Prepared by Dr Della Lee Sue, Marist College MICROECONOMICS: Theory & Applications Chapter 9: Profit Maximization in Perfectly Competitive Markets By Edgar K Browning & Mark A Zupan John Wiley & Sons, Inc 12th Edition, Copyright 2015 Copyright © 2015 John Wiley & Sons, Inc All rights reserved Learning Objectives      Outline the conditions that characterize perfect competition Explain why it is appropriate to assume profit maximization on the part of firms Show why the fact that a competitive firm is a price taker implies that the demand curve for the firm is perfectly horizontal Explain a competitive firm’s optimal output choice in the short run and how the firm’s shortrun supply curve may be derived through this output selection Describe the firm’s short-run supply curve (continued) Copyright © 2015 John Wiley & Sons, Inc All rights reserved Learning Objectives      (continued) Explain how the short-run industry supply curve is derived Define the conditions characterizing long-run competitive equilibrium Understand how the long-run industry supply curve describes the relationship between price and industry output over the long run, taking into account how input prices may be affected by an industry’s expansion/contraction Analyze the extent to which the competitive market model applies Delineate the mathematics behind perfect competition Copyright © 2015 John Wiley & Sons, Inc All rights reserved Outline the conditions that characterize perfect competition 9.1 THE ASSUMPTIONS OF PERFECT COMPETITION Copyright © 2015 John Wiley & Sons, Inc All rights reserved The Assumptions of Perfect Competition     Large numbers of buyers and sellers Free entry and exit Product Homogeneity Perfect information Copyright © 2015 John Wiley & Sons, Inc All rights reserved Explain why it is appropriate to assume profit maximization on the part of firms 9.2 PROFIT MAXIMIZATION Copyright © 2015 John Wiley & Sons, Inc All rights reserved Profit Maximization   Assumption: firms select an output level so as to maximize profit, defined as the difference between revenue and cost “Survivor Principle” – the observation that in competitive markets, firms that not approximate profit-maximizing behavior fail, and that survivors are those firms that, intentionally or not, make the appropriate profit-maximizing decisions Copyright © 2015 John Wiley & Sons, Inc All rights reserved Show why the fact that a competitive firm is a price taker implies that the demand curve for the firm is perfectly horizontal 9.3 THE DEMAND CURVE FOR A COMPETITIVE FIRM Copyright © 2015 John Wiley & Sons, Inc All rights reserved The Demand Curve for a Competitive Firm  Price taker – a firm that takes prices as given and does not expect its output decisions to affect price =>horizontal demand curve  Total revenue (TR) – price times the quantity sold Average revenue (AR) – total revenue divided by output Marginal revenue (MR) – the change in total revenue when there is a one-unit change in output   Copyright © 2015 John Wiley & Sons, Inc All rights reserved Figure 9.1 - The Competitive Firm’s Demand Curve Copyright © 2015 John Wiley & Sons, Inc All rights reserved 10 Figure 9.9 – Long-Run Competitive Equilibrium Copyright © 2015 John Wiley & Sons, Inc All rights reserved 31 Zero Profit When Firms’ Cost Curves Differ?  When all firms in a competitive industry have identical cost curves, each firm earns zero economic profit in long-run equilibrium  What happens if cost curves differ among firms? There is a tendency for factor inputs to receive compensation equal to their opportunity costs This process leads to the zero-profit equilibrium Copyright © 2015 John Wiley & Sons, Inc All rights reserved 32 Understand how the long-run industry supply curve describes the relationship between price and industry output over the long run, taking into account how input prices may be affected by an industry’s expansion/contraction 9.8 THE LONG-RUN INDUSTRY SUPPLY CURVE Copyright © 2015 John Wiley & Sons, Inc All rights reserved 33 The Long-Run Industry Supply Curve  The long-run relationship between price and industry output  It depends on whether input prices are constant, increasing, or decreasing as the industry expands or contracts Copyright © 2015 John Wiley & Sons, Inc All rights reserved 34 The Long-Run Industry Supply Curve [Three Classifications]  Constant-cost industry: an industry in which  expansion of output does not bid up input prices  long-run average production cost per unit remains unchanged, and  the long-run industry supply curve is horizontal  Increasing-cost industry: an industry in which  expansion of output leads to higher long-run average production costs  the long-run industry supply curve slopes upward  Decreasing-cost industry: an industry in which  the long-run industry supply curve slopes downward Copyright © 2015 John Wiley & Sons, Inc All rights reserved 35 Figure 9.10 – Long-Run Supply in a Constant-Cost Industry Copyright © 2015 John Wiley & Sons, Inc All rights reserved 36 Figure 9.11 – Long-Run Supply in an Increasing-Cost Industry Copyright © 2015 John Wiley & Sons, Inc All rights reserved 37 Figure 9.12 – Technological Advances Shift the Long-Run Supply Curve Copyright © 2015 John Wiley & Sons, Inc All rights reserved 38 Comments on the Long-Run Supply Curve  The long-run supply curve is not derived by summing the long-run marginal cost curves of an industry’s firms  A movement along the long-run industry supply curve is accompanied with the assumptions that conditions of supply remain constant, such as:  Technology  conditions of input supply factors  government regulations  weather conditions (continued) Copyright © 2015 John Wiley & Sons, Inc All rights reserved 39 Comments on the Long-Run Supply Curve (continued)  Although the industry may never attain a long-run equilibrium in reality, what is important is that there is a tendency for the industry to move in the direction indicated by the theory  Economic profit is zero along a competitive industry’s longrun supply curve  In reality, the process of adjustment from a short-run equilibrium to a long-run equilibrium may vary from the theoretical description Copyright © 2015 John Wiley & Sons, Inc All rights reserved 40 Analyze the extent to which the competitive market model applies 9.9 WHEN DOES THE COMPETITIVE MODEL APPLY? Copyright © 2015 John Wiley & Sons, Inc All rights reserved 41 When Does the Competitive Model Apply?  The assumptions of perfect competition are stringent and are likely to be satisfied fully in very few real-world markets  However, many market come close enough to satisfying the assumptions of perfect competition to make the model useful  And it is useful to assess the effect of deviations from the assumptions in a real-world market Copyright © 2015 John Wiley & Sons, Inc All rights reserved 42 Delineate the mathematics behind perfect competition 9.10 THE MATHEMATICS BEHIND PERFECT COMPETITION* *Denotes digital-only content Copyright © 2015 John Wiley & Sons, Inc All rights reserved 43 The Mathematics Behind Perfect Competition  First-order condition for finding the profit-maximizing output level: MC = P0  Second-order condition: The slope of the marginal cost curve must be positive  NOTE:  Price is constant  No distinction is made between long-run and short-run profit maximization Copyright © 2015 John Wiley & Sons, Inc All rights reserved 44 The Mathematics Behind Perfect Competition Copyright © 2015 John Wiley & Sons, Inc All rights reserved 45 ... revenue and total cost  TR rises in proportion to output since the price is constant TC rises slowly at first and then more rapidly as the plant facility becomes more fully utilized and MC rises... of diminishing marginal returns  Market price and output: determined by interaction between short-run industry supply curve and the market demand curve Copyright © 2015 John Wiley & Sons, Inc... given and does not expect its output decisions to affect price =>horizontal demand curve  Total revenue (TR) – price times the quantity sold Average revenue (AR) – total revenue divided by output