Microeconomics

Lecture 7
Petr Špecián, Ph.D.
Mail: petr.specian@vse.cz
Office hours: see InSIS
Profit Maximization and Supply in
the Short Run

2
The Nature of Firms
Assumption: Firm’s decisions are made by a single dictatorial manager
who rationally pursues the goal of maximizing economic profit

3
Definition of Profits
Economic profits (p):

p = 𝑇𝑅(𝑞) − 𝑇𝐶(𝑞)

What level of output will generate the largest profit?

4
Profit Maximization
∗
𝑑𝜋
𝜋 𝑖𝑓𝑓 =0
𝑑𝑞

𝑑𝜋 𝑑𝑇𝑅(𝑞) 𝑑𝑇𝐶 𝑞
= − = 𝑀𝑅 − 𝑀𝐶 = 0
𝑑𝑞 𝑑𝑞 𝑑𝑞

𝑀𝑅 = 𝑀𝐶
At the profit maximizing level of output, marginal revenue is equal to
marginal cost
5
Marginal Revenue of a Price-Taking Firm
A price taker is an agent whose decisions have no effect on the
prevailing market price
• For a price taking firm, 𝑀𝑅 = 𝑃

6
Short-Run Profit Maximization
P
MC

P0 MR = AR
Economic profit (𝜋 > 0)
ACq* AC

q* q 7
Short-Run Profit Maximization
For an output decision to be truly profit-maximizing, the marginal cost
curve must also be increasing
• To be discussed in the seminars…

8
Firm’s Short-Run Supply
Firm’s short-run supply curve: relationship between price and quantity
supplied by the firm in the short-run

𝑞 ∗ > 0 iff 𝑇𝑅 ≥ 𝑉𝐶:

𝑃 ∗ 𝑞 ≥ 𝑉𝐶
𝑉𝐶
𝑃 ≥
𝑞
𝑷 ≥ 𝑨𝑽𝑪

9
The Shutdown Decision
Shutdown price: price below which the firm will choose to produce no
output in the short-run
• Equal to 𝐴𝑉𝐶"#$

10
Price
MC SAC
($/q)
SR Supply
AVC

SACmin Short Run Supply of a

Price Taking Firm
AVCmin
Shutdown point

AFC

q0 q1 q
11
Chapter 9
Perfect Competition

12
Week #7: Reading
Compulsory: NS Chapter 9 [the course skips Ch. 10]

13
Perfect Competition: Assumptions
• Profit maximizing firms & utility maximizing consumers
• A large number of buyers and sellers
• No barriers to entry and exit
• Homogeneous product
• Perfect factor mobility
• Perfect information → price takers
• Zero transaction costs
• No externalities…

14
Short-Run Market Supply Curve

Market supply is a horizontal sum of individual firms’ supply

15
Supply Response & Time
Supply response: change in quantity of output if demand conditions
change
• SR: no firms enter or exit the market
• LR: new firms may enter the market

16
 Short Run Price Determination

P P P
S
D’ d’
SMC
d
P2
SAC
P1

q1 q2 q Q1 Q2 Q 𝑞! 1 𝑞! 2 𝑞’
!1 q

Representative firm Market Representative consumer

17
Reasons for a Shift in a Demand or Supply
Curve (Normal Good)

18
Short-Run Supply Elasticity
Short-run price elasticity of supply

∆𝑄%
𝑄%
𝑒% =
∆𝑃
𝑃

• 𝑒# > 1 → price elastic

• 𝑒# < 1 → price inelastic
• 𝑒# = 0 → perfectly inelastic
• 𝑒# = ∞ → perfectly elastic

19
Effects of Demand Shifting

20
The Long Run
Long run supply responses are more flexible
1. LR cost curves reflect greater input flexibility
2. Firms can enter and exit the market in response to profit
opportunities

21
Equilibrium Conditions
Perfectly competitive equilibrium: LR situation where no firm has an
incentive to change its behavior
1. Firms choose the profit maximizing level of output
2. No firm is motivated to enter or to leave the market

Implication: firms’ economic profit must be 0

22
Profit Maximization in the Long Run

Since for a price taker 𝑃 = 𝐴𝑅 = 𝑀𝑅,

and profit maximization requires 𝑀𝑅 = 𝑀𝐶,
𝑃 = 𝑀𝐶 is the first equilibrium condition

Determines the firm’s output choice and its choice of inputs

23
Entry and Exit
Free entry in the LR
• 𝜋 > 0 attract new firms into the industry
• 𝜋 < 0 cause firms to leave the industry

24
Entry and Exit
Entry: SR market supply curve shifts outward → P decreases
• Until 𝜋 = 0

Exit: SR market supply curve shifts inward → P increases

• Until 𝜋 = 0

25
Long-Run Equilibrium
Assumption: Identical cost curves

Second equilibrium condition: In the LR equilibrium all firms earn 𝜋 =

0, i.e.

𝑃 = 𝐴𝐶

26
Long-Run Equilibrium
Summary:
1. 𝑷 = 𝑴𝑪 because firms are profit maximizers & price takers
2. 𝑷 = 𝑨𝑪 because market forces in LR cause 𝜋 = 0

27
Long-Run Supply: The Constant Cost Case
Constant cost case: entry and exit have no effect on the cost curves of
firms

28
 Long-Run Supply: The Constant Cost Case
P P
SMC MC D’
AC S
D
S‘
P2
LS
P1

q1 q2 q Q1 Q2 Q3 Q
Representative firm Market 29