LECTURE 7

PROFIT MAXIMIZATION AND

COMPETITIVE SUPPLY

Module: 4ECON005C Module Leader:

Exploring Economics Zohid Askarov

Semester 1
Lecture Outline

1. Perfectly Competitive Markets

2. Profit Maximization
3. Marginal Revenue, Marginal Cost, and Profit
Maximization
4. Choosing Output in the Short Run
5. The Competitive Firm’s Short-Run Supply Curve
6. The Short-Run Market Supply Curve
7. Choosing Output in the Long Run

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 MARKET TYPES

Perfect competition is a market system characterized

by many different buyers and sellers
Monopoly is a market for a good or service that has
no close substitutes and in which there is one supplier
that is protected from competition by a barrier
preventing the entry of new firms.
Monopolistic competition is a market in which a
large number of firms compete by making similar but
slightly different products.
Oligopoly is a market in which a small number of firms
compete.

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 Three Basic Assumptions of Perfect Competition

Perfect competition exists when

1. Many firms sell an identical product

(homogeneous) to many buyers.

2. Firm that has no influence over market price and

thus takes the price as given.

3. There are no restrictions on entry into (or exit from)

the market. No barriers to entry.

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 Marginal Revenue, Marginal Cost, and Profit
Maximization
Profit. Difference between total revenue and
total cost.
Π=R -C
Marginal Revenue Change in revenue
resulting from a one-unit increase in
output.
FIGURE 8.1
PROFIT MAXIMIZATON IN THE SHORT RUN

A firm chooses output q*, so that profit,

the difference AB between revenue R
and cost C, is maximized.
At that output, marginal revenue (the
slope of the revenue curve) is equal to
marginal cost (the slope of the cost
curve). MR = MC
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DEMAND CURVE FACED BY A COMPETITIVE FIRM

Demand and Marginal Revenue for a Competitive Firm

FIGURE 8.2

In (a) the demand curve facing the firm is perfectly elastic, even though
the market demand curve in (b) is downward sloping.

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A competitive firm making a positive profit

FIGURE 8.3

In the short run, the

competitive firm maximizes its
profit by choosing an output
q* at which MC = MR = P.
The profit of the firm is
measured by the rectangle
ABCD.

q*

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A competitive firm incurring losses

FIGURE 8.4

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The firm’s short-run decision to Shut Down

• A shutdown refers to a short-run decision not to

produce anything during a specific period of time
because of current market conditions.

• Exit refers to a long-run decision to leave the

market.

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The firm’s short-run decision to shut down
• The firm shuts down if the revenue it gets from
producing is less than the variable cost of
production.

Shut down if TR < VC

Shut down if TR/Q < VC/Q
Shut down if P < AVC

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The firm’s long-run decision to exit
• In the long run, the firm exits if the revenue it
would get from producing is less than its total
cost.

Exit if TR < TC
Exit if TR/Q < TC/Q
Exit if P < ATC

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Shutdown

MC = S
(dollars per hamburger)
Marginal revenue & marginal cost

1.50

1.05
Shutdown if MR is AVC
less than this point

s
0.67 MR0

0 60 70 80
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The Competitive Firm’s Short-run Supply Curve
The firm’s supply curve is the portion of the marginal cost curve for which marginal cost is
greater than average variable cost.

FIGURE 8.6

THE SHORT-RUN SUPPLY CURVE FOR A

COMPETITIVE FIRM

In the short run, the firm chooses its output

so that marginal cost MC is equal to price as
long as the firm covers its average variable
cost.

The short-run supply curve is given by the

crosshatched portion of the marginal cost
curve.

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 THE RESPONSE OF A FIRM TO A CHANGE IN INPUT PRICE

The Firm’s Response to an Input Price Change

FIGURE 8.7

When the marginal cost of

production for a firm increases
(from MC1 to MC2),
the level of output that
maximizes profit falls (from q1 to
q2).

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Producer Surplus in the Short Run
Producer surplus Sum over all units produced by a firm of differences between the market
price of a good and the marginal cost of production.

FIGURE 8.11

PRODUCER SURPLUS FOR A FIRM

The producer surplus for a firm is measured by

the yellow area below the market price and
above the marginal cost curve, between
outputs 0 and q*, the profit-maximizing output.

Alternatively, it is equal to rectangle ABCD

because the sum of all marginal costs up to q*
is equal to the variable costs of producing q*.

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 PRODUCER SURPLUS FOR A MARKET

PRODUCER SURPLUS VERSUS PROFIT

Producer surplus = PS = R - VC

Profit = Π = R - VC - FC

FIGURE 8.12

The producer surplus for a

market is the area below the
market price and above the
market supply curve, between
0 and output Q*.

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Choosing Output in the Long Run

Long-Run Profit Maximization

FIGURE 8.13

The firm maximizes its profit

by choosing the output at
which price equals long-run
marginal cost LMC.
In the diagram, the firm
increases its profit from
ABCD to EFGD by
increasing its output in the
long run.

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Choosing Output in the Long Run

ACCOUNTING PROFIT AND ECONOMIC PROFIT

Economic profit takes into account opportunity costs. One such opportunity cost
is the return to the firm’s owners if their capital were used elsewhere. Accounting
profit equals revenues R minus labor cost wL, which is positive. Economic profit
𝜋, however, equals revenues R minus labor cost wL minus the capital cost, rK.

Π = R - wL - rK

ZERO ECONOMIC PROFIT

Zero economic profit: A firm is earning a normal return on its investment—i.e., it is doing
as well as it could by investing its money elsewhere.

ENTRY AND EXIT

In a market with entry and exit, a firm enters when it can earn a positive long-run profit and
exits when it faces the prospect of a long-run loss.

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Accounting Profit vs. Economic Profit: Example

No Firm Firm (scenario 1) Firm (scenario 1) Firm (scenario 1)

Rent = 10 TC = 20 TC = 20 TC = 20

Wage = 5 TR = 30 TR = 35 TR = 40

Profit = 15 Acc. Profit = + 10 Acc. Profit = + 15 Acc. Profit = + 20

Ec. Profit = -5 Ec. Profit = 0 Ec. Profit = + 5

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Suggested Reading
• For this lecture
• Pindyck & Rubinfeld (2015). “Microeconomics”, 8th edition. Chapter 8.

Alternatively
• Varian, H. “Intermediate Microeconomics”, Chapters 19, 22, 23.
• Perloff, J.M. "Microeconomics", 5th edition, Chapter 8.
• Or, any Microeconomics textbook, sections on profit maximization and
perfect competition.

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