Microeconomics ii
• Profit Maximization in a Perfectly Competitive Market • MC = MR • Economic vs. accounting profit • Supernormal profit • Shut down and exit decisions
Class content
• Firms are price takers • Firms can freely enter and exit the market • Main goal of firms: to maximize profit • Total revenue (TR) = P x Q • Total costs (TC) = FC + VC
Firms in competitive markets
a) Increase the price of the product
b) Increase the quantity of production
c) Reduce the cost of production
How can competitive firms increase profit?
NO
MAYBE
YES
The firm wants to produce the quantity that maximizes the difference between total revenue and total cost!
Profit maximization
Profit is maximized
when the firm produces 4-5 liters of milk
• If marginal revenue is greater than marginal cost, the firm should increase production
• If marginal revenue is less than marginal cost, the firm should decrease production
• Maximum profit: MR = MC
Profit maximization: comparing MR and MC
Profit is maximized
when the firm produces 4-5 liters of milk
Graphing the profit maximum
Price is determined
by the market and it is
constant!
MC curve = supply curve
• If market price rises, the firm increases the production along the marginal cost curve because in order to maximize profit MC = MR = P is necessary at all times
• Therefore, the marginal cost curve above ATC is he firm s supply curve!
Economic versus accounting profit
• Profit is equal to total revenue minus total cost. – To an economist, total cost includes all opportunity costs of the firm.
• Normal profits: When a firm is earning zero profit, this must mean that the firm's revenues are compensating the firm's owners for the time and money that they have expended to keep their businesses going.
• Supernormal profit: the profit above normal profit (positive profit). – Also called as abnormal profit!
Normal versus supernormal profit
• Shutdown: a short-run decision not to produce anything during a specific period of time because of current market conditions
• In the short run fixed costs are not avoidable in any case – Sunk cost: a cost that has already been committed and cannot be
recovered
• Determinants of a shutdown: – The firm shuts down if the revenue that it would get from producing
is less than its variable costs of production OR – if the price of the good is less than the average variable cost of
production TR < VC
P < AVC
Short-run decisions of a firm
Short-run decision on shutdown
• Exit: long-run decision to leave the market – A firm exits the market if the revenue it would get from producing is
less than its total costs OR – if the price of the good is less than the average total cost of
production
TR < TC P < ATC
• Entry is the opposite of exit: – A firm enters a market if it can produce with profit
TR > TC P > ATC
Long-run decisions of a firm on exit or entry
Long-run decision on exit/entry
• Assumptions – firms are price takers – freedom of entry – identical products – perfect knowledge
• Short-run equilibrium of the firm: P = MC • Possible supernormal profits when AR > ATC
– Profit = TR – TC = (PxQ) – TC = (AR - ATC)xQ • Possible short-run loss when AR < ATC
– Losses= TR – TC = (PxQ) – TC = (AR - ATC)xQ • Long-run equilibrium of the firm: P = ATC
Perfect competition
• Advantages: – P = MC – production at minimum ATC – only normal profits in long run – responsive to consumer wishes – competition generated efficiency – no point in advertising
• Disadvantages: – insufficient profits for investment – lack of product variety – lack of competition over product design and specification
Advantages and disadvantages of perfect competition
• You ve been hired as a management consultant to WaffleCo, a maker of generic-brand frozen waffles. They re each trying to figure out if they should produce a little more output or a little bit less in order to maximize their profits.
• The firms all have typical marginal cost curves: They rise as the firm produces more. Your staff did all the hard work for you of figuring out the price of the firm s output is $4 per box and the marginal cost of producing one more unit of output is $2 per box at its current level of output.
• However, they forgot to collect data on how much the firm is actually producing at the moment. Fortunately, that doesn t matter.
• In your final report, you need to decide if the firm should produce more, less, or stay at the current output level. What do you recommend?
Exercise 1.
P = 4 MC = 2 P > MC
Therefore the firm should produce more to maximize its profit!
Exercise 1 solution
MC < P
• The Hubble Bubble Company sells chewing gum in a competitive market. • Complete the table. • How much should the firm produce to maximize profit? • Should the firm consider to exit the market?
Exercise 2.
Quantity Total revenue
$
Total cost $
Profit Marginal revenue
Average total cost
Marginal cost
0 0 3 10 6 5 20 12 8 30 18 12 40 24 17 50 30 23 60 36 30
• Profit maximum for competitive firms: MC = MR = P • Profit: TR – TC • Supernormal profit: the profit above normal profit (positive
profit) – Possible supernormal profits when AR > ATC – Possible short-run loss when AR < ATC
• Shutdown: a short-run decision not to produce anything during a specific period of time because of current market conditions – TR < VC or P < AVC
• Exit: long-run decision to leave the market – TR < TC or P < ATC
Summary