Profit Maximization and Competitive Supply

Objectives:
To see how a perfectly competitive firm chooses the level of output that maximizes
its profit and also to see how the output choices of individual firms lead to a supply
curve for an entire industry.

I. Perfectly Competitive Markets

Perfectly competitive market is a market structure in which all firms produce an

identical product and each is so small in relation to the industry that its
production decisions have no effect on market price.

Three (3) basic assumptions on the model of perfect competition:

1. Price Taking – because each individual firm sells a sufficiently small
proportion of total market output, its decision have no impact on market
price. Thus, each firm takes the market price as given.
2. Product Homogeneity – it is when the products of all the firms in a market are
perfectly substitutable with one another. Economists refer to such
homogenous products as commodities.
3. Free Entry and Exit – means that there are no special costs that make it
difficult for a new firm either to enter an industry and produce or to exit if it
cannot make a profit.

When is a Market Highly Competitive?

Many markets are highly competitive in the sense that the firms face highly
elastic demand curves and relatively easy entry and exit. Yet, even if market
demand is not very elastic, firms might compete aggressively. Although firms
may behave competitively in many situations, there is no simple indicator to tell
us when a market is highly competitive.

I. Profit Maximization

In previous discussion we learned that a household maximizes utility while a firm

maximizes profit.

Do Firms Maximize Profit?

The question of whether firms actually do seek to maximize profit has been
controversial.
For smaller firms managed by their owners, profit is likely to dominate almost all
decisions. However, in larger firms, there are instances where managers can
deviate from profit maximizing behavior and focus more on revenue
 maximization since they usually have little contact with the owners (i.e.
stockholders), such firm will not likely to survive. Larger firms that do survive in
competitive industries make long-run profit maximization one of their highest
priorities.

II. Marginal Revenue, Marginal Cost, and Profit Maximization

Profit is the difference between total revenue and total cost. πq= Rq- C(q)
Finding the firm’s profit-maximizing output level means analyzing it revenue.
To maximize profit, the firm selects the output for which the difference between
revenue and cost is the greatest.

Marginal revenue (MR) – the slope of revenue curve R(q)

– the change in revenue resulting from add’l one-unit
increase in output

Marginal cost (MC) – the slope of total cost curve C(q)

– measures the additional cost of producing one additional
unit of output

q* – is the level where marginal revenue and marginal cost are

equal
MRq=MC(q)
– it is the profit-maximizing output level

Profit declines from its maximum when output increases above q*.

Demand and Marginal Revenue for a Competitive Firm

Given that competitive firm is a price taker, thus, the demand curve facing an
individual competitive firm is given by a horizontal line because the firm’s sales
will have no effect on price. However, the market demand curve is downward
sloping because consumers buy more of a particular commodity at a lower price.
When an individual firm faces a horizontal demand curve, it can sell an
additional unit output without lowering price. As a result, when it sells an
additional unit, the firm’s total revenue increases by an amount equal to the
price, thus, marginal revenue is constant at that price per unit. At the same
time, average revenue received by the firm is the same amount because each
unit produced will be sold at the same price given.
Therefore, the demand curve facing an individual firm in a competitive
market is both its average revenue curve and its marginal revenue curve. Along
this demand curve, marginal revenue, average revenue, and price are all equal.

Profit Maximization by a Competitive Firm

 A perfectly competitive firm should choose its output so that marginal cost
equals price, given that demand curve facing a competitive firm is horizontal
which implies that MR = P.

MCq= MR=P

Since competitive firms take price as fixed, this is a rule for setting output,
not price.

III.Choosing Output in the Short Run

Short-Run Profit Maximization by a Competitive Firm

In the short run, a firm operates with a fixed amount of capital and must choose
the levels of its variable inputs to maximize profit. It maximizes its profit by
choosing an output q* at which its marginal cost MC is equal to price P (or
marginal revenue MR) of its product.

The condition of profit maximization:

Marginal revenue equals marginal cost at a point at which the marginal
cost curve is rising.

Output Rule:
If a firm is producing any output at all, it should produce at the level at
which marginal revenue equals marginal cost.

The Short-Run Profit of a Competitive Firm

A firm need not always earn a profit in the short run. A firm might operate at loss
in the short run because it expects to earn a profit in the future, when the price
of its product increases or the cost of production falls, and because shutting
down and starting up again would be costly.
In fact, in earning a loss, a firm has two choices: it can produce some output
or it can shut down. If the price of the product is greater than the average
economic cost of production, the firm makes a positive economic profit by
producing. Thus, it will choose to produce. On the other hand, if the price of the
product is less than the average total cost at the profit-maximizing output, the
firm should shut down. It is because there are fixed costs, and average variable
cost is less than average total cost and the firm is indeed losing money.
The firm should stay in business as long as the price of its product is greater
than its average variable cost of production at the profit-maximizing output.

Shut-Down Rule:
The firm should shut down if the price of the product is less than the
average economic cost of production at the profit-maximizing output.
Some Cost Considerations for Managers
The application of the rule that marginal revenue should equal marginal cost
MRq=MC(q) depends on a manager’s ability to estimate marginal cost.

Managers’ three (3) guidelines to obtain useful measures of cost:

1. Average variable cost should not be used as a substitute for marginal cost.
2. A single item on a firm’s accounting ledger may have two components, only
one of which involves marginal cost.
3. All opportunity costs should be included in determining marginal cost.

Failure to follow to do so can cause production to be too high or too low and
thereby reduce profit.