Profit, Loss & Perfect Competition

 Market Types
 Maximizing Profit/Minimizing Loss
 The Marginal Revenue Curve
 Perfect Competition
 Short-Run vs Long-Run
 Questions for Next Time
 Market Types
 Each firm’s goal is to maximize profits – But
 Different competitive scenarios place unique decision
making requirements on business managers
 Purpose of the next several chapters
-- describe various competitive scenarios
-- examine how business managers make decisions
-- rational choice, balancing costs and benefits at the
margin, and responding to incentives
 Market Types

 Perfect Competition

 Monopoly

 Monopolistic Competition

 Oligopoly
 Maximizing Profit/Minimizing Loss

 Total Revenue = Price x Total Revenue

 Marginal Revenue = the increase in total revenue when output
increases by one unit, or

MR = Change in Total Revenue

Change in Output

 As long as MR > MC, the addition to Total Profit is increasing

and production should be increased
 As soon as MR < MC, the addition to Total Profit is decreased
and production should be decreased
 Therefore Profit is Maximized (Losses Minimized) where
MR = MC
 Graphing Demand & Marginal Revenue
Marginal revenue is the increase in total revenue when
output sold goes up by one unit

Output Price Total Revenue Marginal Revenue

1 $5 $ 5 $5
2 5 10 5
3 5 15 5
4 5 20 5
5 5 25 5

6 5 30 5

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-3
 Graphing Demand & Marginal Revenue

Output Price Total Revenue Marginal Revenue

1 $5 $ 5 $5 6

2 5 10 5 5 D,MR

3 5 15 5 4

4 5 20 5 3

5 5 25 5 2

6 5 30 5 1

0
0 1 2 3 4 5 6
Output

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-4
 Profit Maximization and Loss Minimization
Output Price TR MR TC ATC MC Total Profits
1 1 $200 $200 $200 $500 $500 $100 - $300
1 2 200 400 200 550 275 50 - 150
1 3 200 600 200 610 203 60 - 10
1 4 200 800 200 700 175 90 100
1 5 200 1000 200 830 166 130 170
1 6 200 1200 200 1000 167 170 200
7 200 1400 200 1205 172 205 195
Profit Maximization Point: MC = MR

This occurs somewhere between 6 and 7 units.

We are assuming output can be produced in tenths of a unit

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-6
 Profit Maximization and Loss Minimization

Output MR MC 500

1 $200 $100
400
2 200 50
3 200 60 300

4 200 90
5 200 130 200
D,MR MC

6 200 170 ATC

7 200 205 100

Profit Maximization Point: MC = MR

0
0 1 2 3 4 5 6 7
Most efficient Production Point: MC = ATC Output

The most profitable output is where the MC curve crosses the D, MR curve. This
occurs at an output of 6.7 units
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 21-7
 Market Types
 Perfect Competition
-- many firms sell an identical product to many
buyers
-- no restrictions on entry to or exit from the market
-- established firms have no advantage over new
firms
-- sellers and buyers are well informed about prices

Example: commodities, especially farming

 Perfect Competition
 The firm has no control over its price – set by forces
of market demand and supply
 The firm can sell all of its production at the going
price
 The primary decision the firm must make is how
much to produce
 It makes no sense to produce a single unit where
what you receive (revenue/price) is less than the
unit’s cost (ATC/MC)
 So, problem is to determine the profit maximizing
level of output (TR-TC = Max Profit)
 Short Run Production Decisions

 How much the firm chooses to produce is becomes a

question of production cost vs revenue
 The firm will logically choose to produce at a level
that maximizes profit
 Two methods of computing that level of production
1. The point where Total Revenue – Total Cost =
Max Profit, or where TR-TC = Max P
2. The point where Marginal Cost = Marginal
Revenue, or where MC=MR
 The Perfect Competitor’s Demand Curve
Firm Industry S
9

6 D,MR 6

5 5

4 4 D

3 3

2 2

1 1

5 10 15 20 25 30 1 2 3 4 5 6 7
Output Output (in millions)

The intersection of the industry supply and demand curve set the
price that is taken by the individual firm, in this case $6
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 22-6
 The Perfect Competitor in the Short Run
20
MC
18

16

14

12
ATC
10

6 D,MR

0
0 2 4 6 8 10 12 14 16 18 20
Output

In the short run the perfect competitor may make a profit or lose
money
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 22-10
 The Perfect Competitor in the Short Run
20
MC
18

16

14

12
ATC
10 D,MR

0
0 2 4 6 8 10 12 14 16 18 20
Output

Is this firm making a profit or losing money?

Answer: Making a profit because the D,MR curve is above the ATC curve

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 22-13
 Exit & Temporary Shutdown Decisions
 When Total Costs exceed Total Revenue, what does the firm
do?
 In the long run, the firm may choose to exit the market if it
feels the imbalance is permanent
 In the short run, the firm must analyze its revenue & costs
-- If Revenue exceeds Variable Cost, then some revenue is
contributing toward covering part of fixed cost and the firm
should continue to operate
-- If Revenue is less than Variable Cost, then the firm is incurring
all its fixed costs plus some of the Variable Cost and the
firm should consider a temporary shutdown
 Long Run- Output, Price & Profit

 In the long run the firm in perfect competition earns

zero economic profit. Means firm earns the “normal”
profit only
 Economic Profit brings in other firms which increases
competition – Industry Supply Curve shifts to the
right = more product and lower prices
 Economic Loss induces higher cost firms to exit the
industry – Industry Supply Curve shifts to the left =
less product and higher prices for firms that are left
 Long Run – Permanent Change in
Demand

 A permanent increase in demand creates short term

economic profits, but encourage new firms to enter
the market

 A permanent decrease in demand triggers a similar

response except in the opposite direction – incurring
economic losses encourages firms to exit the industry
 Going from Taking a Loss in the Short Run to
Breaking Even in the Long Run
Firm Market
20 20
MC
18 18 S2 S1

16 16

14 14

12 12
ATC
10 10

8 D2 ,MR2 8

6 D1 ,MR1 6

4 4

2 2 D

0 0
0 2 4 6 8 10 12 14 16 18 20 0 1 2 3
Output Output (in millions)

This pushes the industry price up to $8. At this price the firm breaks even.

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 22-18
 Going from Making a Profit in the Short Run to
Breaking Even in the Long Run
Firm Market
20 20
MC S1 S2
18 18

16 16

14 14

12 12
ATC
10 D 1,MR1 10

8 D2,MR2 8

6 6

4 4 D

2 2

0 0
0 2 4 6 8 10 12 14 16 18 20 0 1 2 3
Output Output (in millions)

New firms are attracted into the industry. This increases supply moving the
supply curve from S1 to S2

Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 22-20
 The Perfect Competitor in the Long Run
24
MC
23

22 ATC

21

20

19
Price = ATC D,MR
18

17
The most profitable level of 16
output is 11.1
15

5 10 15 20
Output

In the long run the firm breaks even

The ATC curve is tangent to the demand curve at the point where MC = MR.
ATC will equal price at the break-even point (the minimum point on the ATC
curve) 22-22
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
 External Economies & Diseconomies
 External Economies – Factors beyond a firm’s control
that will lower its costs as the market output increases
-- improvement in farm inputs (seed, fertilizer)
-- technological change

 External Diseconomies – Factors beyond a firm’s

control that will increase its costs as market output
increases
-- Congestion (Airline Industry)
 Market Types
 Monopoly

-- one firm sells a good or service with no close

substitutes
-- a barrier blocks the entry of new firms

Example: Utility companies/DeBeers in diamonds

 Market Types
 Monopolistic Competition
-- Large number of firms making similar but slightly
different products
-- Each producer is a sole producer of a particular
version of the product (Branding)
-- Although each firm has a monopoly on its brand,
they still compete with one another

Example: Nike/Reebok
 Market Types
 Oligopoly
-- Small number of firms compete and dominate the
industry
-- Products might be very similar, or they may have
brand differentiation

Example: Kodak/Fuji or Coke/Pepsi