Profit Maximization in Perfectly Competitive Markets, Study notes of Marketing

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Perfect Competition--Perfect Competition--AA

Model of MarketsModel of Markets

Econ Dept, UMR

Presents

StarringStarring

u uThe Perfectly CompetitiveThe Perfectly Competitive

FirmFirm

u uProfit Maximizing DecisionsProfit Maximizing Decisions

\ \ In the Short RunIn the Short Run

\ \ In the Long RunIn the Long Run

Part II: Profit Maximization in thePart II: Profit Maximization in the

Short RunShort Run

u u First, we define some termsFirst, we define some terms

u u Second, we explore the MR = MC ruleSecond, we explore the MR = MC rule

u u Third, we look at theThird, we look at the

vv The BreakThe Break--even point, andeven point, and vv (^) The Shut down pointThe Shut down point

Reminders...Reminders...

u u Firms operate in perfectlyFirms operate in perfectly

competitive output and inputcompetitive output and input

marketsmarkets

u u In perfectly competitive industries,In perfectly competitive industries,

prices are determined in the marketprices are determined in the market

and firms are price takersand firms are price takers

u u The demand curve for the firmThe demand curve for the firm’’ss

product is perceived to be perfectlyproduct is perceived to be perfectly

elasticelastic

Marginal RevenueMarginal Revenue

u u Marginal Revenue is the change inMarginal Revenue is the change in

revenue from selling one more, or onerevenue from selling one more, or one

less unitless unit

u u If the firm gets price p* for every unit itIf the firm gets price p* for every unit it

sells,sells,^ as it does in perfect competitionas it does in perfect competition ,,

then p* is the marginal revenue at allthen p* is the marginal revenue at all

quantitiesquantities

vv MR =MR = ∆∆ in TR /in TR /∆∆ in Qin Q

u u Horizontal Demand Curve means,Horizontal Demand Curve means,

vv MR = PMR = P

Demand Curve, d, as seen by theDemand Curve, d, as seen by the

price taking firmprice taking firm

$

0

p*

q/t

d d

Profit MaximizationProfit Maximization

uu^ We assume that the firm is profitWe assume that the firm is profit

maximizingmaximizing

uu^ Profit = Total Revenue -Profit = Total Revenue- Total CostTotal Cost

uu^ Total Revenue is P x qTotal Revenue is P x q

uu Profit maximization means cost ofProfit maximization means cost of

producing any output is minimizedproducing any output is minimized

v v The input mix is such that MPThe input mix is such that MPii/P/Pii = MP= MPjj/P/Pjj for all variable inputs i and j used for all variable inputs i and j used v v The cost curves drawn are the lowestThe cost curves drawn are the lowest possiblepossible

Consider the following data for a firm

q TFC TVC MC P=MR TR TC TR-TC 0 $55 $ 0 $-- $ 40 1 55 45 40 2 55 65 40 3 55 70 40 4 55 80 40 5 55 95 40 6 55 120 40 7 55 155 40 8 55 200 40

Can you fill in the missing

columns?

Profit MaximizingProfit Maximizing

uu^ Since the perfectly competitive firmSince the perfectly competitive firm

cannot choose the price, the only choicecannot choose the price, the only choice

left for the firm is to choose how muchleft for the firm is to choose how much

to produce.to produce.

uu^ The firm will choose the quantity whereThe firm will choose the quantity where

TR-TR-TC is the largest, in other wordsTC is the largest, in other words --

where the difference between the TRwhere the difference between the TR

and TC curves is the biggestand TC curves is the biggest

Profit Maximized when TRProfit Maximized when TR

and TC are furthest apartand TC are furthest apart

TC TR $

q* q/t

(^5555)

(^280280)

(^210210)

= 7= 7

Profit Max without CalculusProfit Max without Calculus

q/t

$ MC

MR

q 1 q 2 q 3 q 4

Profit MaximizingProfit Maximizing

uu^ Consider the quantity qConsider the quantity q 11

uu^ At qAt q 11 MR>MC. ThisMR>MC. This means that themeans that the additional revenue fromadditional revenue from selling one more isselling one more is greater than the cost ofgreater than the cost of making one more.making one more.

uu^ This means the firm willThis means the firm will make more profit bymake more profit by making one more, somaking one more, so they willthey will

uu^ The same is true at qThe same is true at q 22

q/t

$ (^) MC

MR

q 1 q 2 q 3 q 4

Profit MaximizingProfit Maximizing

uu And at qAnd at q 44 , MR<MC., MR<MC. This means that itThis means that it costs more to makecosts more to make one more than it willone more than it will bring in when it isbring in when it is soldsold

uu^ This means the firmThis means the firm will lose moneywill lose money

uu^ So the firm wouldSo the firm would want to decreasewant to decrease production to bringproduction to bring MC downMC down

q/t

$ (^) MC

MR

q 1 q 2 q 3 q 4

The Golden RuleThe Golden Rule

uu^ A profit maximizing firm will alwaysA profit maximizing firm will always

produce where MC=MRproduce where MC=MR

uu^ In the case of Perfect Competition, weIn the case of Perfect Competition, we

know MR=P, so we could also say thatknow MR=P, so we could also say that

a profit maximizing firm producesa profit maximizing firm produces

where P=MCwhere P=MC