Perfect Competition Chapter 14-2. Profit Maximizing and Shutting Down Profit-Maximizing Level of Output • The goal of the firm is to maximize profits. • Profit is the difference.
Download ReportTranscript Perfect Competition Chapter 14-2. Profit Maximizing and Shutting Down Profit-Maximizing Level of Output • The goal of the firm is to maximize profits. • Profit is the difference.
Perfect Competition
Chapter 14-2.
Profit Maximizing and Shutting Down
Profit-Maximizing Level of Output
• The goal of the firm is to maximize profits.
• Profit is the difference between total revenue and total cost.
Profit-Maximizing Level of Output
• What happens to profit in response to a change in output is determined by marginal revenue (
MR
) and marginal cost (
MC
).
• A firm maximizes profit when
MC
=
MR
.
•
Profit-Maximizing Level of Output
Marginal revenue
(
MR
) – the change in total revenue associated with a change in quantity.
•
Marginal cost
(
MC
) – the change in total cost associated with a change in quantity.
Marginal Revenue
• A perfect competitor accepts the market price as given.
• As a result, marginal revenue equals price (
MR = P
).
Marginal Cost
• Initially, marginal cost falls and then begins to rise.
• Marginal concepts are best defined between the numbers.
Profit Maximization:
MC = MR
• To maximize profits, a firm should produce where marginal cost equals marginal revenue.
How to Maximize Profit
• If marginal revenue does not equal marginal cost, a firm can increase profit by changing output.
• The supplier will continue to produce as long as marginal cost is less than marginal revenue.
How to Maximize Profit
• The supplier will cut back on production if marginal cost is greater than marginal revenue.
• Thus, the profit-maximizing condition of a competitive firm is
MC = MR = P
.
Again! MR=MC
• Profit is maximized when MR=MC.
– If the cost of producing one more unit is
less
than the revenue it generates, then a profit is available for the firm that increases production by one unit.
– If the cost of producing one more unit is
more
than the revenue it generates, then increasing production reduces profit.
Marginal Cost, Marginal Revenue, and Price
Price = MR Quantity Produced $35.00
35.00
35.00
35.00
35.00
35.00
35.00
35.00
35.00
35.00
35.00
0 1 2 3 4 5 6 7 8 9 10 Marginal Cost $28.00
20.00
16.00
14.00
12.00
17.00
22.00
30.00
40.00
54.00
68.00
Costs 60 50 40 30 20 10 0
A
A
B
C
MC P = D = MR
1 2 3 4 5 6 7 8 9 10 Quantity
© 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
McGraw-Hill/Irwin
Profit Maximization: Graphical Analysis
Profit Maximization: The Numbers
MR=MC
MC ATC Q
0 1 2 3 4 5 6 7 8
9
10 11
P
$1 $1 $1 $1 $1 $1 $1 $1 $1
$1
$1 $1
TR
$0 $1 $2 $3 $4 $5 $6 $7 $8
$9
$10 $11
TC
$1.00
$2.00
$2.80
$3.50
$4.00
$4.50
$5.20
$6.00
$6.86
$7.86
$9.36
$12.00
TR-TC
-$1.00
-$1.00
-$0.80
-$0.50
$0.00
$0.50
$0.80
$1.00
$1.14
$1.14
$0.64
-$1.00
MR
$1 $1 $1 $1 $1 $1 $1 $1 $1
$1
$1 $1 $1.00
$0.80
$0.70
$0.50
$0.50
$0.70
$0.80
$0.86
$1.00
$1.50
$2.64
$2.00
$1.40
$1.17
$1.00
$0.90
$0.87
$0.86
$0.86
$0.87
$0.94
$1.09
The Marginal Cost Curve Is the Supply Curve
• The marginal cost curve is the firm's supply curve above the point where price exceeds average variable cost.
The Marginal Cost Curve Is the Supply Curve
• The MC curve tells the competitive firm how much it should produce at a given price.
• The firm can do no better than produce the quantity at which marginal cost equals marginal revenue which in turn equals price.
The Marginal Cost Curve Is the Firm’s Supply Curve
Marginal cost $70 C 60 50
A
40 30 20
B
10 0 1 2 3 4 5 6 7 8 9 10 Quantity
Firms Maximize Total Profit
• Firms seek to maximize total profit, not profit per unit.
– Firms do not care about profit per unit.
– As long as increasing output increases total profits, a profit-maximizing firm should produce more.
Profit Maximization Using Total Revenue and Total Cost
• Profit is maximized where the vertical distance between total revenue and total cost is greatest.
• At that output,
MR
(the slope of the total revenue curve) and
MC
(the slope of the total cost curve) are equal.
Profit Determination Using Total Cost and Revenue Curves
McGraw-Hill/Irwin
$385 350 315 280 245 210 175 140 105 70 35 0 Maximum profit =$81 $130 Loss Loss Profit =$45 1 2 3 4 5 6 7 8 9
TC
Profit
TR
Quantity
© 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Total Profit at the Profit Maximizing Level of Output
• The
P = MR = MC
condition tells us how much output a competitive firm should produce to maximize profit.
• It does not tell us how much profit the firm makes.
Determining Profit and Loss From a Table of Costs
• Profit can be calculated from a table of costs and revenues.
• Profit is determined by total revenue minus total cost.
— 35.00
35.00
35.00
35.00
35.00
35.00
0 1 2 3 4 5 6 40.00
68.00
88.00
104.00
118.00
130.00
147.00
— 28.00
20.00
16.00
14.00
12.00
17.00
Average Total Cost — 68.00
44.00
34.67
29.50
26.00
24.50
Total Revenue 0 35.00
70.00
105.00
140.00
175.00
210.00
Profit TR-TC –40.00
–33.00
–18.00
1.00
22.00
45.00
63.00
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
35.00
35.00
35.00
35.00
35.00
35.00
35.00
6 7 4 5 8 9 10 118.00
130.00
147.00
169.00
199.00
239.00
293.00
14.00
12.00
17.00
22.00
30.00
40.00
54.00
Average Total Cost 29.50
26.00
24.50
24.14
24.88
26.56
29.30
Total Revenue 140.00
175.00
210.00
245.00
280.00
315.00
350.00
Profit TR-TC 22.00
45.00
63.00
76.00
81.00
76.00
57.00
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Determining Profit and Loss From a Graph
• Find output where
MC = MR
.
– The intersection of
MC = MR
(
P
) determines the quantity the firm will produce if it wishes to maximize profits.
Determining Profit and Loss From a Graph
• Find profit per unit where MC = MR.
– Drop a line down from where MC equals MR, and then to the ATC curve.
– This is the profit per unit.
– Extend a line back to the vertical axis to identify total profit.
Determining Profit and Loss From a Graph
• The firm makes a profit when the ATC curve is below the MR curve.
• The firm incurs a loss when the ATC curve is above the MR curve.
Determining Profit and Loss From a Graph
• Zero profit or loss where MC=MR.
– Firms can earn zero profit or even a loss where MC = MR.
– Even though economic profit is zero, all resources, including entrepreneurs, are being paid their opportunity costs.
Determining Profits Graphically
Price 65 60 55 50 45 40 35 30 25 20 15 10 5 0
C D
Profit
E A B MC
1 2 3 4 5 6 7 8 9 10 12 Quantity (a) Profit case Price
MC P = MR ATC AVC
65 60 55 50 45 40 35 30 25 20 15 10 5 0 Quantity (b) Zero profit case
ATC P = MR AVC
1 2 3 4 5 6 7 8 9 10 12 Price
MC
65 60 55 50 45 40 35 30 25 20 15 10 5 Loss (c) Loss case Quantity
ATC P = MR AVC
0 1 2 3 4 5 6 7 8 910 12
Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000
Loss Minimization
Average cost of a unit of output Market price falls Revenue generated by a unit of output
The Shutdown Point
• The firm will shut down if it cannot cover average variable costs. – A firm should continue to produce as long as price is greater than average variable cost.
– If price falls below that point it makes sense to shut down temporarily and save the variable costs.
The Shutdown Point
• The
shutdown point
is the point at which the firm will be better off it it shuts down than it will if it stays in business.
The Shutdown Point
• If total revenue is more than total variable cost, the firm’s best strategy is to temporarily produce at a loss.
• It is taking less of a loss than it would by shutting down.
The Shutdown Decision
MC
Price 60
ATC
50 40 30 Loss
P = MR AVC
20 $17.80
10 0 2 4 6
A
8 Quantity
Minimizing Loss
•
Shutdown price:
the minimum point of the average-variable-cost (AVC) curve.
•
Break-even price:
A price that is equal to the minimum point of the average-total cost (ATC) curve.
– At this price, economic profit is zero.
Profit Maximizing Level of Output
• The goal of the firm is to maximize profits, the difference between total revenue and total cost • • • A firm maximizes profit when marginal revenue equals marginal cost
Marginal revenue (MR)
is the change in total revenue associated with a change in quantity
Marginal cost (MC)
is the change in total cost associated with a change in quantity 14-35
Profit Maximizing Level of Output
• The profit-maximizing condition of a competitive firm is:
MR = MC
• For a competitive firm,
MR = P
• A firm maximizes total profit, not profit per unit If
MR > MC
, • a firm can increase profit by increasing output If
MR < MC
, • a firm can increase profit by decreasing its output 14-36
Marginal Cost, Marginal Revenue, and Price Graph P Marginal Cost $35 MC < P, increase output to increase total profit MC = P MC > P, decrease output to increase total profit P = D = MR Q MC = P at 8 units, total profit is maximized
14-37
The Marginal Cost Curve is the Supply Curve
P Marginal Cost = Firm’s Supply Curve $61 $35 $19.50
Because the marginal cost curve tells us how much of a good a firm will supply at a given price,
the marginal cost curve is the firm’s supply curve Q 6 8 10
14-38
Profit Maximization using Total Revenue and Total Cost
• An alternative method to determine the profit-maximizing level of output is to look at the total and total cost curves fixed costs 14-39
Total Revenue and Total Cost Table
Total Cost, Total Revenue
Max profit = $81 at 8 units of output
$280 TC TR
The total revenue curve is a straight line The total cost curve is bowed upward at most quantities reflecting increasing marginal cost
$175 $130
Losses
Profits
Losses
Q
Profits are maximized when the vertical distance between TR and TC is greatest
3 5 8
14-40
P ATC Determining Profits Graphically: A Firm with Profit P MC
Find output where MC = MR, this is the profit maximizing Q
MC = MR Profits ATC AVC P = D = MR
Find profit per unit where the profit max Q intersects ATC
ATC at Q profit max Since P>ATC at the profit maximizing quantity, this firm is earning profits Q profit max Q
14-41
Determining Profits Graphically: A Firm with Zero Profit or Losses P
Find output where MC = MR, this is the profit maximizing Q
MC
Find profit per unit where the profit max Q intersects ATC
Since P=ATC at the profit maximizing quantity, this firm is earning zero profit or loss P =ATC ATC MC = MR AVC P = D = MR ATC at Q profit max Q profit max Q
14-42
ATC P Determining Profits Graphically: A Firm with Losses P MC
Find output where MC = MR, this is the profit maximizing Q
ATC at Q profit max ATC AVC P = D = MR
Find profit per unit where the profit max Q intersects ATC
Losses MC = MR Q Since P
14-43
Determining Profits Graphically: The Shutdown Decision
• The shutdown point is the
P
point below which the firm will be better off if it shuts down than it will if it stays in business • If P>min of AVC, then the firm will still produce, but earn a loss • If P P Shut down Q profit max AVC MC ATC P = D = MR Q 14-44 • While the firm’s demand curve is perfectly elastic, the industry’s demand curve is downward sloping • The market supply curve takes into account any changes in input prices that might occur • The market (industry) supply curve is the horizontal sum of all the firms’ marginal cost curves 14-45 P P Short-Run Market Supply and Demand Graph Market P Firm MC Market Supply ATC P ATC Profits P = D = MR Market Demand Q Q profit max Q 14-46Short-Run Market Supply and Demand