Chapter 21
Profit, Loss, and Perfect
Competition
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-1
Objectives
•
•
•
•
•
•
•
•
•
Marginal Revenue
Profit maximization and loss minimization
The short-run supply curve
The characteristics of perfect competition
The perfect competitor in the short run and
long run
The long-run supply curve
The shut-down and break-even points
Economic efficiency
Economic profits and accounting profits
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-2
Graphing Demand and Marginal Revenue
Total Revenue is price X output
Marginal revenue is the increase in total revenue when
output sold goes up by one unit
Output
Price
Total Revenue
Marginal
Revenue
1
$5
$ 5
$5
2
5
10
5
3
5
15
5
4
5
20
5
5
5
25
5
6
5
30
5
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-3
Graphing Demand and Marginal Revenue
Output
Price
Total Revenue
Marginal Revenue
1
$5
$ 5
$5
6
2
5
10
5
5
3
5
15
5
4
4
5
20
5
3
5
5
25
5
2
6
5
30
5
1
D,MR
0
0
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
1
2
3
4
Output
5
6
21-4
Economic and Accounting Profits
• Accounting profits are what is left over
from total revenue after a firm has paid
all of its explicit cost
– Explicit cost is the cost of doing business
• rent, wages, cost of goods sold, fuel, taxes, etc.
Total Revenue
- Total Cost (explicit cost)
Accounting Profit
$4,300,000
3,750,000
550,000
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-5
Economic and Accounting Profits
• Economic profits are what is left over from
accounting profits after a firm has
subtracted its implicit cost
– Implicit cost are a firm’s opportunity cost
• the opportunity cost of any choice is the forgone
value of the next-best alternative
Suppose you have invested $100,000 of your own money in your business. You
could have earned $15,000 interest on this money. Instead of you and your
spouse working 12 hours a day, seven days a week, both could have earned
$70,000 working for someone else. ($15,000 + $70,000 = $85,000 implicit cost)
Accounting profit $ 85,000
- Explicit cost
Economic Profit
85,000
0
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-6
Economic and Accounting Profits
• Why stay in business if your economic
profits are zero?
– You are still making accounting profits
– You wouldn’t do any better if you invested
your money elsewhere and worked for
someone else
– You are your own boss by having your own
business
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-7
Economic and Accounting Profits
• When economic profits become negative,
particularly if those losses are substantial and
appear they may be permanent, more and more
people will close their businesses
– They will go to work for someone else
– They will go into a different business
• Market supply decreases and forces prices up
– This process continues until people stop getting out
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-8
Economic and Accounting Profits
• When economic profits become negative,
particularly if those losses are substantial and
appear they may be permanent, more and more
people will close their businesses
– They will go to work for someone else
– They will go into a different business
• Market supply decreases and forces prices up
– This process continues until people stop getting out
S2
S1
P2
P1
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-9
Economic and Accounting Profits
• When there are economic profits (short run)
more people are attracted to this type of
business
• Market supply increases and forces prices
down
– This process continues until people stop getting in
– Economic profits are zero at this point (long run)
– No one else wants to enter or leave
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-10
Economic and Accounting Profits
• When there are economic profits (short run)
more people are attracted to this type of
business
• Market supply increases and forces prices
down
– This process continues until people stop getting in
– Economic profits are zero at this point (long run)
– No one else wants to enter or leave
S2
S1
P2
P1
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-11
Profit Maximization and Loss Minimization
Output Price TR
1
$500 $500
2
500 1000
3
500
1500
4
500
2000
5
500
2500
6
500 3000
7
500
3500
MR
TC ATC
$500 $1000 $1000
500 1500
750
500 1800
600
500 2000
500
500 2300
460
500 2850
475
500 3710
530
MC Total Profits
$--- $500
500
- 500
300
- 300
200
0
300
200
550
150
860
- 210
1
1
1
1
1
1
Profit Maximization Point: MC = MR
This occurs somewhere between 5 and 6 units.
We are assuming output can be produced in tenths or one
hundredth of a unit
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-12
Profit Maximization and Loss Minimization
Output MR MC
1
$500 $--2
500 500
3
500 300
4
500 200
5
500 300
6
500 550
7
500 860
Profit Maximization Point: MC = MR
The most profitable output is where the MC curve crosses the D, MR curve. This
occurs at an output of 5.87 units
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-13
Profit Maximization and Loss Minimization
Total Profit = Output X (Price - ATC)
TP =Total Profit; P = Price
TP = Output X (P-ATC)
TP = 5.87 X ($500-$465)
TP =5.87 X $35
TP =$205.45
Price is $500
ATC is $465
Profit Maximization Point: MC = MR
The most profitable output is where the MC curve crosses the D, MR curve. This
occurs at an output of 5.87 units
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-14
Making Sure We Are Maximizing Profit
Output
Profit
5.00. . . . . . . . . . . . . $200
5.10
5.20
5.30
5.40
If you calculated the total profit at
every level of output (5.0 through 6.0)
you would find that the output level of
5.87 units would provide you with the
greatest level of profit.
5.50
5.87 ------------------- 205.45 Best we can do!
5.60
5.70
5.80
This is the output level where
MC=MR
5.90
6.00 . . . . . . . . . . . . . . 150
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-15
Profit Maximization and Loss Minimization
Total Profit= Output X (Price-ATC)
TP =Total Profit; P = Price
TP = Output X (P-ATC)
TP = 5.35 X ($400 - $456)
TP = 5.87 X (- $56)
TP = - $299.60
ATC is $465
Price is $400
Profit Maximization Point: MC = MR
The most profitable output is where the MC curve crosses the D, MR curve. This
occurs at an output of 5.35 units
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-16
In the long run this firm
will not accept any price
below $125.50
In the short run this firm
will not accept any price
below $101
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-17
Producing Exactly at the Output Level Where
MC = MR Enables Us to Maximize Total Profits
(or Minimize Total Losses)
• MR is the additional revenue from selling one
more unit of output
• MC is the additional cost of producing one
more unit of output
• We keep adding to output as long as MR
exceeds MC
– If we stop short of this point, we would not
maximize our profit
• We stop adding to output when MR = MC
– If we continued to add output, MC would exceed
MR and this would diminish our profits
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-18
The Short-Run and Long-Run Supply Curves
The Short-Run Supply Curve
A firm will always produce where MC equals MR
A firm will operate in the short run if sales (TR) are greater than
variable cost (VC) [ Remember TR = Price X Output]
A firm will shut down if variable cost (VC) is greater than sales
(TR) [Remember, sales and TR are the same]
Therefore, a firm will shut down if VC is greater TR or if VC are
greater than Price X Output
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-19
A firm will shut down if VC > TR or if VC > Price X Output
A firm will shut down if
VC > Price X Output
Let’s divide both side of the above equation by Output
VC > Price X Output
Output
Output
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-20
A firm will shut down if VC > TR or if VC > Price X Output
A firm will shut down if
VC > Price X Output
Let’s divide both side of the above equation by Output
VC > Price X Output
Output
Output
AVC > Price
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-21
In the short run a firm will shut down if the
AVC is greater than the price
Alternatively
In the short run a firm will operate if the
price is greater than the AVC
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-22
Cost Curves
• At any given time, a business firm will have a
certain set of cost curves: AVC, ATC, and MC.
– These curves are determined mainly by the firm’s
capital stock – its plant and equipment
• Over time these curves can change; but at any
given time they’re fixed
• At any given time, we can assume the MC
curve doesn’t change
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-23
Review
• MC must equal MR
• MC stays the same
• MR can change to any value because
whenever price changes we have an new
MR line
• When the price changes MR changes and
will equal MC at some other point on the
MC curve
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-24
Derivation of the Firm’s Short-Run and Long-Run Supply Curve
The firm’s short-run supply
curve begins at the shutdown point and runs all the
way up the MC curve
The firm’s long-run supply
curve begins at the breakeven point and runs all the
way up the MC curve
60
MC
55
50
45
40
35
30
25
ATC
20
Break-even point
AVC
15
Minimum point on the ATC
10
Shut-dow n point
5
0
Minimum point on the AVC
0
1
2
3
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
4
5
6
7
8
9
10
11
Output
21-25
Four Rules
• In the short run
– If the price is below the shut-down point, the firm
will shut down
– If the price is above the shut-down point, the firm
will operate
• In the long run
– If the price is below the break-even point, the firm
will go out of business
– If the price is above the break-even point, the firm
will stay in business
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-26
The Shut-Down and Break-Even Points
200
What is the lowest price the
firm will accept in the short
run?
Answer: $101
180
MC
160
Break-even
point
140
ATC
D,MR
Output AVC ATC Total Profits
1
$150 $250
-$120
2
120
170
- 80
3
106.67 140
- 30
4
102.50 127.50
+ 10
5
106
126
+ 20
6
116.67 133.33
- 20
120
AVC
100
Shut-dow n point
80
0
1
2
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
3
4
Output
5
6
7
21-27
The Shut-Down and Break-Even Points
200
What is the lowest price the
firm will accept in the long
run?
180
MC
160
Answer: $125.50
Break-even
point
140
ATC
D,MR
Output AVC ATC Total Profits
1
$150 $250
-$120
2
120
170
- 80
3
106.67 140
- 30
4
102.50 127.50
+ 10
5
106
126
+ 20
6
116.67 133.33
- 20
120
AVC
100
Shut-dow n point
80
0
1
2
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
3
4
Output
5
6
7
21-28
The Shut-Down and Break-Even Points
Calculate Total Profit
TP = Output X (P – ATC)
TP = 5.25 X ($130 – $126)
TP = 4 X 5.25
TP = $21
200
180
MC
160
Break-even
point
140
ATC
Price is 130
D,MR
120
AVC
ATC is 126
100
Shut-dow n point
80
0
1
2
3
4
Output
5
6
7
Output is 5.25
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-29
The Shut-Down and Break-Even Points
200
How much will the firm’s
output be in the short run and
the long run if the price is
$170?
The firm will maximize profits
at an output of 6
180
D, MR
MC
160
Break-even
point
140
ATC
D,MR
120
AVC
In both the short run and the
long run the output will be six
because that is where MC=MR
100
Shut-dow n point
80
0
1
2
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
3
4
Output
5
6
7
21-30
The Shut-Down and Break-Even Points
200
How much will the firm’s
output be in the short run and
the long run if the price is
$115?
The firm will maximize profits
at an output of 4.85
180
MC
160
Break-even
point
140
ATC
D,MR
120
The output in the shot run will
be 4.85 because the price is
above the shut-down point. The
output in the long run will be
zero because the price is below
the break-even point.
AVC
D, MR
100
Shut-dow n point
80
0
1
2
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
3
4
Output
5
6
7
21-31
The Shut-Down and Break-Even Points
200
How much will the firm’s
output be in the short run and
the long run if the price is $90?
180
MC
160
The answer to both questions
is zero. The price of $90 is
below both the break-even
point and the shut-down
point.
Break-even
point
140
ATC
D,MR
120
AVC
100
Shut-dow n point
D, MR
80
In the short run the firm will
shut down. In the long run the
firm will go out of business
0
1
2
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
3
4
Output
5
6
7
21-32
The Most Efficient Output
How much is the firm’s most
efficient output?
This occurs at an output of 10,
which is the minimum point on
the ATC (which is the breakeven point)
MC
ATC
80
AVC
70
60
D,MR
50
40
How much is the most profitable
output?
30
20
10
This occurs at an output of 11
which is where MC = MR
0
2
4
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
6
8
10
12
Output
14
16
18
21-33
Perfect Competition
• Is the first of four competitive modes
• It is a theoretical model that does not exist in
the real world
• This will serve as the standard by which we will
measure the next three competitive models
– Monopoly
– Monopolistic Competition
– Oligopoly
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-34
Perfect Competition
• In the long run the perfect competitor is
forced to operate at the break-even point
– This means it is operating at peak efficiency
– The price it gets is just equal to the
minimum point of its ATC (the break-even
point)
– It charges the lowest price and operates most
efficiently
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-35
Definition of Perfect Competition
• Perfect competition is a market structure
with many well-informed sellers and
buyers of an identical product and no
barriers to entering or leaving the
market.
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-36
Definition of Perfect Competition
• There are so many firms that no one firm
is large enough to influence price
– Either by withholding output from the
market or by increasing its output
• The firms are selling an identical product
– A product is identical, in the minds of the
buyers, if they have no reason to prefer one
seller over another
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-37
Definition of Perfect Competition
• The market has perfect mobility
– No barriers to entry such as licenses, longterm contracts, government franchises,
patents, control over vital resources, etc.
– One possible exception is money
• Perfect knowledge about the market exist
– Everyone knows about every possible
economic opportunity
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-38
The Perfect Competitor’s Demand Curve
The intersection of the industry supply and demand curve set the
price that is taken by the individual firm, in this case $6
21-39
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
The Perfect Competitor’s Demand Curve
The perfect competitor faces a horizontal, or perfectly elastic, demand curve
A firm with a perfectly elastic demand curve has an identical MR curve (MR = P)
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-40
The Perfect Competitor’s Demand Curve
The perfect competitor has to take the market price (it is a price taker!)
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-41
The Perfect Competitor’s Demand Curve
30/4,000,000 = .0000075
75
10,000,000
Why is the individual firm’s demand curve flat instead of sloping down to the right?
The individual firm’s output is between 0 & 30 units. The industry’s output in the millions. It is
impossible for the individual firm to increase output enough to change the price even one cent.
Theoretically, the individual firm’s demand curve slopes down and to the right ever so slightly. But we
can’t see the slope, so we draw it horizontally and consider it perfectly elastic
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-42
The Perfect Competitor in the Short Run
20
MC
18
16
14
12
ATC
10
8
6
D,MR
4
2
0
0
2
4
6
8
10 12
Output
14
16
18
20
In the short run the perfect competitor may make a profit or lose
money
21-43
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
The Perfect Competitor in the Short Run
20
MC
18
16
14
12
ATC
10
8
6
D,MR
4
2
0
0
2
4
6
8
10 12
Output
14
16
18
20
Is this firm making a profit or losing money?
Answer: Losing money because the D,MR curve is below the ATC
curve
21-44
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
The Perfect Competitor in the Short Run
20
MC
18
16
14
12
ATC
10
ATC = $8.50
8
6
D,MR
4
2
0
0
Price = $6
Output = $8
2
4
6
8
10 12
Output
14
16
18
20
How much money is this firm losing?
TP = ( P – ATC) X Output
TP = ($6 - $8.50) X 8
TP = -$2.50 X 8
TP = - $20
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-45
The Perfect Competitor in the Short Run
20
MC
18
16
14
12
ATC
D,MR
10
8
6
4
2
0
0
2
4
6
8
10 12
Output
14
16
18
20
Is this firm making a profit or losing money?
Answer: Making a profit because the D,MR curve is above the ATC
curve
21-46
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
The Perfect Competitor in the Short Run
20
MC
Price = $10
18
16
14
12
ATC
D,MR
10
ATC = $8.10
8
6
4
2
0
0
Output = $11
2
4
6
8
10 12
Output
14
16
18
20
TP = ( P – ATC) X Output
TP = ($10 - $8.10) X 11
TP = $1.90 X 11
TP = $20.90
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
21-47
The Perfect Competitor in the Long Run
Firm
Market
20
20
MC
S
18
18
16
16
14
14
12
12
ATC
10
10
8
8
6
D,MR
6
4
4
2
2
0
0
D
0
2
4
6
8
10 12
Output
14
16
18
20
0
1
2
3
Output (in millions)
In the long run the perfect competitor breaks even
Since the ATC curve lives above the demand curve, the firm is losing money at a
price of $6. How do we then get to the long run where the firm is breaking even?
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-48
Going from Taking a Loss in the Short Run to Breaking
Even in the Long Run
Firm
Market
20
20
MC
18
18
16
16
14
14
12
S2
S1
12
ATC
10
10
8
D2,MR 2
8
6
D1,MR 1
6
4
4
2
2
0
0
0
2
4
6
8
10 12
Output
14
16
18
20
D
0
1
2
Output (in millions)
3
At a price of $6 the firm is losing money and so, too, are all the other firms in the
industry
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-49
Going from Taking a Loss in the Short Run to Breaking
Even in the Long Run
Firm
Market
20
20
MC
18
18
16
16
14
14
12
S2
S1
12
ATC
10
10
8
D2,MR 2
8
6
D1,MR 1
6
4
4
2
2
0
0
0
2
4
6
8
10 12
Output
14
16
18
20
D
0
1
2
Output (in millions)
3
Some firms leave the industry in the long run, pushing the supply down from S1 to
S2
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-50
Going from Taking a Loss in the Short Run to Breaking
Even in the Long Run
Firm
Market
20
20
MC
18
18
16
16
14
14
12
S2
S1
12
ATC
10
10
8
D2,MR 2
8
6
D1,MR 1
6
4
4
2
2
0
0
0
2
4
6
8
10 12
Output
14
16
18
20
D
0
1
2
Output (in millions)
3
This pushes the industry price up to $8. At this price the firm breaks even.
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-51
Going from Making a Profit in the Short Run to Breaking
Even in the Long Run
Firm
Market
20
20
MC
S1
18
18
16
16
14
14
12
S2
12
10
ATC
D1,MR 1
10
8
D2,MR 2
8
6
6
4
4
2
2
0
D
0
0
2
4
6
8
10
12
14
16
18
20
0
1
Output
2
3
Output (in millions)
At a price of $10 all firms in the industry are making a profit
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-52
Going from Making a Profit in the Short Run to Breaking
Even in the Long Run
Firm
Market
20
20
MC
S1
18
18
16
16
14
14
12
S2
12
10
ATC
D1,MR 1
10
8
D2,MR 2
8
6
6
4
4
2
2
0
D
0
0
2
4
6
8
10
12
14
16
18
20
0
1
Output
2
3
Output (in millions)
New firms are attracted into the industry. This increases supply moving the
supply curve from S1 to S2
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-53
Going from Making a Profit in the Short Run to Breaking
Even in the Long Run
Firm
Market
20
20
MC
S1
18
18
16
16
14
14
12
S2
12
10
ATC
D1,MR 1
10
8
D2,MR 2
8
6
6
4
4
2
2
0
D
0
0
2
4
6
8
10
12
14
16
18
20
0
1
Output
2
3
Output (in millions)
This reduces the industry price to $8, at which the firms break even
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
2-54
The Perfect Competitor in the Long Run
24
MC
23
22
ATC
21
20
19
Price = ATC
D,MR
18
17
The most profitable level of
output is 11.1
16
15
5
10
Output
15
20
In the long run the firm breaks even
The ATC curve is tangent to the demand curve at the point where MC = MR.
ATC will equal price at the break-even point (the minimum point on the ATC
curve)
21-55
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
The Perfect Competitor in the Long Run
24
MC
23
22
ATC
21
20
Price = ATC
19
D,MR
18
17
The most profitable level of
output is 11.1
16
15
5
10
Output
15
20
A firm operates at peak efficiency when it produces at the minimum point of its
ATC. For the perfect competitor in the long run, the most profitable output is at
the minimum point of its ATC because this is also where MC=MR
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-56
The Perfect Competitor: A Price
Taker not a Price Maker
• A firm operates at peak efficiency when it
produces at the lowest possible cost
– That would be the minimum point of its ATC curve (
the break-even point)
• For the perfect competitor in the long run, the
most profitable output is also at the minimum
point of is ATC curve because this will be where
MC = MR
• Because of the degree of competition, the
perfect competitor is forced to operate at peak
efficiency
– Other forms of competition do not force firms to
operate at peak efficiency
Copyright 2005 by The McGraw-Hill Companies, Inc. All rights reserved.
21-57