Study Unit 8Profit maximisation and

competitive supply

Outcomes• Define perfectly competitive markets• Define profit-maximisation position of

the firm• Define and relate marginal revenue,

marginal cost and profit maximisation• Derive short-run market supply curve• Define, describe and illustrate output

decisions in the SR and LR• Derive the long-run market supply

curve

FOUR DIFFERENT MARKTETS

• Markets:– Perfect competition– Monopoly– Monopolistic competition– Oligopoly

• Distinctions based on:– Number of firms in market– Nature of the product – homogeneous or different– Accessibility of market– Control of individual firm over prices

CHARACTERISTICS OF MODELS

PERFECT COMPETITION

• Underlying analysis: Model of perfect competition useful to study various markets.

• Consist of buyers and sellers for a specific goods and services.

• Competition on both sides of the market.• No individual buyer or seller can have an influence

on market price because contribution is too small.• Market price determined by interaction between

demand and supply.

CHARACTERISTICS

• PRICE TAKING: Many buyers and sellers – each participant small in relation to the market.

• PRODUCT HOMOGENEITY: Products perfectly substitutable with one another.

• FREE ENTRY OR EXIT: – Production factors mobile – move freely.– Total freedom of entry and exit.

• No government intervention.• No collusion between sellers – acts independent.

EXAMPLES

• Agriculture: Farmers• Financial markets

Highly competitive market

• Perfectly competitive: – A perfectly horizontal demand curve – For a homogeneous product in industry – With free entry or exit.

• No simple indicator to indicate a highly competitive market.

Profit maximisation

• More is better!– Consumer max utility– Firm max profit

• Differ in small and large firms:– Small firm: Focus on profits– Larger firm: Manager concerned with daily

decisions, revenue max, revenue growth or payment of dividends

Marginal revenue, Marginal cost and profit maximisation

• Profit = Total revenue – Total cost∏(q) = R(q) – C(q)

• Revenue = Price of product * units soldR = Pq

• ∏, R and C depend on q.• To max profit, firm choose output where the

difference between revenue and cost the greatest

Marginal revenue, Marginal cost and profit maximisation

• R(q): Curved line – Sell more by lowering price.

• Slope of R(q) = marginal revenue

• MR(q): Change in revenue resulting from one-unit increase in output.

Marginal revenue, Marginal cost and profit maximisation

• C(q): Slope of curve measure additional cost of producing one additional unit of output = Marginal cost.

• C(q) = positive at 0 = Fixed cost.• Profit negative at low output levels• At q*: Profit max output level, thereafter cost

rise and profit decline.• RULE: Profit max where MR = MC

Marginal revenue, Marginal cost and profit maximisation

• For the competitive firm:P = MR = MC

Price taker = Horizontal demand curve for the firm.Downward sloping for the

industry.

Choosing output in the SR

• SR, firm will operate with fixed capital and choose labour

• RULE: If a firm is producing any output, it should produce at a level where MR = MC

Choosing output in the SR

Choosing output in the SR

Competitive firm’s SR supply curve

• Supply: How much output possible at every possible price.– Increase output where P = MC– Shut down if P < AVC

• Supply curve: Portion of the MC curve for which MC > AVC

Competitive firm’s SR supply curve

Response of firm to change in input price

SR market supply curve

• Shows the amount of output that the industry will produce in the SR for every possible price

• Industry output = Sum of individual firm’s quantity supplied

SR market supply curve

• Not always easy to determine the supply curve.

• Price elasticity of market supply: Measure sensitivity of industry output to market price

Es = (∆Q/Q)/(∆P/P)• SR elasticity of supply always positive.• IF MC increase rapidly, elasticity is low.• IF MC increase slow, supply elastic – firm

produce more.

Producer surplus in SR

• Sum over all units produced by a firm of differences between the market price of a good and the MC of production.

Producer surplus for a market

Producer surplus vs. Producer profit

• Surplus closely related to profit.• SR, surplus = Revenue – Variable cost =

Variable profitPS = R – VC

• Total profit = Revenue – All costs∏ = R – VC – FC

Choosing output in the LR

• LR, exit industry or produce new products

• Remember: Free entry/exit• SR firm: Horizontal demand curve• ABCD = Positive profit• LAC reflect economy of scale at q2

and diseconomy of scale higher up

• If price remain $40, increase plant to produce at q3 = Profit EFGD

• More than q3: MC > MR – NO!• If fall to $30 = 0 profit.

LR competitive equilibrium

LR competitive equilibrium

• LR competitive equilibrium: All firms in industry are at max profit, no incentive to enter or exit, price is such that supply = demand

• Economic rent: Amount firm is willing to pay for an input less the minimum amount necessary to obtain itExample: 2 owned locations. 1 Next to river and can ship in inputs rather than transport on land.

0 Profit and Economic rent

Industry LR supply curve

• Can’t analyse as with SR.• Need to know input price = increase, decrease or

stay the same.• We study:

– Constant cost industries– Increasing cost industries– Decreasing cost industries

• Keep in mind: Is input price increase, decrease or remain constant after an increase in demand – higher profits are made, new firms join the industry.

Constant cost industry

Increasing cost industry

Effects of an output tax

• Tax on output• Pollutant tax

Effects of an output tax