INTRODUCTION

This chapter addresses the following key
questions:



What are profits?
What are the unique characteristics of competitive
firms?
How much output will a competitive firm produce?
THE COMPETITIVE FIRM
Chapter 7
2
THE PROFIT MOTIVE

The basic incentive for producing goods and
services is the expectation of profit.



ECONOMIC PROFITS
Economic profit is the difference between total
revenues and total economic costs.
 Economic cost is the value of all resources used
to produce a good or service – opportunity cost.

Profit is the difference between total revenue and
total cost.
The profit motive encourages businesses to produce
the goods and services consumers’ desire, at prices
they are willing to pay.
Personal reasons also motivate producers.


Producers seek social status and crave recognition.
Non-owner managers of corporations may be more
interested in their own jobs, salaries, and selfpreservation than earning profits for stockholders.
3
ECONOMIC PROFITS

4
ECONOMIC PROFITS
To determine a firm’s economic profit, all implicit
factor costs must be subtracted from observed
accounting profit.

Economic profits account for the use of all
resources.


Normal profit is the opportunity cost of capital –
zero economic profit.
Economic profits represent something over and above
normal profits.
A productive activity reaps an economic profit
only if it earns more than its opportunity cost.
 Whenever economic costs exceed explicit costs,
observed (accounting) profits will exceed true
(economic) profits.

5
6
ECONOMIC PROFITS
ENTREPRENEURSHIP
AND
RISK
The inducement to take on the added
responsibilities of owning and operating a business
is the potential for profit.
 The potential for profit is not a guarantee of profit.
 Substantial risks are attached to starting and
operating a business.

7
MARKET STRUCTURE
8
MARKET STRUCTURE
The opportunity for profit may be limited by the
structure of the industry.
 Market structure is the number and relative
size of firms in an industry.
 Perfect competition is market in which no
buyer or seller has market power.
 Monopoly is a firm that produces the entire
market supply of a particular good or service.

Imperfect competition
Perfect
Monopolistic Oligopoly
competition competition
Duopoly
Monopoly
9
THE NATURE OF PERFECT COMPETITION

PRICE TAKERS
A perfectly competitive industry has several
distinguishing characteristics:



10

Many firms – lots of firms are competing for
consumer purchases.
Identical products – the products of the different
firms are identical, or nearly so.
Low entry barriers – it’s relatively easy to get into
the business.
A perfectly competitive firm has no market
power and has no ability to alter the market price
of the goods it produces.


11
Market Power - The ability to alter the market
price of a good or service.
The output of a perfectly competitive firm is so
small relative to market supply that it has no
significant effect on the total quantity or price in
the market.
12
MARKET DEMAND CURVES VS. FIRM
DEMAND CURVES
MARKET DEMAND CURVES VS. FIRM
DEMAND CURVES
It is important to distinguish between the market
demand curve and the demand curve confronting a
particular firm.
 While the actions of a single competitive firm are
negligible, the unified actions of many such firms
are not.
 The market demand curve for a product is always
downward-sloping.
 The demand curve confronting a perfectly
competitive firm is horizontal.

The T-shirt market
Demand facing one shop
PRICE (per shirt)
Market supply
pe
Equilibrium
price
pe
Demand facing
single firm
Market demand
Quantity (thousand shirts per day)
Quantity (shirts per day)
13
14
THE PRODUCTION DECISION
OUTPUT AND REVENUES
A competitive firm has only one decision to make:
how much to produce.
 The production decision is the selection of the
short-run rate of output (with existing plant and
equipment).


In searching for the most desirable rate of output,
the distinction between total revenue and total
profit must be kept in mind.

Total revenue - The price of the good multiplied by
the quantity sold in a given time period.
Total revenue = price X quantity

15
16
OUTPUT AND COSTS
Total Revenue
TOTAL REVENUE
The total revenue curve of a perfectly competitive
firm is an upward-sloping straight line, with a
slope equal to pe.
$96
88
80
72
64
56
48
40
32
24
16
8
0
To maximize profits a firm must consider how
increased production will affect costs as well as
revenues.
 Producers are saddled with certain costs in the
short-run.
Short-run - The period in which the quantity
(and quality) of some inputs cannot be changed.

Total revenue
pe= $8
1 2 3 4 5 6 7 8 9 10 11 12
17
Quantity
18
OUTPUT AND COSTS

OUTPUT AND COSTS
Fixed costs are incurred even if no output is
produced.
G

Fixed costs - Costs of production that do not
change when the rate of output is altered, e.g.,
the cost of basic plant and equipment.
Once a firm starts producing output, it incurs
variable costs as well.
G
Variable costs - Costs of production that
change when the rate of output is altered, e.g.
labor and material costs.
19
Total Cost (dollars per time period)
TOTAL COST
OUTPUT AND COSTS

Total cost
The shape of the total cost curve reflects
increasing marginal costs and the law of
diminishing returns.

Marginal cost is the increase in total costs
associated with a one-unit increase in production.
z

Total costs escalate due to the
law of diminishing returns
The primary objective of the producer is to find
that one particular rate of output that maximizes
profits.
Fixed cost
Output (units per time period)
21
TOTAL PROFIT
Revenues Or Costs (dollars per period)
20
22
PROFIT-MAXIMIZING RULE
The best single rule for maximizing short-run
profits is straightforward:
 Never produce a unit of output that costs more
than it brings in.

Total cost
Total revenue
r
s
f
h
g
Output (units per period)
23
24
MARGINAL REVENUE = PRICE
MARGINAL REVENUE = PRICE
The contribution to total revenue of an additional
unit of output is called marginal revenue.
 Marginal revenue (MR) is the change in total
revenue that results from a one-unit increase in
the quantity sold.


For perfectly competitive firms, price equals
marginal revenue.
25
MARGINAL REVENUE AND MARGINAL COST
26
MARGINAL COST
A firm’s goal is not to maximize revenues, but to
maximize profits.
 Marginal revenue is compared to marginal costs
to determine the best level of output.

What an additional unit of output brings in is its
marginal revenue (MR).
 What it costs to produce is its marginal cost
(MC).

27
28
SHORT-RUN PROFIT-MAXIMIZATION
RULES FOR COMPETITIVE FIRM
PROFIT-MAXIMIZING RATE OF OUTPUT
 According
to the profit-maximization
rule a firm should produce at that rate of
output where marginal revenue equals
marginal cost.
Price > MC É increase output
Price = MC É maintain output
and
maximize profit
If marginal cost exceeds price, total profits
decline if the additional output is produced.
 If marginal cost is less than price, total profits
increase if the additional output is produced.
 Profits are maximized at the rate of output
where price equals marginal cost.

Price < MC É decrease output
29
30
PROFIT-MAXIMIZING RATE OF OUTPUT
ADDING UP PROFITS

$18
Marginal cost
Price or Cost (per bushel)
16
14
12
10
p = MC
MRB

Profits decreasing
Total profit = total revenue – total cost
Price (= MR)
Profits increasing
8
4

Profit-maximizing
rate of output
6
Profits can be computed in two ways.
Total profit is the difference between total
revenue and total cost.
Total profit is average profit times the number
sold.
Profit per unit = price – ATC
MCB
2
0
1
2
3
4
5
Quantity (bushels per day)
6
Total profit = profit per unit X quantity
7
31
32
Total profit = (p – ATC) X q
ADDING UP PROFITS
ALTERNATIVE VIEWS OF TOTAL PROFIT
 The
profit-maximizing producer never
seeks to maximize per-unit profits.
What counts is total profits, not the amount of
profit per unit.
 The
profit-maximizing producer has no
desire to produce at that rate of output
where ATC is at a minimum.
0
33
THE SHUTDOWN DECISION
Price and average cost
Total revenue
Maximum
total profit
Total cost
1
2 3 4 5
Rate of Output
6
7
Price or Cost (per unit)
Revenue or Cost (dollars per day)

Total revenue and total cost
$90
80
70
60
50
40
30
20
10
$18
16
14
12
10
8
6
4
2
0
Average total
cost
Total Profit
Marginal cost
1
Price
Profit per
unit
Cost per unit
2 3 4 5
Rate of Output
6
7
34
PRICE VS. AVC
The short-run profit maximization rule does not
guarantee any profits.
 Fixed costs must be paid even if all output
ceases.
 A firm should shut down only if the losses from
continuing production exceed fixed costs.
Where price exceeds average variable cost but
not average total cost, the profit maximizing rule
minimizes losses.
 When price does not cover average variable costs
at any rate of output, production should cease.
 The shutdown point is that rate of output
where price equals minimum AVC.


35
36
THE SHUTDOWN POINT
Profit
18
Loss
MC
16
ATC
14
X
12
Price
(=MR)
MC
ATC
AVC
Price
Y
8
MC
ATC
AVC
10
 The
Shutdown
investment decision is the decision to
build, buy, or lease plant and equipment.
 It also involves the decision to enter or exit
an industry.
 The shut-down decision is a short-run
response.
AVC
6
Price
4

shutdown point
2
0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 8
Quantity
Quantity
Investment decisions are long-run decisions.
G
Long-run – A period of time long enough for all inputs
to be varied (no fixed costs).
37
38
0 1 2 3 4 5 6 7 8
Quantity
LONG-RUN COSTS
DETERMINANTS OF SUPPLY
In making long-run decisions, the producer is
confronted with many possible cost figures.
 A producer will want to build, buy or lease a
plant that is most efficient for the anticipated
rate of output.
The quantity of a good supplied is affected by all
forces that alter marginal cost.
 The short-run determinants of a firm’s supply
include:






The price of factor inputs.
Technology (the available production function).
Expectations (for costs, sales, technology).
Taxes and subsidies.
39
SHORT-RUN SUPPLY CURVE

SHORT-RUN SUPPLY CURVE
The marginal cost curve is the short-run supply
curve for a competitive firm.


40
Supply curve – A curve describing the quantities of
a good a producer is willing and able to sell (produce)
at alternative prices in a given time period, ceteris
paribus.
Price (per bushel)
Price or Cost
THE INVESTMENT DECISION
If any determinant of supply changes, the supply
curve shifts.
$18
16
14
12
10
8
6
4
2
0
41
X
Shutdown
point
Y
Marginal cost
curve
1
2
3
Short-run supply curve
= for competitive firm
4
5
Quantity Supplied (bushels per day)
6
7
42
TAXING BUSINESS
PROPERTY TAXES
Some tax changes alter short-run supply
behavior.
 Others affect only long-run supply decisions.
Property taxes are a fixed cost.
They raise average costs and reduce profit.
 Because they don’t affect marginal costs, they
leave the profit-maximizing output unchanged.



43
PAYROLL TAXES
44
PROFIT TAXES
Payroll taxes increase marginal costs.
They reduce the profit maximizing rate of output.
 They increase average costs and lower total and
per-unit profits.
Profit taxes are neither a fixed cost nor a variable
cost.
 They don’t affect marginal cost or prices.
 They don’t affect production level decisions but
may affect investment decisions.



45
46
IMPACT OF TAXES ON BUSINESS
DECISIONS
Property taxes
affect fixed costs
MC1
ATCa
ATC1
pe
Payroll taxes
alter marginal
costs
Profits taxes
don't change
costs
MCb
MC1
MC1
ATCb
ATC1
ATC1
pe
pe
THE COMPETITIVE FIRM
End of Chapter 7
q1
qb q1
q1
47