Fall 2008-09 Fall 2009-10 Harvard University KSG API-105A/GSD 5203A – Markets and Market Failure with Cases Class #10 Profit Maximization and Perfect Competition.

Fall 2008-09Fall 2008-09Fall 2009-10Harvard UniversityHarvard University KSG API-105A/GSD 5203A – Markets and Market KSG API-105A/GSD 5203A – Markets and Market Failure with CasesFailure with Cases

Class #10

Profit Maximization andPerfect Competition

Fall 2010-11

Erich Muehlegger


The Economics of Production Review… What is the most efficient (least cost) way to

produce any given amount of output?– Budget Constraint – All the combinations of inputs which a firm

can buy for a given budget.– Isoquant – All the combinations of input with which a firm can

produce a given amount of output.– Technically Efficient (i.e., least cost) production – Choose the

combination of inputs so that the contribution to output per dollar spent on an input is equated across inputs (the point where the slope of the Isoquant and the slope of the Budget Constraint are equal).

– Expansion Path – What is the most efficient (lowest cost) way of producing any particular amount of production?

– Average and Marginal Cost Curves – How costs vary as output changes

Fall 2010-11


Profit Maximization

Profit = Total Revenues (TR) – Total Costs (TC) What do we mean by profit?

– Economic Profit v. Accounting Profit

Is the assumption of profit maximization reasonable? What else might a firm maximize?– Total sales? – Size? – ??

Fall 2010-11

Fall 2008-09Fall 2008-09 Fall 2009-10

The “Expansion Path” of Efficient Production

Harvard UniversityHarvard University KSG API-105A/GSD 5203A – Markets and Market KSG API-105A/GSD 5203A – Markets and Market Failure with CasesFailure with Cases

PW = $10/day

Worker Days

10

Capital (Machinery) PM = $100/day M W Q TC AC

At Pt. A 4 60 50 $1000 $20

At Pt. C 3 50 40 $800 $20

At Pt. D 7.5 75 60 $1500 $25

Q = 50

60

4 A

Q = 40

C

50

3

8

15

D

75

7.5

Expansion Path

Q = 60

Fall 2010-11

Fall 2008-09Fall 2008-09

How Much Would a Manufacturer Pay for Steel?

20 100

30 600

40 1000

50 1300

60 1500

70 1600

Tons of Steel

OutputQ

Marginal Product

(MP=Q/Tons)

Marginal Value to the Consumer Per Ton(PxMP)


$500

$400

$300

$200

$100

50

40

30

20

10

Suppose Consumer Price Per Unit of Output = $10Mfgr’s

Willingness to Pay for

Steel

Tons of Steel

10 20 30 40 50 60 70

$100

$200

$300

$400

$500

…It is the marginal contribution of

value to consumers when steel is used in

manufacturing.

This willingness to pay is the mfgr’s

DEMAND for steel…

Fall 2010-11

Fall 2008-09Fall 2008-09Fall 2009-10

The Relationship BetweenAverage and Marginal Cost


$/Q

Q

Average Cost (AC)Marginal Cost (MC)

Minimum of AC

Fall 2010-11

Fall 2008-09Fall 2008-09Harvard UniversityHarvard University KSG API-105A/GSD 5203A – Markets and Market KSG API-105A/GSD 5203A – Markets and Market Failure with CasesFailure with Cases

Total and Marginal Cost

10 $2000 $200

20 $2400 $120

30 $2900 $96.67

40 $3500 $87.50

50 $4200 $84

60 $5000 $83.33

70 $6000 $85.71

Quantity(Q)

Total Cost(TC)

AC(= TC/Q)

MC(= TC/Q)

$50

$60

$70

$80

$100

$40

Fall 2010-11


Total Cost Curve$

Q

1000

2000

3000

4000

5000

6000

10 20 30 40 50 60 70 80

Slope of Total Cost Curve = ∆TC/∆Q= Marginal Cost

Fall 2010-11


Demand Curve Facing the Firm Total Revenues

Price

Quantity

$150

7010

$90

$140

20

Fall 2010-11


Total and Marginal Revenue

10 $150 $1500

20 $140 $2800

30 $130 $3900

40 $120 $4800

50 $110 $5500

60 $100 $6000

70 $90 $6300

Quantity(Q)

Price(P)

Total Revenue= P*Q

MR(= TR/Q)

$110

$90

$70

$50

$30

$130

Fall 2010-11


Total Revenue Curve$

Q

1000

2000

3000

4000

5000

6000

10 20 30 40 50 60 70 80

Slope of Total Revenue Curve = ∆TR/∆Q= Marginal Revenue

Fall 2010-11


Profit Maximization:Where is Profit (= TR – TC) greatest?

10 $150 $1500 $2000 -$500

20 $140 $2800 $2400 $400

30 $130 $3900 $2900 $1000

40 $120 $4800 $3500 $1300

50 $110 $5500 $4200 $1300

60 $100 $6000 $5000 $1000

70 $90 $6300 $6000 $300

Quantity(Q)

Price(P)

Total Rev(TR)

Total Cost(TC)

Profit(TR – TC)

Fall 2010-11


Profit Maximization$

Q

1000

2000

3000

4000

5000

6000

10 20 30 40 50 60 70 80

Total Cost CurveTotal Revenue Curve

Profit = Vertical DistanceBetween Total Revenue and

Total Cost Curve

Fall 2010-11


What Output Maximizes Profits? …Where MR = MC

10 $1500 $2000

20 $2800 $2400

30 $3900 $2900

40 $4800 $3500

50 $5500 $4200

60 $6000 $5000

70 $6300 $6000

Quantity(Q)

Total Rev(TR)

MarginalRevenue

Total Cost(TC)

MarginalCost

$110

$90

$70

$50

$30

$130

$50

$60

$70

$80

$100

$40

Fall 2010-11


Perfect Competition

Attributes of a Perfectly Competitive Market– Each firm is small relative to overall industry.– Each firm produces a homogenous product.– Firms can freely enter or exit the industry.

Implications:– Each firm is a price taker. They can sell as much or as little at

the market price as they want without effecting the market price.– There are no “special” costs required to enter or exit the industry.

In the long-run, firms will enter if there are profits to be made and will exit if losing money.

Examples– Agriculture

Fall 2010-11


The Demand Curve Faced By A Price-Taking Firm

Price

$20

Market Price = $20

10 20 30 40 50 60 Quantity

Demand

What is the Marginal Revenue?

Perfect Competition Price = Marginal Revenue

Fall 2010-11


Short-Run Profit MaximizationPrice

$20

10 20 30 40 50 60 Quantity

DemandMR = P

Marginal Cost

Average Cost

Profits Are Maximizedwhere MR = MC

qC

Fall 2010-11


Short-Run Profits for a Price-Taking Firm

Price

pC = $20

10 20 30 40 50 60 Quantity

DemandMR = P

Marginal Cost

Average Cost

qC=46

AC = $15

Profit = TR – TC= qc(pc) – qc(AC)= qc(pc – AC)

(pc – AC)= $5 Short-Run Profits = $5*46 = $230

Fall 2010-11


Short-Run Losses in aPerfectly Competitive Industry

Price

pC = $12

10 20 30 40 50 60 Quantity

DemandMR = P

Marginal Cost

Average Cost

qC=34

AC = $13

Short-Run Losses = qc(pc - AC) = 34 * (-1) = -$34

AVC

If Price is between AVC and AC, the firm covers its variable costs and is able to cover part of its fixed costs.

Fall 2010-11


Shutting Down Production in aPerfectly Competitive Industry

Price

10 20 30 40 50 60 Quantity

pC = $12 DemandMR = P

Marginal Cost

Average Cost

qC=34

AVC

If Price is below AVC, the firm doesn’t even cover its variable costs. The profit-

seeking firm should shut down.

Fall 2010-11


Short-Run Production (Supply) Curve How much would a firm produce at each price?

10 20 30 40 50 60 Quantity

Marginal Cost

Average Cost

AVC

Price

Fall 2010-11

Fall 2008-09 Fall 2009-10 Harvard University KSG API-105A/GSD 5203A – Markets and Market Failure with Cases Class #10 Profit Maximization and Perfect Competition.

Documents

marginal cost fall

steel fall

market failure

cost production

cases total cost curve

marginal cost curves

quantity q total cost

q tons marginal value