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Profit Maximization

This document discusses profit maximization under different market structures. It defines concepts like total revenue, total cost, average costs, marginal costs and revenues. It then explains how profit is maximized for firms under perfect competition and monopoly. Perfect competitors are price takers and will produce where price equals marginal cost. Monopolists are price makers and restrict output to maximize profits, producing where marginal revenue equals marginal cost.

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689 views5 pages

Profit Maximization

This document discusses profit maximization under different market structures. It defines concepts like total revenue, total cost, average costs, marginal costs and revenues. It then explains how profit is maximized for firms under perfect competition and monopoly. Perfect competitors are price takers and will produce where price equals marginal cost. Monopolists are price makers and restrict output to maximize profits, producing where marginal revenue equals marginal cost.

Uploaded by

qwert2526
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Principles of Econ: Profit Maximization Under Different Market Structures

Prof. H.Grob, Spring 2006

Profit Maximization

Profits = Total Revenue - Total Costs

Total Revenue = Price x Quantity

Total Cost = Average Total Cost x Quantity

Therefore: Profit = (Price x Quantity) (Average Cost x Quantity)

Profit= (Price Average Cost) * Quantity

* There is a difference between economic profit and accounting profit.

Average Total Cost, Average Variable Cost, Average Fixed Cost

Total Cost = Total Fixed Cost + Total Variable Cost

Average variable cost = Total cost / quantity

Average fixed costs = Total fixed cost / quantity

Average Total Cost = Average Fixed Cost + Average Variable Cost

Average Total Cost = (Total Fixed Cost/ Q) + (Total Variable Cost / Q)

* A firm should shut down when the total variable cost exceeds total revenue

Marginal cost, marginal revenue

Marginal cost = Change in Total cost / Change in quantity

* Marginal cost intersects average total cost and average variable cost curves at
the minimum points because for each additional change in cost, there will be a
corresponding (but not necessarily equal) change in average variable costs.

Marginal Revenue = Change in total revenue / change in quantity sold

* All efficient firms, whether monopoly or competitive, will set quantity where
marginal revenue equals marginal cost.
Profit maximization under conditions of perfect competition

A perfectly competitive market is characterized by many sellers, many buyers,


relatively easy entry into and from a market, standardized products, and perfect
information. Perfectly competitive firms operate at lowest cost, lowest price.

Perfectly competitive firms are price TAKERS. Therefore, the demand curve
facing the individual firm is horizontal. Because price does not change, and
because TR=P x Q and MR=dTR/dQ, then P=MR.

Perfectly competitive firms will operate or produce where P=MR=MC. At this


point, the firm maximizes profits and minimizes losses.

P
MC

D=MR

Conditions necessary for optimal allocation of resources


1. Market goods are marketable, divisible
2. Distribution is not a problem
3. Goods and services are perfect substitutes
4. Perfect information
5. Perfect competition

Absence of any of these conditions can cause market failure.


Profit maximization under conditions of monopoly

Monopoly markets are characterized by one seller. Barriers to entry and exit,
patents, control over resources or economies of scale can result in monopolistic
conditions.

Economies of scale mean that the more the firm produces, the less costly the
production becomes. Economies of scale often benefit consumers.

Monopolies are price MAKERS. This means that the monopoly faces the market
demand curve. A monopoly can command any price or set any level of quantity
so long as it meets demand, but the most efficient point of operation will be at the
point where MR=MC. Price will generally be set higher, however.

The monopolist will restrict output in order to maximize profit. By keeping prices
high and quantity low, the monopolist disturbs the balance of conditions
necessary for market clearing to occur. Allocation is therefore sub-optimal.

Natural monopolies are able to supply the entire market at a lower cost per unit
than would be achieved by two or more firms supplying it. They often experience
economies of scale.

P
MC

MR

Q
PRACTICE:

1. What is the equation for each of the following?

a. Total Revenue =

b. Profit =

c. Marginal Cost =

2. Using the following information, calculate average and marginal costs.

TC Q Marginal cost Average Cost

700 0 _______ _______

1300 1 _______ _______

2500 2 _______ _______

3300 3 _______ _______

2. Fill in the following table. It might help to write the equation above each
column.

(A) (B) (C.) (D) (E) (F) (G) (H)

Total Total Average Average Average


Total fixed variable total variable fixed Marginal
Output cost cost cost cost cost cost cost

0 400 400 0 -x- -x- -x- -x-

1 800 400 400 800 400 400 400

2 1000 400 600 500 300 200 200

3 1,200 400 800 400 _____ 133 _____

4 1,600 400 1200 400 _____ _____ _____

5 1,700 400 1300 ______ _____ _____ _____


__
3. Using this information answer the questions below

Output P=MR ATC MC

10 $10 $20.80 --x--

20 10 12.40 $4.00

30 10 9.92 5.00

40 10 9.00 6.20

50 10 8.80 8.00

60 10 9.00 10.00

70 10 9.56 13.00

80 10 10.50 17.00

Source: Carbaugh, Contemporary Economics, 2005

a. Sketch a graph of the MR, ATC and MC curves, putting price on the
vertical axis and quantity on the horizontal axis.

b. In what market structure does this firm operate and how do you know?

c. What level of output maximizes the firms profits? What price will be
charged?

d. What is the firms maximum total profit?

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