Microeconomics Third Edition

Chapter 12 Perfect Competition and the Supply Curve

Copyright © 2013 by Worth Publishers

Paul Krugman and Robin Wells

Part 2: Profits and profit maximization

3. Profit maximization for firms in competitive markets

A. some reminders…

profit = revenue – costs

In general (but there are exceptions!), the firm maximizes profit by operating where P = MC, i.e., by continuing to produce until P (= MR) = MC

costs are economic (not accounting) costs, and include the opportunity cost of capital (= the return that the capital owned by the firm could have generated in next-best alternative activity, = “normal profit”)

since costs are economic costs, profit is economic (not accounting) profit: positive economic profit = accounting profit that more than covers all costs, i.e., an accounting profit above “normal profit” negative economic profit (economic loss) = accounting profit that doesn’t cover all costs, i.e., an accounting profit below “normal profit”

Figure 12.1 The Price-Taking Firm’s Profit-Maximizing Quantity of Output Krugman and Wells: Microeconomics, Third Edition Copyright © 2013 by Worth Publishers

Figure 12.2 Costs and Production in the Short Run Krugman and Wells: Microeconomics, Third Edition Copyright © 2013 by Worth Publishers

B. finding profits at the profit-maximizing level of output: a few simple steps compare P and MC to determine Q profit = Revenue – Total Cost = R – TC profit per unit of output = (R/Q) – (TC/Q) = (PQ/Q) – ATC = P – ATC so: to get profit per unit of output at Q*, find P – ATC to get total profit at Q*, multiply (P – ATC) ×Q* Note: the firm doesn’t particularly care about either profit per unit, P – ATC, or about total sales, Q*. What it really cares about is the product of the two, (P – ATC) ×Q* = total profit! Now consider profit at various different prices and levels of output:

If P < minimum AVC, Q* = 0 – the firm shuts down!

producing output Q1 (where P1 = MC) won’t generate enough revenue to cover variable costs: at Q1, P1 < minimum AVC, so R = P1Q1 < AVC1×Q1 = VC

in this case, the firm does better by shutting down completely if Q = 0, then R = 0 and VC = 0, so profits = R – TC = -FC (the firm’s loss is only FC)

but if Q = Q1, then profits = R – TC = P1Q1 – (VC1 + FC) = -FC + (P1Q1 – VC1) since P1Q1 < VC1, “profits” here will be an even greater loss than –FC

Figure 12.3 (a) Profitability and the Market Price Krugman and Wells: Microeconomics, Third Edition Copyright © 2013 by Worth Publishers

Here, P = 18. Maximize profit by producing where P = MC, i.e., at Q = 5. When Q = 5, P > ATC, so here the firm earns a positive economic profit. At Q = 5, Profit = (P – ATC) × Q = (18 – 14.40) × 5 = 18 = area shaded in green

When economic profits are positive (as in the previous slide), revenues are more than enough to cover total costs, including the opportunity cost of capital. So accounting profits exceed the accounting profits that could be

earned elsewhere, in the next-best use of capital. There are no barriers to entry into this industry. So in the long run, this situation will attract new firms to the industry, and existing firms will expand their output. In turn, this will tend to increase market supply, to drive the price of output down, and to reduce total economic profit to zero (i.e., to a level that is just enough to cover the opportunity cost of capital)

Figure 12.3 (b) Profitability and the Market Price Krugman and Wells: Microeconomics, Third Edition Copyright © 2013 by Worth Publishers

Here, P = 10. Maximize profit by producing where P = MC, i.e., at Q = 3. When Q = 3, P < ATC, so here the firm earns a negative economic profit. At Q = 3, Profit = (P – ATC) × Q = (10 – 14.67) × 3 = 14.01 = area shaded in yellow (Thus, this is an economic loss, which might or might not be an accounting loss.)

Note: although the firm has an economic loss at Q = 3, it is nevertheless better to continue to operate rather than shut down, provided P > minimum AVC (= the “shutdown price”).

When economic profits are negative (as in the previous slide), revenues are too low to cover total costs, including the opportunity cost of capital. So accounting profits are below the accounting profits that could be

earned elsewhere, in the next-best use of capital. There are no barriers to exit from this industry. So in the long run, this situation will cause some firms to leave the

industry; other firms will stay but will contract their output. In turn, this will tend to reduce market supply, to drive the price of output up, and to raise total economic profit to zero (i.e., to a level that is just enough to cover the opportunity cost of capital)

Note the general principle: • Positive economic profits cause expansion of and entry into the

industry, driving prices and economic profits down until economic profit equals zero

• Negative economic profits cause contraction of and exit from the industry, driving prices and profits up until economic profit equals zero

This is an example of Adam Smith’s “invisible hand”:

Actors in the market, motivated solely by their own self-interest (e.g., profit-seeking), are nevertheless guided, “as if by an invisible hand,” to work in the interest of society as a whole.

Figure 12.4 The Short-Run Individual Supply Curve Krugman and Wells: Microeconomics, Third Edition Copyright © 2013 by Worth Publishers

So the firm’s short-run supply curve is the pink line below, consisting of… (a) the vertical axis between P = 0 and the shutdown price, and (b) the MC curve beginning at the level of minimum AVC. (Note the discontinuity: below the shutdown price, Q = 0; above the shutdown price, Q is at least 3.)

Table 12.4 Summary of the Perfectly Competitive Firm’s Profitability and Production Conditions Krugman and Wells: Microeconomics, Third Edition Copyright © 2013 by Worth Publishers

Figure 12.5 The Short-Run Market Equilibrium Krugman and Wells: Microeconomics, Third Edition Copyright © 2013 by Worth Publishers

Thus, this

The industry’s short-run supply curve is the horizontal sum of the MC curves of its member firms, beginning with the shutdown point of the lowest-cost producer.

Figure 12.6 The Long-Run Market Equilibrium Krugman and Wells: Microeconomics, Third Edition Copyright © 2013 by Worth Publishers

A high price (P=18) means positive economic profit. Existing firms produce high levels of output (e.g., Q=5 in panel (b)). This attracts new entrants (so S curve shifts out from S1 to S2 to S3 …). This drives the price down; existing firms contract their output. Eventually the industry hits a zero-economic-profit equilibrium (e.g., at the “break-even” price P = 14, where P = ATC). :

Figure 12.8 Comparing the Short-Run and Long-Run Industry Supply Curves Krugman and Wells: Microeconomics, Third Edition Copyright © 2013 by Worth Publishers

Entry of new firms into an industry can occur only in the long run. (In the short run, the stock of capital inputs is fixed.) So the long-run industry supply curve is more elastic than the short-run industry supply curve.