio (CR) Herfindahl-Hirschman Index
The proportion of total output in (HHI)
an industry produced by the A measure of concentration of
four (CR4) or eight (CR8) largest the production in an industry
firms in an industry calculated as the sum of the
squares of market shares for
CR 0 each firm
50% 75-80% 100%
HHI 0 1000 1800 10000

Perfect Monopolisti Oligopoly Oligopoly Monopoly

Competit c (Medium (High
ion Concentrati Concentrati
on) on)
 2 PROFIT MAXIMIZATION
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.

The demand d curve facing an individual firm in a competitive market is both its AR curve and its MR
curve. Along this demand curve, MR, AR, and price are all equal.
 2 PROFIT MAXIMIZATION

Profit difference between total revenue and total cost

(q) = R(q) C(q)

Marginal Revenue Change in revenue resulting from a one-unit increase in output

Margina As long as marginal revenue

Total Margi Chan
Total Profi l exceeds marginal cost,
Q Revenu nal ge in
Cost t Revenu increasing output will raise profit
e Cost Profit
e
If marginal revenue is less than
0 $0 $3 $-3 - - -
marginal cost, the firm can
1 6 5 1 $6 $2 $4 increase profit by decreasing
output
2 12 8 4 6 3 3
3 18 12 6 6 4 2 Profit-maximization occurs
4 24 17 7 6 5 1 where marginal revenue is
equal to marginal
5 30 23 7 6 6 0
cost.
6 36 30 6 6 7 -1
7 42 38 4 6 8 -2
8 48 47 1 6 9 -3
 2 PROFIT MAXIMIZATION
Profit Maximization 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).

/q = R/q C/q = 0
MR(q) = MC(q)
2 PROFIT MAXIMIZATION

As a recent graduate of this university you

have landed a job in production
management. You are responsible for the
entire company on weekends

Quantity Average Total Cost

500 200
501 201

Your current level of production is 500 units.

All 500 units have been ordered by your
regular customers

The phone rings. Its a new customer who

wants to buy one unit of your product. This
means you would have to increase production
to 501 units. Your new customer offers you
$450 to produce the extra unit

Should you accept this offer?

 2 PROFIT MAXIMIZATION
Short Run Profit Maximization of a Competitive
MC(q) = MR = P
Firm
A Competitive Firm Making a
Positive Profit

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
 4 COMPETITIVE FIRMS SHORT RUN SUPPLY CURVE
THE

Firms Shut Down Decision

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.

Shut-Down Rule
The firm should shut down if the
price of the product is less than
the average variable cost of
production at the profit-
maximizing output.
 4 COMPETITIVE FIRMS SHORT RUN SUPPLY CURVE
THE

The firms supply curve is the portion of the

marginal cost curve for which marginal cost is
greater than average variable cost

The Short-Run Supply Curve for a

Competitive Firm

In the short run, the firm chooses

its output so that marginal cost MC
is equal to price as long as the firm
covers its average variable cost.

The short-run supply curve is given

by the crosshatched portion of the
marginal cost curve.
 4 COMPETITIVE FIRMS SHORT RUN SUPPLY CURVE
THE

Industry Supply in the Short Run

The short-run industry supply curve is the summation of the supply curves of the individual firms.

Because the third firm has a lower average variable cost curve than the first two firms, the market
supply curve S begins at price P1 and follows the marginal cost curve of the third firm MC 3 until price
equals P2, when there is a kink.

For P2 and all prices above it, the industry quantity supplied is the sum of the quantities supplied by
each of the three firms.
Profit Max & Competitive Market