Profit Maximization: MR=MC

Magnitude of profit/loss depends on the

position of AC curve
35

30

25

20

15

10

0
0 1 2 3 4 5 6 7
 Profit maximising under monopoly
Rs MC
AC

a
PM

Profit
AC
b

D
MR
O Qm Q
Market Structure:
Perfect Competition
 Market Structure

• Number & size distribution of Sellers

• Number & size distribution of Buyers
• Product differentiation
• Entry & exit barriers (LR)
• Four types of market structure
– Perfect competition
– Monopoly
– Monopolistic competition &
– Oligopoly
• In markets, where there are a large
number of small buyers and sellers,
individual firms have little control over
price

• By product differentiation, a firm can

gain some control over price

• If it is easy for new firms to enter,

existing firms may have little freedom in
their pricing decisions
 PERFECT COMPETITION
• Assumptions
– Many buyers and sellers
– Firms (sellers) and buyers are price takers
– Product is homogeneous - identical products
– Perfect knowledge of market conditions
– Perfect mobility of resources
– Freedom of entry & exit
– Sellers facing a horizontal (infinitely elastic) demand
curve
– Example: Unskilled labor mkt, Stock Market,
Agricultural markets
 Marginal Revenue & Average Revenue

• Average Revenue
AR = TR/Q = P.Q/Q = P
= revenue earned per unit of output sold

• Marginal Revenue =
Change in total revenue/change in output
=dTR/dQ
= the revenue a firm gains in producing one
additional unit of a commodity
 Demand and Marginal Revenue

P = a – bQ; a = intercept, b = slope

TR = PQ = Q(a – bQ) = aQ – bQ2
MR = d[TR/dQ] = a – 2bQ

• Demand and MR curve have same intercept

• However, MR curve has twice the slope of

the demand curve
 The Optimal Output Rule

•The optimal output rule says that profit is

maximized by producing the quantity of
output at which the marginal cost of the last
unit produced is equal to its marginal
revenue.
 Profit Maximization

Profit(Π) = TR – TC

• For profit maximization,

d(Π)/dQ = d(TR)/dQ – d(TC)/dQ = 0

MR = MC
 Marginal Analysis Leads to Profit-
Maximizing Quantity of Output

•The price-taking firm’s optimal output rule

says that a price-taking firm’s profit is
maximized by producing the quantity of
output at which the marginal cost of the last
unit produced is equal to the market price.
Profit Maximization under perfect competition

Profit(Π) = TR – TC
• For profit maximization,
d(Π)/dQ = d(TR)/dQ – d(TC)/dQ = 0
MR = MC
MR = d(PQ)/dQ = MC
Q(dP/dQ) + P(dQ/dQ) = MC
0 + P = MC, P = MC
• Short-run equilibrium of the firm
P = MC = MR
 Summary

• Profit Maximization: MR=MC

– MR=MC=P for perfect competition

• Both MC and AC curves are U- shaped

– MC curve cuts AC curve from below at the
minimum point of AC curve

• MR curve is twice the slope of the

demand curve and same intercept
• Equilibrium price above AC curve is the
profit per unit of output
 The profit-
maximizing point
is where the
marginal cost
curve crosses the
marginal revenue
curve (which is a
horizontal line at
the market
price):
at an output of 5
bushels of
tomatoes (the
output quantity
is at point E).

The Price-Taking Firm’s Profit-Maximizing

Quantity of Output
Short-run (some inputs fixed) equilibrium of
industry and firm under perfect competition
• Market demand curve is downward slopping

• Market supply curve is upward slopping

• Intersection of DD and SS curve indicates

market equilibrium

• Since individual firm in perfectly competitive

market is price-takers so firm has no control
over price

• So, individual firm faces horizontal straight

line demand curve at Pe
Short-run (some inputs fixed) equilibrium of industry
and firm under perfect competition

P Rs
S MC AC

Pe D = AR
AR
AC = MR

D
O O Qe
Q (millions) Q (thousands)

(a) Industry (b) Firm

Short-run (some inputs fixed) equilibrium of
industry and firm under perfect competition
• Any price above Pe there will be no buyer as
they have perfect knowledge about price and
availability of substitute products

• It is not worthwhile for the firm to offer any

quantity either, since it can sell as much as it
wants at the prevailing market price

• This implies total revenue of a firm would

increase at a constant rate

• So, marginal revenue is constant

 Perfect Competition
Price Determination

QD  625  5 P QS  175  5 P
QD  QS
625  5P  175  5P
450  10P P  $45

QD  625  5 P  625  5(45)  400

QS  175  5 P  175  5(45)  400

 Numerical example
• A new lassi shop opens in Ajmir. The average price of
medium glass lassi is Rs 10 and because of the large
number of lassi sellers, the price will not be affected
by the new entrant. The owner estimates that monthly
total cost, including normal profit will be TC = 1000 +
2Q + 0.01 Q2. What is SR economic profit and
quantity?

• Solution:
• P=MC; 10= 2+0.02Q; Q = 400
• Economic profit: TR – TC
• 10(400) - [1000+2(400)+0.01(400)2 = Rs
600
Short-run (some inputs fixed) equilibrium of
industry and firm under perfect competition

• In SR, individual firm in perfect

competition can earn supernormal,
normal profit or even incur losses
– Normal profits are basically earning what is
required to keep you in the business.
– Any less than that, and you would go do something
else.

• This depend upon the position of short

run AC curve
 The farm is profitable
because price exceeds
minimum average total
cost, the break-even
price, $14.
The farm’s optimal
output choice is (E)
 output of 5 bushels.
The average total cost
of producing bushels is
(Z on the ATC curve)
$14.40
The vertical distance
between E and Z:
farm’s per unit profit,
$18.00 − $14.40 =
$3.60
Total profit: 5 × $3.60
= $18.00

Short-run Equilibrium – Case of

Supernormal Profit
 Short-run Equilibrium –
Case of Supernormal Profit

• Firm maximizes profit where MR = MC =

P and also where MC curve cuts MR
from below, point of equilibrium is E

• Firm can sell 5 units at price $18

• Cost of production $14

• Firm earn supernormal profit

 At point C (the
minimum average
total cost), the
market price is $14
and output is 4
bushels of tomatoes
(the minimum-cost
output).

This is where MC cuts

the ATC curve at its
minimum.

Minimum average
total cost is equal to
the firm’s break-even
price.

Short-run Equilibrium –
Case of Normal Profit
 The farm is
unprofitable because
the price falls below
the minimum
average total cost,
$14.
The farm’s optimal
output choice is (A)
 output of 3
bushels.
The average total
cost of producing
bushels is (Y on the
ATC curve) $14.67

The vertical distance

between A and Y:
farm’s per unit loss,
$14.67 − $10.00 =
$4.67
Short-run Equilibrium – Total loss: 3 × $4.67
= approx. $14.00
Case of Sub-normal Profit
 Profit, Break-even or Loss
•The break-even price of a price-taking firm
is the market price at which it earns zero
profits
•Whenever market price exceeds minimum
average total cost, the producer is profitable
•Whenever the market price equals minimum
average total cost, the producer break even

•Whenever market price is less than minimum

average total cost, the producer is unprofitable.
Losses & Shutdown Decision for a firm in a
perfectly competitive market; P=MC
Quantity Total Total Total Marginal Average Average
Fixed Cost Variable Cost Cost Variable Total
Cost Cost Cost
0 5 0 5
1 5 5 10 5 5.00 10.00
2 5 9 14 4 4.50 7.00
3 5 12 17 3 4.00 5.67
4 5 14 19 2 3.50 4.75
5 5 17 22 3 3.40 4.40
6 5 21 26 4 3.50 4.33
7 5 26 31 5 3.72 4.42
8 5 32 37 6 4.00 4.63
9 5 39 44 7 4.33 4.88
• Since P=MC, if the price is 5, the firm should
produce 7 units, 8 units for price 6, 9 units for
price 7

• What if the price declines to Rs 3?

• Applying same logic, if should produce 5 units

• But average variable cost at 5 units is Rs. 3.4

and total variable cost is Rs 17, which can be
avoided if the firm didn’t produce 5 units

• As TR=(3x5)=15, while TC=17+5=22

• Total loss=22-15=Rs 7
• At Rs 3, producing any other output rate would
cause equal or greater losses

– For ex., cutting back to 4 units, would

results in a total loss of Rs 7 and expanding
output to 6 units would increase firm’s loss
to Rs 8

• If the manager shut down the firm then there

will be no revenue and no variable costs and
loss would be Rs 5 the fixed cost

• So firm minimize its loss by shutting down the

plant when price falls below AVC
• Suppose firm can sell at price Rs. 4 and sale 6
units

• So it will generate revenue of Rs 24 and cause

the firm to incur total costs of Rs 26, hence
loss is Rs 2

• If the firm shuts down then the loss would be

Rs 5

• Clearly the firm minimizes its loss by

continuing production

• As long as price exceeds AVC, the firm is

better off if it continue to produce
 Lessen Learnt

• Firm in perfect competition maximizes

profit by producing at the rate of output
where P = MC

• In SR, managers of a firm should shut

down the operation if price is below the
average variable cost

• If the price is above the average variable

cost but less than the average total cost,
the firm should produce in SR
 Summary of the Competitive Firm’s
Profitability and Production Conditions
 Calculating Shutdown Price

• A lamp manufacturer faces a horizontal demand

curve. Firm’s total cost is given by the equation
TVC = 150Q-20Q2 +Q3. Below what price
should the firm shut down the operation?
• Solution
• MC = 150-40Q+3Q2
• AVC = TVC/Q = 150-20Q+Q2
• Shutdown point; P=MC=AVC; Q=0,10
• P=MC=50 (for Q=10)
• Thus if price below Rs 50, then firm should
shut down
Long-run equilibrium of the firm under perfect
competition
• In the LR, all inputs are variable and there is no
entry or exit barrier

• So firm can enter or exit or even change their

production capacity

• In SR firm earn supernormal profit by

producing Q1

• In LR more firms will enter and producing

more output so supply curve will be shifted to
right from S1 to Se and hence new equilibrium
price and quantity are PL and QL
 Long-run equilibrium under perfect competition
The Dynamics

P Rs
S1 S2 MC
AC
Se

P1 AR1 D1
P2 D2
ARL
P D
L L

D
O Q1 QL O QL Q1

Q (millions) Q (thousands)

(a) Industry (b) Firm

Long-run equilibrium of the firm under
perfect competition
• At this lower price, individual firm faces a new
(lower) horizontal demand curve

• At QL , P = MC = AC, so firm is earning only

normal profit

• At this stage, there is no incentive for fresh

capital to enter in the industry, similarly there
is no reasons for existing owners to withdraw
capital from industry

• This is LR equilibrium
Long-run equilibrium of the firm under perfect competition

Rs (SR)MC
(SR)AC

LRAC

DL
AR = MR

LRAC = (SR)AC = (SR)MC = MR = AR

O Q
 Lessen Learnt

• In LR, economic profit is eliminated

by the entry of new firms

• Price maximizing rate of output

occurs where P = MC = AC

• Production takes place at the

minimum point on the average cost
curve
• Suppose that a competitive firm long-run supply curve is
given by the expression QF = -500 + 10P. Does this
mean that the firm will supply -500 units of output at a
zero price? If so, what does output of -500 units
mean?

• Taken literally, a competitive firm long-run supply curve

given by the expression QF = -500 + 10P means that the
firm will supply -500 units of output at a zero price.
However, this is a nonsensical interpretation. There is no
such thing as negative production. Instead, there is a
simple and economically appropriate interpretation of the
expression QF = -500 + 10P. This expression simply means
that firm supply will equals zero unless the market price
exceeds $50. When P > $50, the firm will begin to supply a
positive amount of production. For market prices less than
or equal to $50, firm supply will equal zero.
 PERFECT COMPETITION

• Advantages of perfect competition

P = MC
 production at minimum AC
 Only normal profits in long run
 Competition  efficiency
 No point in advertising
 PERFECT COMPETITION

• Disadvantages of perfect competition

 Insufficient profits for investment
 California Power Crisis
(https://en.wikipedia.org/wiki/California_electri
city_crisis)

 Lack of product variety

 Lackof competition over product design
and specification
• The relation between a firm’s
demand curve and market
demand curve can be explained in
two ways.
• When there are innumerable
firms under competition each
firm’s demand quantity appears
as a dot or a point (f1, f2...fn)
on the market demand curve.
• Again with each addition of a
firm to the market the industry
demand curve becomes more
flexible; structurally it gets
flatter.
• It starts moving in the direction
of DD  DD1DD2 and
ultimately assumes the form of a
horizontal straight line.
 Normal vs. Economic Profit

• When economic profit is equal to zero; this occurs when

the difference between total revenue and total cost
(explicit and implicit costs) equals zero.

• Normal profit is different than accounting profit because

opportunity cost is taken into consideration.

Normal profit is the minimum level of profit needed for a

company to remain competitive in the market.

• Normal profit occurs at the point at which the resources

available to the firm are being efficiently used and could
not be put to better use elsewhere.