Profit Maximization

1
Chapter 9

• Profit Maximization
• Use the facts about cost curves Chap 8 to
  figure out the supply
• curve of a competitive firm i.e. Maximization
  problem facing a
• competitive firm
• (1) Max PQ TC(Q) such that Q 0.i.e competitive
  firm wants to maximize
• Q
• profits -- difference between its revenue, PQ,
  and its costs, C(Q).
• Question What level of output will a firm choose
  to produce? It will
• operate where MR MC i.e. where extra revenue
  gained by one more
• unit just equals the extra cost of producing
  another unit.
• Thus, (2) p PQ TC(Q) PQ ATC x Q

Note For Perfect Competition, assume P is
determined by the industry and NOT the firm.
Given the Cost Side, the only variable the firm
can adjust on the Benefit Side is Q and not P!
2
Profit Maximization

• That is, for a given P, the firm will increase
  its output
• by ?Q because doing so increases profits.
• Observation
• The MC(Q) curve of a competitive firm is its
  Supply Curve OR
• The market price, P, is precisely the MC(Q) as
  long as each firm is producing at its
  profit-maximizing level.
• Two exceptions to this observation
• Where there are several levels of output where
  PMC(Q).
• Where P ltAVC
• The conditions for optimal supply, Q are (1)
  PMC and (2) the MC
• must be increasing. If PltAVC, the firm supplies
  Q0

3
MR and MC

• Marginal Revenue Change in Total Revenue/Change
  in Total Output
• MR ?TR/?Q slope of the TR curve
• Marginal Cost Change in Total Cost/Change in
  Total Output
• MC ?TC/?Q slope of the TC curve
• Comparing marginal revenue and marginal cost
  determines whether the firm needs to supply more
  or less in order to maximize profit.
• From the firms viewpoint, this is equivalent to
  doing Cost-Benefit Analysis, i.e. comparing
  marginal change in costs (MC) and marginal
  changes in benefits (MR)

4
Profit Maximization
5
Market Structure

• The selling environment in which a firm produces
  and sells its product is called a market
  structure. There are 4 types of market
  environment (perfect competition, monopoly,
  monopolistic competition oligopoly)
• Defined by three characteristics
• The number of firms in the market
• The ease of entry and exit of firms
• The degree of product differentiation
• We begin with Perfect Competition

6
I Perfect Competition

• Perfect Competition is a market structure
• characterized by
• Many large firms, so large that no one firm has
  the ability to affect the market. These firms are
  price takersthey have to go along with the
  market price.
• Identical products, the products are identical,
  generic products.
• Easy entry into the industry.
• The demand curve is perceived by each firm to be
  horizontal.

7
Perfect Competition
MC
MRP
Rule Set MR MC
Recall ?TR/?Q MR P d only in perfect
competition
8
Differentiation in a Perfect Market

• Milk has been a brandless market for years.
• Some milk producers have decided to offer organic
• milk, from cows not injected with hormones.
• Organic milk accounts for only 4 percent of
  sales, but demand in some areas outstrips supply
  by about 40 percent.
• A 1/2-gallon carton of organic milk costs 3.69,
  compared with 1.99 for a 1/2 gallon of
  conventional whole milk.

9
II Monopoly

• Monopoly is a market structure in which there
• is just one firm, and entry by other firms is not
• possible.
• There are no close substitutes.
• The firm has the power to set the price (via
  control of Q), but still sets an optimal price to
  maximize profit. If the monopolist sets the price
  too high, revenue will decline. The Rule Set
  MRMC still applies.
• The firm is a price maker.
• The firms demand curve is the market demand
  curve, and it is downward sloping.

10
Monopoly
MR
Note Since there 1 firm that is also the
industry, market demand firms demand, i.e. D
d
11
Cable TV

• Despite the introduction of satellite service in
  the 1990s, cable dominates the paid television
  market in the U.S.
• With virtually no competition, cable monopolies
  have been able to raise prices dramatically.
  Telephone companies have begun offering TV
  service in certain areas. In these areas average
  prices are falling about 56.40 per month.

12
III Monopolistic Competition

• Monopolistic Competition is characterized by
• A large number of firms
• Easy entry
• Differentiated products, because each firms
  product is slightly different, each firm is kind
  of a mini-monopolythe only producer of that
  specific product.
• This allows the firm to be a price maker.
• The firms demand curve is downward sloping and
  depending on the differentiation of the firms
  product, it may be fairly inelastic.

13
Monopolistic Competition
Mon Com
DMono
Flatter than Monopoly
14
IV Oligopoly

• Oligopoly is characterized by
• Few firmsmore than one, but few enough so each
  firm alone can affect the market.
• Entry is more difficult, but can occur.
• The firms are interdependenteach is affected by
  what others do. e.g. gas stations at Fair Oaks
  Watt
• The demand curve is downward sloping for each
  firm.

15
Oligopoly
16
Profit Maximizationfor the Price Taker and Price
Maker
17
Summary of Market Structures
18
Accounting Profit Economic Profit

• The profit figure reported in annual reports
• and income statements is accounting
• profit
• pAccounting PQ (cost of land) - (cost of
  labor) (cost of capital) -
• 
  (other
  inputs )
• Note Accounting profit does not include the cost
  of ownership called equity capital represented
  by economists opportunity cost
• Economic profit includes all opportunity costs.
• pEconomic accounting profit cost of equity
  capital