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Chapter 8 1 ©2005 Pearson Education, Inc. Marginal Revenue, Marginal Cost, and Profit Maximization pp. 262-8 We can study profit maximizing output for any firm, whether perfectly competitive or not Profit (π) = Total Revenue - Total Cost If q is output of the firm, then total revenue is price of the good times quantity Total Revenue (R) = Pq

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### Transcript of Marginal Revenue, Marginal Cost, and Profit Maximization

Chapter 8 1©2005 Pearson Education, Inc.

Marginal Revenue, Marginal Cost,and Profit Maximization pp. 262-8

�We can study profit maximizing output forany firm, whether perfectly competitive ornot�Profit (π) = Total Revenue - Total Cost

�If q is output of the firm, then total revenue isprice of the good times quantity

�Total Revenue (R) = Pq

Chapter 8 2©2005 Pearson Education, Inc.

Marginal Revenue, Marginal Cost,and Profit Maximization pp. 262-8

�Costs of production depends on output, q�Total Cost (C) = C(q)

�Profit for the firm, π, is differencebetween revenue and costs

)()()( qCqRq −=π

Chapter 8 3©2005 Pearson Education, Inc.

Marginal Revenue, Marginal Cost,and Profit Maximization pp. 262-8

� Firm selects output to maximize thedifference between revenue and cost

�We can graph the total revenue and totalcost curves to show maximizing profitsfor the firm

�Distance between revenues and costsshow profits

Chapter 8 4©2005 Pearson Education, Inc.

Marginal Revenue, Marginal Cost,and Profit Maximization pp. 262-8

� Revenue is a curve, showing that a firm canonly sell more if it lowers its price

� Slope of the revenue curve is the marginalrevenue�Change in revenue resulting from a one-unit increase

in output

� Slope of the total cost curve is marginal cost�Additional cost of producing an additional unit of

output

Chapter 8 5©2005 Pearson Education, Inc.

Profit Maximization – Short Run pp.262-8

0

Cost,Revenue,

Profit(\$s per

year)

Output

C(q)

R(q)A

B

π(q)q0 q*

Profits are maximized where MR (slopeat A) and MC (slope at B) are equal

Profits aremaximizedwhere R(q) –C(q) ismaximized

Chapter 8 6©2005 Pearson Education, Inc.

Marginal Revenue, Marginal Cost,and Profit Maximization pp. 262-8

� If the producer tries to raise price, sales arezero

� Profit is negative to begin with, since revenue isnot large enough to cover fixed and variablecosts

� As output rises, revenue rises faster than costsincreasing profit

� Profit increases until it is maxed at q*� Profit is maximized where MR = MC or where

slopes of the R(q) and C(q) curves are equal

Chapter 8 7©2005 Pearson Education, Inc.

Marginal Revenue, Marginal Cost,and Profit Maximization pp. 262-8

�Profit is maximized at the point at whichan additional increment to output leavesprofit unchanged

π = R −C

ΔπΔq

=ΔRΔq

−ΔCΔq

= 0

MR − MC = 0

MR = MC

Chapter 8 8©2005 Pearson Education, Inc.

Marginal Revenue, Marginal Cost,and Profit Maximization pp. 262-8

� The Competitive Firm�Price taker – market price and output

determined from total market demand andsupply

�Market output (Q) and firm output (q)

�Market demand (D) and firm demand (d)

Chapter 8 9©2005 Pearson Education, Inc.

The Competitive Firm pp. 262-8

�Demand curve faced by an individual firmis a horizontal line� Each firm is so small that its sales have no

effect on market price. As a result, eachregards market price as given.

�Demand curve faced by whole market isdownward sloping�Shows amount of goods all consumers will

purchase at different prices

Chapter 8 10©2005 Pearson Education, Inc.

The Competitive Firm pp. 262-8

d\$4

Output (bushels)

Price\$ per bushel

100 200

Firm Industry

D

\$4

S

Price\$ per bushel

Output (millions of bushels)

100

Chapter 8 11©2005 Pearson Education, Inc.

The Competitive Firm pp. 262-8

� The competitive firm’s demand�Individual producer sells all units for \$4

regardless of that producer’s level of output

�MR = P with the horizontal demand curve

�For a perfectly competitive firm, profitmaximizing output occurs when

ARPMRqMC ===)(

Chapter 8 12©2005 Pearson Education, Inc.

Profit Maximization – Short Run pp.262-8

0

Cost,Revenue,

Profit(\$s per

year)

Output

C(q)

π(q)

q*

Profits are maximized where MR=p andMC are equal

Profits aremaximizedwhere R(q) –C(q) ismaximized

R(q)=pq

Chapter 8 13©2005 Pearson Education, Inc.

Choosing Output: Short Run pp. 268-73

� In the short run, capital is fixed and a firmmust choose levels of variable inputs tomaximize profits

�We can look at the graph of MR, MC,ATC and AVC to determine profits

Chapter 8 14©2005 Pearson Education, Inc.

q2

A Competitive Firm pp. 268-73

10

20

30

40

Price

50

MC

AVC

ATC

0 1 2 3 4 5 6 7 8 9 10 11Outputq*

AR=MR=PA

q1 : MR > MCq2: MC > MRq*: MC = MR

q1

Lost Profitfor q2>q*Lost Profit

for q2>q*

Chapter 8 15©2005 Pearson Education, Inc.

Choosing Output: Short Run pp. 268-73

� The point where MR = MC, the profitmaximizing output is chosen�MR = MC at quantity, q*, of 8

�At a quantity less than 8, MR > MC, so moreprofit can be gained by increasing output

�At a quantity greater than 8, MC > MR,increasing output will decrease profits

See also Fig. 8-8 on p. 275 of the text for anexample of actual MC curve.

Chapter 8 16©2005 Pearson Education, Inc.

A Competitive Firm – PositiveProfits pp. 268-73

10

20

30

40

Price

50

0 1 2 3 4 5 6 7 8 9 10 11Outputq2

MC

AVC

ATC

q*

AR=MR=PA

q1

D

C B Profits aredetermined

by output perunit timesquantity

Profit perunit = P-AC(q) =A to B

TotalProfit =ABCD

Chapter 8 17©2005 Pearson Education, Inc.

The Competitive Firm pp. 268-73

�A firm does not have to make profits

� It is possible a firm will incur losses if theP < AC for the profit maximizing quantity�Still measured by profit per unit times

quantity

�Profit per unit is negative (P – AC < 0)

Chapter 8 18©2005 Pearson Education, Inc.

A Competitive Firm – Losses pp. 268-73

Price

Output

MC

AVC

ATC

P = MRD

At q*: MR =MC and P <ATCLosses =(P- AC) x q*

or ABCD

q*

A

BC

Chapter 8 19©2005 Pearson Education, Inc.

Short Run Production pp. 268-73

�Why would a firm produce at a loss?Leave as your exercise!�Might think price will increase in near future�Shutting down and starting up could be

costly

� Firm has two choices in short run�Continue producing�Shut down temporarily�Will compare profitability of both choices

Chapter 8 20©2005 Pearson Education, Inc.

Short Run Production pp. 268-73

�When should the firm shut down?�If AVC < P < ATC, the firm should continue

producing in the short run� Can cover all of its variable costs and some of

its fixed costs

�If P< AVC< ATC, the firm should shut down� Cannot cover its variable costs or any of its

fixed costs

Chapter 8 21©2005 Pearson Education, Inc.

A Competitive Firm – Losses pp. 268-73

Price

Output

P < ATC but�AVC sofirm willcontinue toproduce inshort run

MC

AVC

ATC

P = MRD

q*

A

BC

Losses

EF

Chapter 8 22©2005 Pearson Education, Inc.

Competitive Firm – Short RunSupply pp. 273-6

�Supply curve tells how much output willbe produced at different prices

�Competitive firms determine quantity toproduce where P = MC�Firm shuts down when P < AVC

�Competitive firms’ supply curve is portionof the marginal cost curve above theAVC curve

Chapter 8 23©2005 Pearson Education, Inc.

A Competitive Firm’sShort-Run Supply Curve pp. 273-6

Price(\$ perunit)

Output

MC

AVC

ATC

P = AVC

P2

q2

The firm chooses theoutput level where P = MR = MC,

as long as P > AVC.

P1

q1

S

Supply is MCabove AVC

Chapter 8 24©2005 Pearson Education, Inc.

A Competitive Firm’sShort-Run Supply Curve pp. 273-6

�Supply is upward sloping due todiminishing returns

�Higher price compensates the firm for thehigher cost of additional output andincreases total profit because it applies toall units

Chapter 8 25©2005 Pearson Education, Inc.

A Competitive Firm’sShort-Run Supply Curve pp. 273-6

�Over time, prices of product and inputscan change

�How does the firm’s output change inresponse to a change in the price of aninput?�We can show an increase in marginal costs

and the change in the firm’s output decisions

Chapter 8 26©2005 Pearson Education, Inc.

MC2

q2

Input cost increases and MC shifts to MC2

and q falls to q2.

MC1

q1

The Response of a Firm toa Change in Input Price pp. 273-6

Price(\$ perunit)

Output

\$5

Savings to the firmfrom reducing output

Chapter 8 27©2005 Pearson Education, Inc.

Short-Run Market Supply Curve pp. 276-81

�Shows the amount of product the wholemarket will produce at given prices

� Is the sum of all the individual producersin the market

�We can show graphically how we cansum the supply curves of individualproducers

Chapter 8 28©2005 Pearson Education, Inc.

MC3

Industry Supply in the ShortRun pp. 276-81

\$ perunit

MC1

SSThe short-runindustry supply curve

is the horizontalsummation of the supply

curves of the firms.

Q

MC2

15 21

P1

P3

P2

1082 4 75

Chapter 8 29©2005 Pearson Education, Inc.

ProducerProducerSurplusSurplus

Producer surplusis area above MC

to the price

Producer Surplus for a Firm pp. 276-81

Price(\$ per

unit ofoutput)

Output

AVCAVCMCMC

AABB

PP

qq**

At q* MC = MR.Between 0 and q,

MR > MC for all units.

Chapter 8 30©2005 Pearson Education, Inc.

Producer Surplus in the ShortRun pp. 276-81

� Price is greater than MC on all but the last unit ofoutput

� Therefore, surplus is earned on all but the last unit

� The producer surplus is the sum over all unitsproduced of the difference between the marketprice of the good and the marginal cost ofproduction ( It indicates a firm’s gains fromtrade.)

� Area above supply curve to the market price

Chapter 8 31©2005 Pearson Education, Inc.

The Short-Run Market SupplyCurve pp. 276-81

�Sum of MC from 0 to q*, it is the sum ofthe total variable cost of producing q*

�Producer Surplus can be defined as thedifference between the firm’s revenueand its total variable cost

�We can show this graphically by therectangle ABCD�Revenue (0ABq*) minus variable cost

(0DCq*)

Chapter 8 32©2005 Pearson Education, Inc.

Producer surplusis also ABCD =Revenue minusvariable costs

Producer Surplus for a Firm pp. 276-81

Price(\$ per

unit ofoutput)

Output

ProducerProducerSurplusSurplus

AVCAVCMCMC

AABB

PP

qq**

CCDD

Chapter 8 33©2005 Pearson Education, Inc.

DD

PP**

QQ**

ProducerProducerSurplusSurplus

Market producer surplus isthe difference between P*

and S from 0 to Q*.

Producer Surplus for a Market pp. 276-81

Price(\$ per

unit ofoutput)

Output

SS

Chapter 8 34©2005 Pearson Education, Inc.

Choosing Output in the LongRun pp. 281-7

� In short run, one or more inputs are fixed�Depending on the time, it may limit the

flexibility of the firm

� In the long run, a firm can alter all itsinputs, including the size of the plant

�We assume free entry and free exit�No legal restrictions or extra costs

Chapter 8 35©2005 Pearson Education, Inc.

Choosing Output in the LongRun pp. 281-7

� In the short run, a firm faces a horizontal demandcurve

�Take market price as given

� The short-run average cost curve (SAC) andshort-run marginal cost curve (SMC) are lowenough for firm to make positive profits (ABCD)

� The long-run average cost curve (LRAC)

�Economies of scale to q2

�Diseconomies of scale after q2

Chapter 8 36©2005 Pearson Education, Inc.

q1

BC

In the short run, thefirm is faced with fixedinputs. P = \$40 > ATC.Profit is equal to ABCD.

Output Choice in the Long Run pp. 281-7

Price

Output

P = MR\$40

SACSMC

q3q2

\$30

LAC

LMC

Chapter 8 37©2005 Pearson Education, Inc.

Output Choice in the Long Run pp. 281-7

Price

Outputq1

BC

SACSMC

q3q2

\$30

LAC

LMC

In the long run, the plant size will be increased and output increased to q3.

Long-run profit, EFGD > short runprofit ABCD.

FG

Chapter 8 38©2005 Pearson Education, Inc.

Long-Run CompetitiveEquilibrium pp. 281-7

� For long run equilibrium, firms must haveno desire to enter or leave the industry

�We can relate economic profit to theincentive to enter and exit the market

Chapter 8 39©2005 Pearson Education, Inc.

Long-Run CompetitiveEquilibrium pp. 281-7

� Firm uses labor (L) and capital (K) withpurchased capital

�Accounting Profit and Economic Profit�Accounting profit: π = R - wL

�Economic profit: π = R = wL - rK� wl = labor cost

� rk = opportunity cost of capital

Chapter 8 40©2005 Pearson Education, Inc.

Long-Run CompetitiveEquilibrium pp. 281-7

� Zero-Profit�A firm is earning a normal return on its

investment

�Doing as well as it could by investing itsmoney elsewhere

�Normal return is firm’s opportunity cost ofusing money to buy capital instead ofinvesting elsewhere

�Competitive market long run equilibrium

Chapter 8 41©2005 Pearson Education, Inc.

Long-Run CompetitiveEquilibrium pp. 281-7

�Entry and Exit�The long-run response to short-run profits is

to increase output and profits

�Profits will attract other producers

�More producers increase industry supply,which lowers the market price

�This continues until there are no more profitsto be gained in the market – zero economicprofits

Chapter 8 42©2005 Pearson Education, Inc.

Long-Run CompetitiveEquilibrium – Profits pp. 281-7

S1

Output Output

\$ per unit ofoutput

\$ per unit ofoutput

LAC

LMC

D

S2

\$40 P1

Q1

Firm Industry

Q2

P2

q2

\$30

•Profit attracts firms: New entrants•Supply increases until profit = 0

Chapter 8 43©2005 Pearson Education, Inc.

Long-Run CompetitiveEquilibrium – Losses pp. 281-7

S2

Output Output

\$ per unit ofoutput

\$ per unit ofoutput

LAC

LMC

D

S1

P2

Q2

Firm Industry

Q1

P1

q2

\$20

\$30

•Losses causeexisting firms to leave•Supply decreases until profit = 0

Chapter 8 44©2005 Pearson Education, Inc.

Long-Run CompetitiveEquilibrium pp. 281-7

1. All firms in industry are maximizingprofits� p = MC

2. No firm has incentive to enter or exitindustry� Earning zero economic profits

3. Market is in equilibrium� QD = QS

Chapter 8 45©2005 Pearson Education, Inc.

Firms Earn Zero Profit inLong-Run Equilibrium pp. 281-7

TicketPrice

Season TicketsSales (millions)

\$7\$7

1.01.0

A baseball teamin a moderate-sized city

sells enough tickets so that price is equal to marginal

and average cost(profit = 0).

LACLMC

Chapter 8 46©2005 Pearson Education, Inc.

Chapter 8 47©2005 Pearson Education, Inc.

Chapter 8 48©2005 Pearson Education, Inc.