Profit Maximization1. Perfectly Competitive Markets2. Profit Maximization3. Marginal Revenue, Marginal Cost, and Profit Maximization4. Maximizing Profits in the Short-Run5. Producer Surplus6. Maximizing Profits in the Long Run1Perfectly Competitive MarketsIt is essentially a market in which there is enough competition that itdoesn’t make sense to identify your rivals. There are so many competitorsthat you cannot single out any one of them as an opponent.Three Basic Assumptions1. price taking• A price taking consumer is a consumer whose actions have no effecton the market price of the good or service s/he buys.• A price taking producer is a producer whose actions have no effecton the market price of the good or service it sells.• In general, for producers and consumers to be price takers thereneeds to be many independent firms and consumers in the market,all of whom, believe that their decisions will not affect prices.• Further there needs to be full awareness by consumers of the pricescharged by all sellers in the market.22. product homogeneity• Firms must produce identical or nearly identical products. Thatis, the products of all the firms in market must be perfectly substi-tutable with one another.• If a firm were to raises its price above the market price, it would loseall its customers.• Consumers must regard the competing products as equivalent. AreCap’n Crunch a good substitute for Wheaties? Probably not. Sothe makers of Cap’n Crunch can increase prices without fear of losingall of its consumers to Wheaties.• Many firms go to great lengthes to convince consumers that theirproduct is different from seemingly identical products: (e.g. Cham-pagne versus methode Champenoise).• Are two products the same or different? Ultimately, it is the cus-tomer who decides.33. free entry and exit• We say there is free entry and exit into and from an industry whennew producers can easily enter into and leave an industry.• Thus it is easy to for a buyer to switch from one supplier to another.• There should be no obstacles in the form of government regulationsor limited access to to key resources to prevent new producers fromentering the market. (e.g. taxi cabs in NYC, prescription drugs)• There must also be no additional costs associated with shutting downand leaving an industry.4Profit Maximization• We usually assume firm managers with to maximize profits, that is thedifference between total revenue and total costs.• We draw a distinct between economic profits and accounting profitseconomic profits = sales revenue − economic costsaccount profits = sales revenue − accounting costs• Recall that economic costs include all relevant costs including opportu-nity costs.• Profit maximization is consistent with maximizing the market value(i.e. stock price) of the firm.5Marginal Revenue, Marginal Cost, and Profit Maximization• A firm’s profit is the difference between its revenue and its costs:π(q) = R(q) − C(q)whereπ(q) = profits (not the number 3.14!)R(q) = total revenueC(q) = total economic cost• If the firm is in a competitive market we assume the firm faces a hori-zontal demand curve. Since the firm is a price-taker, the choice of howto sell q has no effect on the price.In this case R(q) = p × q. It is a straight line.• If the firm can effect the price, we assume the firm faces a downward-sloping demand curve. At higher prices, the firm sell less output. Theprice it can charge depends negatively on the quantity it sells.In this case R(q) = p(q) × q and the revenue function is curved.6• Marginal revenue is the change in total revenue generated by an addi-tional unit of output. It is the slope of the revenue curve• Profits are maximized where the slope of the profit function is zero∆π(q)∆q=∆R(q)∆q−∆C(q)∆q= 0• This implies that the firm maximizes profits when the marginal revenueis equal to marginal cost.∆R(q)∆q=∆C(q)∆qMR = MC• Profit is maximized by producing the quantity of output at whichmarginal revenue of the last unit produced is equal to its marginalcost.7• For a firm in a perfectly competitive market (and thus facing a hori-zontal demand curve)MR = ptherefore at the profit maximizing quantityMC(q) = p• A price-taking firm cannot influence the market price by its actions.It always takes the market price as given because it cannot raise themarket price by selling less or lowering the market price by selling more.Thus the additional revenue from producing one more unit is just themarket price.• For the remainder of the lecture, we will assume the firm is operatingin a perfectly competitive market.8When is Production Profitable?• Whether or not a firm is profitable depends on whether the marketprice is more or less than the firm’s minimum average cost.• RecallIf R(q) > C(q) the firm is profitableIf R(q) = C(q) the firm breaks evenIf R(q) < C(q) the firm incurs a loss• Since in a perfectly competitive market R(q) = p × q, if we divide bothtotal revenue and total cost by q we get:If p > AT C the firm is profitableIf p = AT C the firm breaks evenIf p < AT C the firm incurs a loss• In other words:π(q) = R(q) − C(q)= (p − AT C) × q• As long as the market price is greater than the firm’s minimum averagetotal cost the firm will be profitable.9Maximizing Profits in the Short-Run• In the short-run we assume the firm’s capital input is fixed and mustvary its other inputs (labor and materials) to vary output.• In the short-run, even if the firm is unprofitable because the marketprice is below its minimum average total cost, the firm may want tostay in business and continue producing. Why?• Total cost includes fixed cost – cost that do not depend on the amountof output produced. In the short run, fixed cost must be paid, regardlessof whether the firm produces or not.• Since a fixed cost cannot be changed in short run and must be incurredwhether or not the firm produces, it is irrelevant to decision whether toproduce or not.10• Variable costs, however, do matter.• Figure 8.3• Profits are maximized at point A where MC = MR (which since weare in a perfectly competitive case is p.)• When the market price is below minimum average variable cost, theprice the firm receives is not covering its variable cost per unit. A firmin this situation should cease production immediately.– Why? Because there is no level of output at which the firm’s totalrevenue costs its total variable