S&N, Ch.

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Mw, Ch. 14
Assumptions
 Firms seek to maximise profits
 Everyone sells a homogeneous product
 Many buyers and sellers
Each firm is so small it cannot effect the
market price
Each firm can sell as much as it wants
 Firms have to take the market price
 Firms can freely enter and exit the
market

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Consequences of price-
taking
 Let the equilibrium price be P
 If the firm sells one more unit it receives
P
Marginal revenue is P (independent of Q)
Average revenue is P (independent of Q)
 The demand curve is horizontal
The price is P, whatever the quantity sold

3
Profit maximisation
Quantity Total Total Cost Profit = Marginal Marginal Δ(Profit) =
Revenue TR-TC Revenue Cost MR-MC
1 6 5 1
6 3 3
2 12 8 4
6 4 2
3 18 12 6
6 5 1
4 24 17 7
6 6 0
5 30 23 7
6 7 -1
6 36 30 6
6 8 -2
7 42 38 4
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Profit maximisation

MC
ATC

P=MR=AR

AVC

Q1 Qmax Q2 Quantity

5
Profit maximisation
 AtQ1 the marginal revenue exceeds the
marginal cost
Producing one more unit increases profit
 AtQ2 the marginal cost exceeds the
marginal revenue
Producing one less unit increases profit
 Profit
is maximised when marginal
revenue = marginal cost

6
Shutdown
MC

ATC
P1

P2
AVC

P3

Q Q2 Q1 Quantity
3

7
Shutdown
 If the price is P1 the firm makes a profit
 Ifthe price falls to P2 the firm makes zero
economic profit (economic costs include
opportunity costs, financing, owners’
capital and labour, etc.)
 For P3<P<P2 the firm operates to minimise
losses – revenue exceeds variable costs
 For P<P3 the firm shuts down

8
Shutdown vs. Exit
 In the short run a firm has to pay its
fixed costs
 If Price exceeds average variable cost,
then revenue exceeds variable costs,
and the excess offsets some of the fixed
costs
 The shut down point is when price =
AVC
 In the long run the firm exits the market
and eliminates the fixed costs

9
Next time
 Monopoly
S&N, Ch. 9
Mw, Ch. 15

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