perfect competition chapter 14-2. profit maximizing and shutting down
TRANSCRIPT
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Perfect Competition
Chapter 14-2. Profit Maximizing and Profit Maximizing and Shutting DownShutting Down
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Profit-Maximizing Level of Output• The goal of the firm is to maximize
profits.
• Profit is the difference between total revenue and total cost.
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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.
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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.
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Marginal Revenue
• A perfect competitor accepts the market price as given.
• As a result, marginal revenue equals price (MR = P).
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Marginal Cost
• Initially, marginal cost falls and then begins to rise.
• Marginal concepts are best defined between the numbers.
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Profit Maximization: MC = MR
• To maximize profits, a firm should produce where marginal cost equals marginal revenue.
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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.
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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.
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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.
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C
AP = D = MR
Costs
1 2 3 4 5 6 7 8 9 10 Quantity
60
50
40
30
20
10
0
AB
MC
Marginal Cost, Marginal Revenue, and Price
0123456789
10
$28.0020.0016.0014.0012.0017.0022.0030.0040.0054.0068.00
Price = MR Quantity Produced
Marginal Cost
$35.0035.0035.0035.0035.0035.0035.0035.0035.0035.0035.00
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
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Profit Maximization:Graphical Analysis
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Profit Maximization: The Numbers
Q P TR TC TR-TC MR MC ATC
0 $1 $0 $1.00 -$1.00 $1
1 $1 $1 $2.00 -$1.00 $1 $1.00 $2.00
2 $1 $2 $2.80 -$0.80 $1 $0.80 $1.40
3 $1 $3 $3.50 -$0.50 $1 $0.70 $1.17
4 $1 $4 $4.00 $0.00 $1 $0.50 $1.00
5 $1 $5 $4.50 $0.50 $1 $0.50 $0.90
6 $1 $6 $5.20 $0.80 $1 $0.70 $0.87
7 $1 $7 $6.00 $1.00 $1 $0.80 $0.86
8 $1 $8 $6.86 $1.14 $1 $0.86 $0.86
9 $1 $9 $7.86 $1.14 $1 $1.00 $0.87
10 $1 $10 $9.36 $0.64 $1 $1.50 $0.94
11 $1 $11 $12.00 -$1.00 $1 $2.64 $1.09
MR=MCMR=MC
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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.
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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.
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The Marginal Cost Curve Is the Firm’s Supply Curve
A
B
CMarginal cost
Cos
t, P
rice
$70
60
50
40
30
20
10
0 1 Quantity2 3 4 5 6 7 8 9 10
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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.
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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.
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TC TR
0
Tot
al c
ost,
rev
enue
$385350315280245210175140105
7035
Quantity1 2 3 4 5 6 7 8 9
Profit Determination Using Total Cost and Revenue Curves
Maximum profit =$81
$130
Loss
Loss
Profit
Profit =$45
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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.
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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.
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Costs Relevant to a Firm
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
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Costs Relevant to a Firm
McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
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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.
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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.
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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.
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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.
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(a) Profit case (b) Zero profit case (c) Loss case
Determining Profits Graphically
Quantity Quantity Quantity
Price65 60 55 50 45 40 35 30 25 20 15 10
5 0
65 60 55 50 45 40 35 30 25 20 15 10
5 01 2 3 4 5 6 7 8 9 10 12 1 2 3 4 5 6 7 8 9 10 12
D
MC
A P = MR
B ATCAVC
E
Profit
C
MC
ATC
AVC
MC
ATC
AVC
Loss
65 60 55 50 45 40 35 30 25 20 15 10
5 0 1 2 3 4 5 6 7 8 910 12
P = MRP = MR
Price Price
© The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-Hill
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Loss MinimizationAverage cost of a unit of outputAverage cost of a unit of output
Revenue Revenue generated by a generated by a unit of outputunit of output
Market Market price price fallsfalls
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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.
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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.
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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.
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MC
P = MR
2 4 6 8 Quantity
Price
60
50
40
30
20
10
0
ATC
AVC
Loss
A$17.80
The Shutdown Decision
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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.
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Profit Maximizing Level of Output
• Marginal revenue (MR) is the change in total revenue associated with a change in quantity
• A firm maximizes profit when marginal revenue equals marginal cost
• The goal of the firm is to maximize profits, the difference between total revenue and total cost
• Marginal cost (MC) is the change in total cost associated with a change in quantity
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Profit Maximizing Level of Output
If MR < MC, • a firm can increase profit by decreasing its output
If MR > MC, • a firm can increase profit by increasing 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
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Marginal Cost, Marginal Revenue, and Price Graph
P
Q
Marginal Cost
$35 P = D = MR
MC < P, increase output to
increase total profit
MC = P at 8 units,total profit is maximized
MC > P, decrease output to increase total profit
MC = P
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The Marginal Cost Curve is the Supply Curve
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
PMarginal
Cost
$35
Q
$19.50
$61
86 10
Firm’s Supply Curve=
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Profit Maximization using Total Revenue and Total Cost
• Total cost is the cumulative sum of the marginal costs, plus the fixed costs
• An alternative method to determine the profit-maximizing level of output is to look at the total and total cost curves
• Total profit is the difference between total revenue and total cost curves
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Total Revenue and Total Cost Table
Total Cost, Total Revenue TC
$175
Q
$130
$280
85
TR The total revenue curve is a straight line
The total cost curve is bowed upward at most
quantities reflecting increasing marginal cost
Max profit = $81 at 8 units of
output
3
Losses LossesProfits
Profits are maximized when the vertical
distance between TR and TC is greatest
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Determining Profits Graphically: A Firm with Profit
AVC
MC
Q
P
ATC
Find output where MC = MR, this is the profit maximizing Q
P = D = MR
MC = MR
Qprofit max
Find profit per unit where the profit max Q
intersects ATC
ATC at Qprofit max
P
ATCProfits
Since P>ATC at the profit maximizing quantity, this firm is earning profits
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Determining Profits Graphically: A Firm with Zero Profit or Losses
AVC
MC
Q
P
ATC
MC = MR
Qprofit max
ATC at Qprofit max
P =ATC
P = D = MR
Since P=ATC at the profit maximizing quantity,
this firm is earning zero profit or loss
Find output where MC = MR, this is the profit maximizing Q
Find profit per unit where the profit max Q
intersects ATC
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Determining Profits Graphically: A Firm with Losses
AVC
MC
Q
P
ATC
MC = MR
Qprofit max
ATC at Qprofit max
P
ATC P = D = MR
Since P<ATC at the profit maximizing quantity, this firm is earning losses
Find output where MC = MR, this is the profit maximizing Q
Find profit per unit where the profit max Q
intersects ATC Losses
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Determining Profits Graphically: The Shutdown Decision
AVC
MC
Q
P
ATC
Qprofit max
PShutdown
P = D = MR
• The shutdown point is the 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<min of AVC, the firm will shut down
• If a firm shuts down, it still has to pay its fixed costs
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Short-Run Market Supply and Demand
• The market (industry) supply curve is the horizontal sum of all the firms’ marginal cost curves
• 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
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ATCProfits
Short-Run Market Supply and Demand Graph
P
Q
Market Supply
P
Market Demand
P
Q
P P = D = MR
MC
ATC
Qprofit max
Market Firm
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