HSS-01: Economics Lesson: 05

Output, Prices & Markets

Maximizing Profit, Choosing Output,
Supply Curve, Market Structure
 Till now, we studied how consumers make buying decisions. Whether one consumer buys a
certain product or not will hardly make a difference in the market. (In exceptional cases, it
could, but we can ignore it now.)

 However, decisions made by each supplier (of a given product) in the market usually
matters because suppliers are not “too many” like the consumers.

 Let’s see supplier’s decisions on price and output level, and how it depends on
market structure (supply-side).
8.1. PERFECTLY COMPETITIVE
MARKETS
Characteristics

 Price Taking
book
 Product Homogeneity

 Free Entry & Exit

 When Is a Market Highly Competitive?

 In real world, there is no way to judge absolutely whether a market is perfectly competitive or not.

• A market with many suppliers may be not competitive, while a market with a handful of
suppliers might be competitive. How?
8.2. PROFIT MAXIMIZATION
 Do Firms Maximize Profit?

 The assumption of profit-maximizing behavior of firms, used in microeconomics, is an

assumption.
 It makes models easy to be analyzed.

 How true is it in real scenarios?

 Small firms, vs. corporations, vs. cooperatives
 Alternative Forms of Organization

 Non-profit organizations
 Cooperatives: Association of businesses or people jointly owned and operated by members for
mutual benefit several farms might decide to enter into a cooperative agreement by which they pool
their resources in order to distribute and market milk to consumers. Because
each participating member of the milk cooperative is an autonomous economic
unit, each farm will act to maximize its own profits (rather than the profits of
the cooperative as a whole), taking the common marketing and distribution
agreement as given.

For this course, we shall assume that profit maximization is a

reasonable assumption.
8.3. MARGINAL REVENUE & COST,
AND PROFIT MAXIMIZATION
 Profit Maximization in General
• Output: q
• Cost: C(q)
• Revenue: R(q) = p(q) x D(q)
• Profit: π(q) = R(q) – C(q)
• Marginal revenue and cost: partial derivatives of R and C w.r.t. q
• Profit-maximizing output level: MR(q) = MC(q) derivation in book
Profit Maximization
in Short Run

A firm chooses output q*, so that

profit, the difference AB between
revenue R and cost C, is
maximized.
At that output, marginal revenue
(the slope of the revenue curve) is
equal to marginal cost (the slope of
the cost curve).
Demand Curve Faced by a Competitive Firm
Profit Maximization by a Competitive Firm
• Profit-maximizing output level: MR(q) = MC(q)
• MR(q) is independent of q for a firm in a competitive market
• MR(q) = MR = p

• So, choose q such that MC(q) = p

• Its a rule for setting output. Price is taken from the existing market.
• A very simple rule for the level of output.
8.4. CHOOSING OUTPUT IN THE
SHORT RUN
SHORT RUN

At least one of the factors of production is fixed.

Usually, a firm operates with a fixed amount of capital and

chooses the levels of its variable inputs (labor and materials).
 A Competitive
Firm making a
Positive Profit
In the short run, the competitive
firm maximizes its profit by
choosing an output q* at which its
marginal cost MC is equal to the
price P (or marginal revenue MR)
of its product.

The profit of the firm is measured

by the rectangle ABCD.

Any change in output, whether

lower at q1 or higher at q2, will lead
to lower profit.
 A Competitive
Firm making a
Negative Profit
A competitive firm should shut
down if price is below AVC.

The firm may produce in the

short run if price is greater than
average variable cost AVC.

At the profit-maximizing output q*,

the price P is less than average cost.
Line AB measures the average loss
from production. Likewise, the
rectangle ABCD now measures the
firm’s total loss.
 When should a firm shut down?

Suppose a firm is losing money. Should it shut down and leave the industry?

 Depends in part on the firm’s expectations about its future revenue.

 Conditions during market entry. Example: Reliance Jio (what if Jio was a startup?)
 Conditions for a well established firm. Example: A large bank
8.5. COMPETITIVE FIRM’S
SHORT-RUN SUPPLY CURVE
 A simple rule

 We saw that competitive firms will:

• increase output to the point at which price is equal to marginal cost, and
• shut down if price is below average variable cost

 So, firm’s supply curve is the portion of the marginal cost curve for which
MC > AVC

Remember that for a given price p, the firm chooses q such that MC(q) = p.
So given p, the level of q is fully determined.
price taking

A Competitive Firm’s
Short-run Supply Curve

In the short run, the firm chooses

its output so that marginal cost MC
is equal to price as long as the firm
covers its average variable cost.
The short-run supply curve is given
by the crosshatched portion of the
marginal cost curve.
Firm’s Response to a
Change in Input Price

When the marginal cost of

production for a firm increases
(from MC1 to MC2), the level of
output that maximizes profit falls
(from q1 to q2).
8.6. SHORT-RUN MARKET SUPPLY
CURVE
 Industry Supply
in the Short Run
The short-run industry supply curve is
the summation of the supply curves of
the individual firms.
Because the third firm has a lower
average variable cost curve than the first
two firms, the market supply curve S
begins at price P1 and follows the
marginal cost curve of the third firm
MC3 until price equals P2, when there is
a kink.
For P2 and all prices above it, the
industry quantity supplied is the sum of
the quantities supplied by each of the
three firms.
 Producer Surplus
for a Firm

The producer surplus for a firm is

measured by the yellow area below
ABCD the market price and above the
marginal cost curve, between
outputs 0 and q*, the profit-
maximizing output.
Alternatively, it is equal to rectangle
ABCD because the sum of all
marginal costs up to q* is equal to
the variable costs of producing q*.
 Producer Surplus
for a Market

The producer surplus for a market

is the area below the market price
and above the market supply curve,
between 0 and output Q*.
8.7. CHOOSING OUTPUT IN THE
LONG RUN
Output Choice in
the Long Run
The firm maximizes its profit by
choosing the output at which price
equals long-run marginal cost
LMC.

The firm increases its profit from

ABCD to EFGD by increasing its
output in the long run.

π(q) = R(q) – C(q)

R(q) = p(q) x q

Economies of scale upto q2 >> >> Diseconomies of scale

Output Choice in
the Long Run
The firm maximizes its profit by
choosing the output at which price
equals long-run (LR) marginal cost
LMC.

The firm increases its profit from

ABCD to EFGD by increasing its
output in the long run.
Optimal LR
Output when
P = $40
π(q) = R(q) – C(q)
R(q) = p(q) x q

Optimal LR Output if P = $30. Profit = 0 at this point. Below $30, the firm should shut down.
Long-run Competitive Equilibrium
(i) no incentive to enter/exit market, (ii) zero profit
supply = consumer demand

1 2

profit-maximizing level
 Economic Rent

 Amount that firms are willing to pay for an input less

the minimum amount necessary to obtain it.

 In competitive markets, in both the short and the long

run, economic rent is often positive even though profit
is zero.
 An opportunity cost to owning any factor of
production whose supply is restricted
For example, transportation cost worth $10000 is
saved in land used for production is close to the
river/sea. (However, this economic rent would have
been paid as extra fixed cost during purchase of the
land.)
Zero Profit for Firm in Long-run Equilibrium

 In the long run, in a competitive market, the producer surplus that a firm earns on the
output that it sells consists of the economic rent from all its scarce inputs.

• e.g., The firm with land close to river enjoys $10000 benefit because it doesn’t have to spend this
transportation costs.

 However, after accounting for the opportunity cost associated with owning such
scarce inputs, the firm earns zero economic profit.

 The firm is likely to have purchased the land close to river at a higher price (equal to $10000 in the scenario
of common information across all parties involved).
8.8. INDUSTRY’S LONG-RUN
SUPPLY CURVE
Long-run Supply in a Constant-cost Industry
Long-run Supply in an Increasing-cost Industry
Effect of Output Tax
on Firm’s Output

An output tax raises the firm’s

marginal cost curve by the amount
of the tax.
The firm will reduce its output to
the point at which the marginal
cost plus the tax is equal to the
price of the product.
Effect of Output Tax
on Industry Output

An output tax placed on all firms in

a competitive market shifts the
supply curve for the industry
upward by the amount of the tax.
This shift raises the market price of
the product and lowers the total
output of the industry.
10-12 NON-COMPETITIVE /
IMPERFECT MARKET STRUCTURE
 Market Power
market structures that reflect real-world scenarios

 Output determination in perfect • Output determination in imperfect

market conditions market conditions
 Competitive markets • Monopoly, Monopolistic Competition,
Oligopoly

 Price Takers – Can’t decide price • Firm in the market can decide both
price and quantity (to different extents,
depending on exact structure)