Study Unit 8

1. Study Unit 8 Profit maximisation and competitive supply

2. Outcomes • Define perfectly competitive markets • Define profit-maximisation position of the firm • Define and relate marginal revenue, marginal cost and profit maximisation • Derive short-run market supply curve • Define, describe and illustrate output decisions in the SR and LR • Derive the long-run market supply curve

3. FOUR DIFFERENT MARKTETS • Markets: • Perfect competition • Monopoly • Monopolistic competition • Oligopoly • Distinctions based on: • Number of firms in market • Nature of the product – homogeneous or different • Accessibility of market • Control of individual firm over prices

4. CHARACTERISTICS OF MODELS

5. PERFECT COMPETITION • Underlying analysis: Model of perfect competition useful to study various markets. • Consist of buyers and sellers for a specific goods and services. • Competition on both sides of the market. • No individual buyer or seller can have an influence on market price because contribution is too small. • Market price determined by interaction between demand and supply.

6. CHARACTERISTICS • PRICE TAKING: Many buyers and sellers – each participant small in relation to the market. • PRODUCT HOMOGENEITY: Products perfectly substitutable with one another. • FREE ENTRY OR EXIT: • Production factors mobile – move freely. • Total freedom of entry and exit. • No government intervention. • No collusion between sellers – acts independent.

7. EXAMPLES Agriculture: Farmers Financial markets

8. Highly competitive market • Perfectly competitive: • A perfectly horizontal demand curve • For a homogeneous product in industry • With free entry or exit. • No simple indicator to indicate a highly competitive market.

9. Profit maximisation • More is better! • Consumer max utility • Firm max profit • Differ in small and large firms: • Small firm: Focus on profits • Larger firm: Manager concerned with daily decisions, revenue max, revenue growth or payment of dividends

10. Marginal revenue, Marginal cost and profit maximisation • Profit = Total revenue – Total cost ∏(q) = R(q) – C(q) • Revenue = Price of product * units sold R = Pq • ∏, R and C depend on q. • To max profit, firm choose output where the difference between revenue and cost the greatest

11. Marginal revenue, Marginal cost and profit maximisation • R(q): Curved line – Sell more by lowering price. • Slope of R(q) = marginal revenue • MR(q): Change in revenue resulting from one-unit increase in output.

12. Marginal revenue, Marginal cost and profit maximisation • C(q): Slope of curve measure additional cost of producing one additional unit of output = Marginal cost. • C(q) = positive at 0 = Fixed cost. • Profit negative at low output levels • At q*: Profit max output level, thereafter cost rise and profit decline. • RULE: Profit max where MR = MC

13. Marginal revenue, Marginal cost and profit maximisation Price taker = Horizontal demand curve for the firm. Downward sloping for the industry. • For the competitive firm: P = MR = MC

14. Choosing output in the SR • SR, firm will operate with fixed capital and choose labour • RULE: If a firm is producing any output, it should produce at a level where • MR = MC

15. Choosing output in the SR

16. Choosing output in the SR

17. Competitive firm’s SR supply curve • Supply: How much output possible at every possible price. • Increase output where P = MC • Shut down if P < AVC • Supply curve: Portion of the MC curve for which MC > AVC

18. Competitive firm’s SR supply curve

19. Response of firm to change in input price

20. SR market supply curve • Shows the amount of output that the industry will produce in the SR for every possible price • Industry output = Sum of individual firm’s quantity supplied

21. SR market supply curve • Not always easy to determine the supply curve. • Price elasticity of market supply: Measure sensitivity of industry output to market price Es = (∆Q/Q)/(∆P/P) • SR elasticity of supply always positive. • IF MC increase rapidly, elasticity is low. • IF MC increase slow, supply elastic – firm produce more.

22. Producer surplus in SR • Sum over all units produced by a firm of differences between the market price of a good and the MC of production.

23. Producer surplus for a market

24. Producer surplus vs. Producer profit • Surplus closely related to profit. • SR, surplus = Revenue – Variable cost = Variable profit PS = R – VC • Total profit = Revenue – All costs ∏ = R – VC – FC

25. Choosing output in the LR • LR, exit industry or produce new products • Remember: Free entry/exit • SR firm: Horizontal demand curve • ABCD = Positive profit • LAC reflect economy of scale at q2 and diseconomy of scale higher up • If price remain $40, increase plant to produce at q3 = Profit EFGD • More than q3: MC > MR – NO! • If fall to $30 = 0 profit.

26. LR competitive equilibrium

27. LR competitive equilibrium • LR competitive equilibrium: All firms in industry are at max profit, no incentive to enter or exit, price is such that supply = demand • Economic rent: Amount firm is willing to pay for an input less the minimum amount necessary to obtain it Example: 2 owned locations. 1 Next to river and can ship in inputs rather than transport on land.

28. 0 Profit and Economic rent

29. Industry LR supply curve • Can’t analyse as with SR. • Need to know input price = increase, decrease or stay the same. • We study: • Constant cost industries • Increasing cost industries • Decreasing cost industries • Keep in mind: Is input price increase, decrease or remain constant after an increase in demand – higher profits are made, new firms join the industry.

30. Constant cost industry

31. Increasing cost industry

32. Effects of an output tax • Tax on output • Pollutant tax

33. Effects of an output tax