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| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 1 |
8. Profit Maximization and Competitive
Supply
Literature: Pindyck und Rubinfeld, Chapter 8
Varian, Chapter 22, 23
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 2 |
Chapter Outline
• Perfectly Competitive Markets
• Profit Maximization
• Marginal Revenue, Marginal Cost, and Profit Maximization
• Choosing Output in the Short Run
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 3 |
Chapter Topics
• The Competitive Firm’s Short-Run Supply Curve
• The Short-Run Market Supply Curve
• The Long-Run Supply Curve
• The Industry’s Long-Run Supply Curve
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 4 |
Perfectly Competitive Markets
• Characteristics of Perfectly Competitive Markets
1) Price Taking
2) Product Homogeneity
3) Free Entry and Exit
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 5 |
Perfectly Competitive Markets
• Price Taking
– Because each individual firm sells a sufficiently small
proportion of total market output, its decisions have no
impact on market price.
– A single firm has no influence over market price and thus
takes the price as given.
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 6 |
Perfectly Competitive Markets
• Product Homogeneity
– When the products of all of the firms in a market are
perfectly substitutable with one another—i.e., when they
are homogeneous—no firm can raise the price of its
product above the price of other firms without losing most
or all of its business, e.g., agricultural products, copper,
iron, wood, etc.
– In contrast, when products are heterogeneous, each firm
has the opportunity to raise its price above that of its
competitors without losing all of its sales.
– The assumption of product homogeneity is important
because it ensures that there is a single market price,
consistent with supply-demand analysis.
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 7 |
Perfectly Competitive Markets
• Free Entry and Exit
– Condition under which there are no special costs that
make it difficult for a firm to enter (or exit) an industry.
– With free entry (exit), buyers can easily switch from one
supplier to another, and suppliers can easily enter or exit
a market.
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 8 |
Profit Maximization
• Do Firms Maximize Profit?
– Possible objectives
Maximize revenue
Maximize dividends
Short-run profit maximization
– Impact of other objectives other than maximizing profit
For smaller firms managed by their owners, profit is likely
to dominate almost all decisions. In larger firms, however,
managers who make day-to-day decisions usually have
little contact with the owners.
Firms that do not come close to maximizing profit are not
likely to survive. The firms that do survive make long-run
profit maximization one of their highest priorities.
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 9 |
Marginal Revenue, Marginal Cost, and Profit Maximization
• Determining the profit maximizing output decision for
any firm:
Suppose that the firms output is q.
– Revenue (R) = P * q.
– Cost (C) = C * q.
– Hence, Profit ( ) = (total) revenue – (total) cost :
( ) ( ) ( )q R q C q
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 10 |
Profit Maximization in the Short-Run
0
Cost,
revenue,
profit
(€ per year)
Output (units per year)
R(q) Total revenue
Slope of R(q) = MR
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 11 |
Profit Maximization in the Short-Run
0 Output (units per year)
C(q)
Total cost
Slope of C(q) = MC
Why is the cost curve positive when output is zero?
Cost,
revenue,
profit
(€ per year)
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 12 |
Marginal Revenue, Marginal Cost, and Profit Maximization
Marginal revenue: change in revenue resulting from a one-
unit increase in output.
Marginal costs: increase in cost resulting from the
production of one extra unit of output.
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 13 |
Marginal Revenue, Marginal Cost, and Profit Maximization
• Comparing R(q) and C(q)
– Production level: 0-q0
C(q)> R(q)
– Negative
revenue
FC + VC > R(q)
MR > MC
– Indicates higher
revenue with
higher output. 0
Cost,
revenue,
profit
(€ per year)
Output (units per year)
R(q)
C(q)
A
B
q0 q*
)(q
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 14 |
Marginal Revenue, Marginal Cost, and Profit Maximization
• Comparing R(q) and C(q)
– Production levels: q0 - q*
R(q)> C(q)
MR > MC
– Indicates higher revenue with higher output
– Revenue increases
R(q)
0
Output (units per year)
C(q)
A
B
q0 q*
)(q
Cost,
revenue,
profit
(€ per year)
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 15 |
Marginal Revenue, Marginal Cost, and Profit Maximization
• Comparing R(q) and C(q)
– Production level: q*
R(q)= C(q)
MR = MC
Revenue is
maximized
R(q)
0
Output (units per year)
C(q)
A
B
q0 q*
)(q
Cost,
revenue,
profit
(€ per year)
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 16 |
Marginal Revenue, Marginal Cost, and Profit Maximization
• Question
– Why does the profit
decrease when
more(less) than q* is
produced? R(q)
0
Output (units per year)
C(q)
A
B
q0 q*
)(q
Cost,
revenue,
profit
(€ per year)
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 17 |
Marginal Revenue, Marginal Cost, and Profit Maximization
• Comparing R(q) and C(q)
– Production level above q*:
R(q)> C(q)
MC > MR
Profit
decreases.
R(q)
0
Output (units per year)
C(q)
A
B
q0 q*
)(q
Cost,
revenue,
profit
(€ per year)
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 18 |
Marginal Revenue, Marginal Cost, and Profit Maximization
• Consequently, we can say
– Profit is maximized
when
MC = MR. R(q)
0
Output (units per year)
C(q)
A
B
q0 q*
)(q
Cost,
revenue,
profit
(€ per year)
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 19 |
Marginal Revenue, Marginal Cost, and Profit Maximization
R - C
dC or MC=
dq
CMC
q
dR or MR=
dq
RMR
q
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 20 |
Marginal Revenue, Marginal Cost, and Profit Maximization
0, so thatMR MC
MR(q) MC(q)
Thus we conclude that profit is maximized when
𝑑𝜋
𝑑𝑞=
𝑑𝑅
𝑑𝑞−
𝑑𝐶
𝑑𝑞= 0 𝑟𝑒𝑠𝑝𝑒𝑐𝑡𝑖𝑣𝑒𝑙𝑦
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 21 |
Marginal Revenue, Marginal Cost, and Profit Maximization
• The Competitive Firm
– Price taker.
– Denote the market output and firm output by (Q) & (q) respectively.
– Denote the market demand and firm demand by (D) & (d) respectively.
– The demand curve d facing an individual competitive market is given by a horizontal line because p is constant.
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 22 |
Demand and Marginal Revenue for a Competitive Firm
Output
Price
€
Output
d 4
100 200 100
Firm Industry
D
4
q Q
Price
€
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 23 |
Marginal Revenue, Marginal Cost, and Profit Maximization
• The competitive firm
– The demand of competitive firms
Regardless of the production level, the individual producer
sells all units at a price of €4.
If the producer tries to increase the price, sales decrease
to zero.
If the producer tries to lower the price, he can not increase
his sales.
P = MC = MR = AR
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 24 |
Marginal Revenue, Marginal Cost, and Profit Maximization
• The competitive firm
– Profit maximization
MC(q) = MR = P
Therefore a perfectly competitive firm should choose
its output so that marginal cost equals price:
»Price = Marginal costs
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 25 |
Short-Run Profit Maximization by a Competitive Firm
q0
Lost profit for
q1 < q* Lost profit for
q2 > q*
q1 q2
10
20
30
40
Price
(€per unit)
0 1 2 3 4 5 6 7 8 9 10 11
50
60 MC
AVC
ATC AR=MR=P
Output q*
At q*: MR = MC
and P > ATC
* (P - ATC) * q
or ABCD
D A
B C
q1 : MR > MC and
q2: MC> MR and
q0: MC = MR but
MC is decreasing
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 26 |
A Competitive Company that Generates Losses
Would this producer
continue to produce
despite a loss?
Output
AVC
ATC MC
q*
P = MR
B
F
C
A
E
D At q*: MR = MC
and P < ATC
Losses =
(P- ATC) * q* or
ABCD
Price
(€per unit)
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 27 |
Choosing Output in the Short-Run
• Summing up the production decision
– Profit is maximized when MC = MR.
– If P > ATC, the firm makes profits.
– If AVC < P < ATC, the firm should continue to produce
despite a loss.
– If P < AVC < ATC, the firm should shut down.
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 28 |
The Competitive Firm‘s Short-Run Supply Curve
Output
MC
AVC
AC
P = AVC What happens if
P < AVC?
P2
q2
P1
q1
In the short run, the firm chooses its output so that marginal cost
MC is equal to price as long as the firm covers its average
variable cost.
Price
(€per unit)
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 29 |
The Competitive Firm‘s Short-Run Supply Curve
• Remark:
– P = MR
– MC = MR
– P = MC
• The supply curve of the company indicates the quantity of
goods produced at any price. Therefore,
– if P = P1, then q = q1.
– If P = P2, then q = q2.
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 30 |
The Competitive Firm‘s Short-Run Supply Curve
MC
Output
AVC
ATC
P = AVC
P1
P2
q1 q2
P = MC above AVC
Shut down
Price
(€ per unit)
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 31 |
The Firm’s Response to an Input Price Change
• The response of a firm to a change in input price:
– When the marginal cost of production increases (from
MC1 to MC2), the level of output that maximizes the profit
falls (from q1 to q2).
– When the price of its product changes, the firm changes
its output level to ensure that marginal cost of production
remains equal to price.
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 32 |
The Firm‘s Response to an Input Price Change
MC2
q2
When the marginal
cost of production for
a firm increases (from
MC1 to MC2), the level
of output that
maximizes profit falls
(from q1 to q2).
MC1
q1 Output
5
Savings of
the company
by reducing
quantity
produced
Price
(€ per unit)
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 33 |
The Short-Run Market Supply Curve
MC3
0 2 8 10 5 7 15 21
MC1
S
The short-run industry supply curve is the summation of
the supply curves of the individual firms.
Quantitiy
MC2
P1
P3
P2
As price rises, all firms expand
their output. This additional
output increases the demand for
inputs to production and may lead
to higher prices. What influence
does this increase have on the
industry's supply ?
Price
(€per unit)
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 34 |
Producer Surplus in the Short Run
• Producer surplus in the short run
– If marginal cost is rising, the rice of the product is greater
than the marginal cost for every unit produced except the
last one. As a result, firms earn surplus on all but the last
unit of output.
– Producer surplus of a firm is the sum of over all units
produced of the differences between the market price of
the good and the marginal cost of production.
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 35 |
Producer Surplus in the Short-Run
A
D
B
C
Producer Surplus
Alternatively, VC is the sum of MC,
respectively 0DCq*. R is equal to P x q*,
respectively 0ABq*. Producer surplus =
R– AC respectively ABCD.
Price
(€ per unit
of output)
Output
AVC MC
0
Price = MR
q*
In q* MC = MR.
Between 0 and q
MR > MC for all units.
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 36 |
Producer Surplus in the Short-Run
• Producer surplus in the short run
Producer Surplus PS R - VC
Profits R - VC - FC
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 37 |
Producer Surplus for a Market
D
P*
Q*
Producer Surplus
The producer surplus for a
market is the area below the
market price and above the
market supply curve, between
output levels 0 and Q*.
Price
(€ per unit
of output)
Output
S
0
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 38 |
Choosing Output in the Long-Run
• In the long-run, a firm can alter all its inputs, including plant
size.
• We assume that there is free entry and exit into and out of
the market.
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 39 |
Choosing Output in the Long-Run
q1
A
B C
D
Price
(€ per unit
of output)
Output
P = MR €40
SAC
SMC
In the long run the size of production would be expanded to the
output q3. Long-run profit EFGD > short run profit ABCD.
q3 q2
G F
€30
LAC
E
LMC
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 40 |
Choosing Output in the Long-Run
q1
A
B C
D
Price
(€ per unit
of output)
Output
P = MR €40
SAC
SMC
If the price drops to €30, profits are zero
q3 q2
G F
€30
LAC
E
LMC
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 41 |
Choosing Output in the Long-Run
• Zero profit means that the firm is earning a normal-i.e.,
competitive-return on its investment.
– if E > wL + rK, the economic profit is positive.
– if E = wL + rK, economic profit is zero, but the firm
makes normal rate of return indicating that the firm is
competitive.
– if E < wL + rK, the firm should consider shutting
down.
Long-Run Competitive Equilibrium
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 42 |
Choosing Output in the Long-Run
Market Entry and Market Exit
– The long-run response to short-run profits is by
increasing the quantity of goods produced.
– High returns cause investors to enter a certain
market.
– Eventually the increased production associated
with new entry causes the market supply curve
to shift to the right. As a result, market output
increases and the market price of the product
falls.
Long-Run Competitive Equilibrium
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 43 |
Long-Run Competitive Equilibrium
S1
Output Output
$40 LAC
LMC
D
S2
P1
Q1 q2
Firm Industry
$30
Q2
P2
•Profits attract firms
•Supply increases until profit = 0 Price
(€ per unit
of output) Price
(€ per unit
of output)
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 44 |
Choosing Output in the Long-Run
• Long-Run Market Equilibrium: all firms in an industry are
maximizing profit, no firm has an incentive to enter or exit,
and price is such that quantity supplied equals quantity
demanded.
1) MC = MR
2) P = LAC
There is no incentive to enter or leave the market.
Profits = 0
3) Market Equilibrium Price
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 45 |
Choosing Output in the Long-Run
Economic Rent
Amount that firms are willing to pay for an input less the
minimum amount necessary to obtain it.
• In competitive markets, in both the short and the long run,
economic rent is often positive even though profit is zero.
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 46 |
Choosing Output in the Long-Run
• Example
– Two firms A & B
– Both own their land outright; so that the cost of owning the
land is zero
– A is located on a river and can ship its product for €10,000 a
year less than firm B, which is inland.
– In this case, the €10,000 higher profit of firm A is due to
€10,000 per year economic rent associated with its river
location. The rent is created because the land along the
river is valuable and other firms would be willing to pay for it.
– Due to an increase in the demand for riverfront property,
the price of A’s property increases by €10,000.
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 47 |
Choosing Output in the Long-Run
• An Example
– Economic rent = €10,000
€10,000 – (no costs due to owning the property)
– The economic rent increases.
– Economic profits decrease to zero.
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 48 |
Firms Earn Zero Profit in Long-Run Equlibrium
Ticket
price
ticket sales
(100,000)
LAC
€7
1.0
A football team in a moderate-sized city
sells enough tickets so that the price (€7) is equal
to the long-run marginal and average costs (profit = 0).
LMC
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 49 |
Firms Earn Zero Profit in Long-Run Equlibrium
1.3
€10
Economic Rent
Ticket
price
€7
LAC
A team with the same
cost curve, but in a
larger city, sells tickets
can afford to sell tickets
for € 10.
Season ticket
sales (in100.000)
LMC
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 50 |
Firms Earn Zero Profit in Long-Run Equlibrium
• For a fixed input, e.g., the difference between production
costs (LAC = 7) and price (€ 10) corresponds to the value
of the opportunity cost of the input (the site/location) and
also represents the economic rent from the input.
• When the opportunity cost associated with owning the
franchise is taken into account, the team earns zero
economic profit : Economic profit = zero
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 51 |
Effect of an Output Tax t on a Competitive Firm‘s Output
Price
(€ per unit
of output)
Output
AVC1
MC1
P1
q1
The firm will reduce
its output to the
point at which the
marginal cost plus
the tax is equal to
the price of the
product.
q2
t
MC2 = MC1 + tax
AVC1+ tax An output tax raises
the firm’s marginal
cost curve by the
amount of the tax.
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 52 |
Effect of an Output Tax t on Industry Output
Output
D
P1
S1
Q1
P2
Q2
S2 = S1 + t
t An output tax shifts the
supply curve from S1 to
S2; this raises the market
price of the product to P2
and lowers the total output
of the industry to Q2.
Price
(€ per unit
of output)
| 06.06.2017 | Prof. Dr. Kerstin Schneider| Chair of Public Economics and Business Taxation | Microeconomics| Chapter 8 Slide 53 |
For discussion…
Ergo: Job cuts despite record profits (ver.di online)
12 March 2013 | Ver.di criticized the planned and ongoing job cuts at the Ergo
insurance group that were being carried out despite record profits. Ergo is part of the
Munich Reinsurance Company Munich Re, which recorded gains of € 3.2 billion last
year.
According to ver.di, Federal President Beate Mensch opined that a reduction in the
number of employees at Ergo is not justified in view of the profits of Munich Re. A
company with such profitability is not justified in jeopardizing the employment of its
employees. The trade union called on the Ergo board to carry out a turnaround in the
ongoing negotiations with the works councils for approximately 1,500 employees
affected by the job cuts.
Ver.di also rejects an increase in the dividend from €6.25 to €7.00. Almost half of the
funds—which would normally be paid to shareholders as dividends—could stop the
staff cuts or at least postpone them until many of the employees had been
transferred into the pension plan.
Beate Mensch also criticized the fact that the remuneration of the Supervisory Board
was going to be increased. This is difficult to understand in light of the lay-offs.