Perfect
Competition
Chapter 14-2.
Profit Maximizing and
Shutting Down
Profit-Maximizing Level of
Output
• The goal of the firm is to maximize
profits.
• Profit is the difference between total
revenue and total cost.
Profit-Maximizing Level of
Output
Profit-Maximizing Level of
Output
• What happens to profit in response to a
change in output is determined by
marginal revenue (MR) and marginal
cost (MC).
• Marginal revenue (MR) – the change
in total revenue associated with a
change in quantity.
• A firm maximizes profit when MC = MR.
• Marginal cost (MC) – the change in total
cost associated with a change in quantity.
Marginal Revenue
Marginal Cost
• A perfect competitor accepts the
market price as given.
• As a result, marginal revenue equals
price (MR = P).
• Initially, marginal cost falls and then
begins to rise.
• Marginal concepts are best defined
between the numbers.
1
Profit Maximization: MC = MR
How to Maximize Profit
• To maximize profits, a firm should
produce where marginal cost equals
marginal revenue.
• If marginal revenue does not equal
marginal cost, a firm can increase profit
by changing output.
• The supplier will continue to produce as
long as marginal cost is less than
marginal revenue.
How to Maximize Profit
Again! MR=MC
• The supplier will cut back on production
if marginal cost is greater than marginal
revenue.
• Profit is maximized when MR=MC.
• Thus, the profit-maximizing condition of a
competitive firm is MC = MR = P.
Profit Maximization:
Graphical Analysis
Marginal Cost, Marginal
Revenue, and Price
Price = MR Quantity
Produced
$35.00
35.00
35.00
35.00
35.00
35.00
35.00
35.00
35.00
35.00
35.00
McGraw-Hill/Irwin
0
1
2
3
4
5
6
7
8
9
10
Marginal
Cost
Costs
$28.00
20.00
16.00
14.00
12.00
17.00
22.00
30.00
40.00
54.00
68.00
50
– If the cost of producing one more unit is
less than the revenue it generates, then a
profit is available for the firm that
increases production by one unit.
– If the cost of producing one more unit is
more than the revenue it generates, then
increasing production reduces profit.
MC
60
40
30
A
A
C
B
P = D = MR
20
10
0
1 2 3 4 5 6 7 8 9 10 Quantity
© 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
2
MR=MC
Q
P
TR
TC
TR-TC
MR
MC
ATC
0
$1
$0
$1.00
-$1.00
$1
1
$1
$1
$2.00
-$1.00
$1
$1.00
$2.00
2
$1
$2
$2.80
-$0.80
$1
$0.80
$1.40
3
$1
$3
$3.50
-$0.50
$1
$0.70
$1.17
4
$1
$4
$4.00
$0.00
$1
$0.50
$1.00
5
$1
$5
$4.50
$0.50
$1
$0.50
$0.90
6
$1
$6
$5.20
$0.80
$1
$0.70
$0.87
7
$1
$7
$6.00
$1.00
$1
$0.80
$0.86
8
$1
$8
$6.86
$1.14
$1
$0.86
$0.86
9
$1
$9
$7.86
$1.14
$1
$1.00
$0.87
10
$1
$10
$9.36
$0.64
$1
$1.50
$0.94
11
$1
$11
$12.00
-$1.00
$1
$2.64
$1.09
The Marginal Cost Curve Is
the Supply Curve
• The MC curve tells the competitive firm
how much it should produce at a given
price.
• The firm can do no better than produce the
quantity at which marginal cost equals
marginal revenue which in turn equals
price.
The Marginal Cost Curve Is
the Supply Curve
• The marginal cost curve is the firm's
supply curve above the point where
price exceeds average variable cost.
The Marginal Cost Curve Is
the Firm’s Supply Curve
Marginal cost
C
$70
60
Cost, Price
Profit Maximization: The
Numbers
50
A
40
30
B
20
10
0
1
2
3
4
5
6
7
8
9 10 Quantity
Firms Maximize Total
Profit
Profit Maximization Using
Total Revenue and Total Cost
• Firms seek to maximize total profit, not
profit per unit.
• Profit is maximized where the vertical
distance between total revenue and
total cost is greatest.
• At that output, MR (the slope of the
total revenue curve) and MC (the slope
of the total cost curve) are equal.
– Firms do not care about profit per unit.
– As long as increasing output increases
total profits, a profit-maximizing firm
should produce more.
3
Profit Determination Using Total
Cost and Revenue Curves
Total cost, revenue
TC
Loss
$385
350
315 Maximum profit =$81
280
245
210
$130
175
140
105
Profit =$45
70
Loss
35
0
1 2 3 4 5 6 7 8 9
TR
Profit
Total Profit at the ProfitMaximizing Level of Output
• The P = MR = MC condition tells us
how much output a competitive firm
should produce to maximize profit.
• It does not tell us how much profit the
firm makes.
Quantity
© 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
McGraw-Hill/Irwin
Determining Profit and Loss
From a Table of Costs
Costs Relevant to a Firm
• Profit can be calculated from a table of
costs and revenues.
• Profit is determined by total revenue
minus total cost.
Total
P = MR Output Total Cost Marginal Average
Cost
Total Cost Revenue
Profit
TR-TC
—
35.00
35.00
35.00
35.00
35.00
35.00
–40.00
–33.00
–18.00
1.00
22.00
45.00
63.00
0
1
2
3
4
5
6
McGraw-Hill/Irwin
Costs Relevant to a Firm
Total
P = MR Output Total Cost Marginal Average
Cost
Total Cost Revenue
35.00
35.00
35.00
35.00
35.00
35.00
35.00
McGraw-Hill/Irwin
4
5
6
7
8
9
10
118.00
130.00
147.00
169.00
199.00
239.00
293.00
14.00
12.00
17.00
22.00
30.00
40.00
54.00
29.50
26.00
24.50
24.14
24.88
26.56
29.30
140.00
175.00
210.00
245.00
280.00
315.00
350.00
Profit
TR-TC
22.00
45.00
63.00
76.00
81.00
76.00
57.00
40.00
68.00
88.00
104.00
118.00
130.00
147.00
—
28.00
20.00
16.00
14.00
12.00
17.00
—
68.00
44.00
34.67
29.50
26.00
24.50
0
35.00
70.00
105.00
140.00
175.00
210.00
© 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
Determining Profit and
Loss From a Graph
• Find output where MC = MR.
– The intersection of MC = MR (P)
determines the quantity the firm will
produce if it wishes to maximize profits.
© 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.
4
Determining Profit and
Loss From a Graph
Determining Profit and
Loss From a Graph
• Find profit per unit where MC = MR.
• The firm makes a profit when the ATC
curve is below the MR curve.
– Drop a line down from where MC equals MR,
and then to the ATC curve.
– This is the profit per unit.
– Extend a line back to the vertical axis to
identify total profit.
• The firm incurs a loss when the ATC curve
is above the MR curve.
Determining Profits Graphically
Determining Profit and Loss
From a Graph
• Zero profit or loss where MC=MR.
– Firms can earn zero profit or even a loss
where MC = MR.
– Even though economic profit is zero, all
resources, including entrepreneurs, are being
paid their opportunity costs.
MC
MC
MC
Price
Price
Price
65
65
65
60
60
60
55
55
55
ATC
50
50
50
ATC
45
45
45
40
40 D
Loss
A
P = MR 40
P = MR
35
35
35
P = MR
30
30
30 Profit
B ATC
AVC
25
25 C
25
AVC
AVC
E
20
20
20
15
15
15
10
10
10
5
5
5
0
0
0
1 2 3 4 5 6 7 8 910 12
1 2 3 4 5 6 7 8 9 10 12
1 2 3 4 5 6 7 8 9 10 12
Quantity
Quantity
Quantity
(b) Zero profit case
(a) Profit case
(c) Loss case
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 2000
Loss Minimization
Average cost of a unit of output
The Shutdown Point
• The firm will shut down if it cannot
cover average variable costs.
Market
price
falls
Revenue
generated by a
unit of output
– A firm should continue to produce as long
as price is greater than average variable
cost.
– If price falls below that point it makes
sense to shut down temporarily and save
the variable costs.
5
The Shutdown Point
The Shutdown Point
• The shutdown point is the point at
which the firm will be better off it it
shuts down than it will if it stays in
business.
• If total revenue is more than total
variable cost, the firm’s best strategy is
to temporarily produce at a loss.
• It is taking less of a loss than it would by
shutting down.
Minimizing Loss
The Shutdown Decision
MC
Price
60
• Shutdown price: the minimum point of
the average-variable-cost (AVC) curve.
ATC
50
40
Loss
P = MR
30
• Break-even price: A price that is equal to
the minimum point of the average-totalcost (ATC) curve.
AVC
20
$17.80
A
10
0
2
4
6
8
– At this price, economic profit is zero.
Quantity
Profit Maximizing Level of
Output
Profit Maximizing Level of
Output
• The goal of the firm is to maximize profits, the difference
between total revenue and total cost
• The profit-maximizing condition of a competitive firm is:
MR = MC
• A firm maximizes profit when marginal revenue equals
marginal cost
• For a competitive firm, MR = P
• Marginal revenue (MR) is the change in
total revenue associated with a change in
quantity
• A firm maximizes total profit, not profit per unit
If MR > MC,
• a firm can increase profit by increasing output
• Marginal cost (MC) is the change in total cost associated
with a change in quantity
14-35
If MR < MC,
• a firm can increase profit by decreasing
its output
14-36
6
The Marginal Cost Curve is
the Supply Curve
Marginal Cost, Marginal
Revenue, and Price Graph
Marginal
Cost
P
Marginal
Cost
P
MC > P,
decrease output to
increase total profit
MC = P
$35
$61
Firm’s Supply
Curve
Because the marginal cost
curve tells us how much of
a good a firm will supply at
a given price, the
marginal cost curve is the
firm’s supply curve
P = D = MR
$35
MC < P,
increase output to
increase total profit
=
$19.50
Q
MC = P at 8 units,
total profit is
maximized
6
8
Q
10
14-37
14-38
Total Revenue and Total
Cost Table
Profit Maximization using Total
Revenue and Total Cost
• An alternative method to determine the profit-maximizing
level of output is to look at the total and total cost curves
Total Cost,
Total Revenue
TC
Max profit = $81
at 8 units of
output
The total revenue curve
is a straight line
TR
The total cost curve is
bowed upward at most
quantities reflecting
increasing marginal cost
$280
• Total cost is the cumulative sum
• Total profit is the difference between total
of theand
marginal
revenue
total costcosts,
curves plus the
$175
$130
fixed costs
Losses
Losses
Profits
3
5
Q
8
Profits are maximized
when the vertical
distance between TR
and TC is greatest
14-39
Determining Profits Graphically:
A Firm with Profit
P
MC = MR
P
ATC
Profits
Determining Profits Graphically:
A Firm with Zero Profit or Losses
Find output where
MC = MR, this is the
profit maximizing Q
MC
14-40
Find output where
MC = MR, this is the
profit maximizing Q
P
MC
ATC
ATC
P = D = MR
AVC
ATC at Qprofit max
Qprofit max
Q
Find profit per unit
where the profit max Q
intersects ATC
Find profit per unit
where the profit max Q
intersects ATC
Since P>ATC at the
profit maximizing quantity,
this firm is earning profits
14-41
Since P=ATC at the
profit maximizing quantity,
this firm is earning
zero profit or loss
MC = MR
AVC
P
=ATC
P = D = MR
ATC at Qprofit max
Qprofit max
Q
14-42
7
Determining Profits Graphically:
A Firm with Losses
P
Find output where
MC = MR, this is the
profit maximizing Q
MC
AVC
P = D = MR
Losses
MC = MR
Qprofit max
• The shutdown point is the
point below which the firm
will be better off if it shuts
down than it will if it stays
in business
• If P>min of AVC, then the
firm will still produce, but
earn a loss
• If P<min of AVC, the firm
will shut down
• If a firm shuts down, it still
has to pay its fixed costs
ATC
ATC at Qprofit max
ATC
P
Determining Profits Graphically:
The Shutdown Decision
Q
Find profit per unit
where the profit max Q
intersects ATC
Since P<ATC at the
profit maximizing quantity,
this firm is earning losses
P
MC
ATC
AVC
P = D = MR
PShut
down
Q
Qprofit max
14-43
14-44
Short-Run Market Supply
and Demand
Short-Run Market Supply and
Demand Graph
P
• While the firm’s demand curve is perfectly elastic,
the industry’s demand curve is downward sloping
P
Market
Firm
MC
Market
Supply
ATC
• The market supply curve takes into account any
changes in input prices that might occur
P
P
ATC
P = D = MR
Profits
Market
Demand
• The market (industry) supply curve is
the horizontal sum of all the firms’
marginal cost curves
Q
14-45
Qprofit max
Q
14-46
8