ECON 1210 Cost and Profit Maximization Under Competiton

Costs and Profit Maximization
Under Competition
Yujing Xu
University of Hong
Kong
Special Thanks to Dr. Ka-fu Wong1

How do firms behave?
o The assumption:
o Profit is the main motivation for firms’ actions.
o How do firms maximize profit?
o By controlling their variables:
o Price (if possible)
o Quantity
o Cost
o Some firms have more control over prices than others.
2
Market structure according to
ability of controlling price
Perfectly competition Monopoly
No Perfect
control control
over over
price price
3
Competitive Firms
o In this chapter, we focus on competitive markets.
o Characteristics:
o The product is similar across sellers
o There are many buyers and sellers, each small
relative to the size of the market
o Each individual has no impact on price
4
Competitive firms have no control over
price: The market determines each firm’s
What Price to Set? price…
The Market for Lobsters Price The Demand for Your Lobsters
Price
Market
Supply
Demand for
$50 Your
Lobsters
Market The demand for your lobster

Demand
is perfectly elastic
82,000,000 Quantity Quantity
5
Factor of production
o Definition. A factor of production is an input used in the
production of a good or service.
o Definition. A fixed factor of production is an input whose

quantity cannot be altered in the short run.
o Definition. A variable factor of production is an input
whose quantity can be altered in the short run.
6
Example: The making of fortune cookies
Note that marginal product
Total Total number
number of of packs of
(output gains due to the
employees cookies per additional employee) begins
per day day MP to diminish after the third
employee.
0 0
1 40 40 Economists refer to this
2 100 60 pattern as the law of
3 130 30 diminishing returns, and it
4 150 20
always refers to situations in
which at least some factors of
5 165 15
production are fixed.
6 175 10
7 181 6
7
If the fortune cookie company pays a fixed cost of $80 per day, and to each
employee a wage of $24/day, calculate the company’s output, variable cost,
total cost and marginal cost for each level of employment.
Employees Cookies Fixed Cost Variable Total Cost Marginal
per day (packs) ($ per day) Cost ($/day) Cost
per day ($/day) ($/pack)
0 0 80 0 80
1 40 80 24 104 0.6
2 100 80 48 128 0.4
3 130 80 72 152 0.8
4 150 80 96 176 1.2
5 165 80 120 200 1.6
6 175 80 144 224 2.4
7 181 80 168 248 4.0 8
o Suppose the wholesale price of each pack (net of flour,
eggs and other materials costs) is $2.50.
o How many packs of fortune cookies should the firm
produce?
As there is a unique mapping of the number of workers and

output, the two approaches are equivalent in solving the
problem.
(1) By comparing the marginal cost and marginal benefit per
additional pack of cookies.
(2) By comparing the marginal cost and marginal benefit per
additional worker.
9
If we compare marginal benefit brought about by the additional employee and the
marginal cost of hiring additional employee, we can see that the firm should keep
expanding until it reaches 6 employees per day (175 packs per day ).
Marginal Marginal
Variable Total Cost revenue Mu
Employees Packs per Fixed Cost Cost Cost ($/employee ($/employee un
per day day ($ per day) ($/day) ($/day) ) )
0 0 80 0 80
1 40 80 24 104 24 100
2 100 80 48 128 24 150
3 130 80 72 152 24 75
4 150 80 96 176 24 50
5 165 80 120 200 24 37.5
6 175 80 144 224 24 25
7 181 80 168 248 24 15
10
If we compare this marginal benefit of an additional pack ($2.50 per pack) with
the marginal cost of an additional pack, we see that the firm should keep
expanding until it reaches 175 packs per day (6 employees per day).
Marginal
Employees Packs per Fixed Cost Variable Total Cost Cost
per day day ($ per day) Cost ($/day) ($/day) ($/pack)
0 0 80 0 80
1 40 80 24 104 0.6
2 100 80 48 128 0.4
3 130 80 72 152 0.8
4 150 80 96 176 1.2
5 165 80 120 200 1.6
6 175 80 144 224 2.4
7 181 80 168 248 4.0
11
Supply of Fortune cookies
3
Packs Marginal
Employees per Cost
per day day ($/pack)
0 0 2
1 40 0.6
2 100 0.4
3 130 0.8
1
4 150 1.2
5 165 1.6
6 175 2.4
7 181 4.0 0
0 25 50 75 100 125 150 175 200 225
12
To confirm that the cost-benefit principle thus applied identifies the profit-
maximizing number of packs of fortune cookies to produce, we can calculate
profit levels directly:
Employees per Output Total revenue Total cost Profit

day (packs/day) ($/day) ($/day) ($/day)
0 0 0 80 -80
1 40 100 104 -4
2 100 250 128 122
3 130 325 152 173
4 150 375 176 199
5 165 412.50 200 212.50
6 175 437.50 224 213.50
7 181 452.50 248 204.50
13
Choosing Output to Maximize Profit
o When the law of diminishing returns applies (that is,
when some factors of production are fixed), marginal
cost goes up as the firm expands production beyond
some point.
o Under these circumstances, the firm's best option is to
keep expanding output as long as marginal cost is less
than price.
The profit maximizing output level (Q*) for the perfectly

competitive firm (when the variable input and output are
perfectly divisible):
P = MC(Q*)
14
Profit-maximizing quantity
Price MC rises with production because it gets more costly to

produce each additional unit… e.g. more equipment, more
maintenance, etc.
MC
Quantity
15
Price
MR is constant because no matter how much we sell, the next

unit will always sell for the market price.
MR = P
Quantity
16
Price
Profit is Maximized Where MC
P = MC
Maximum Profit
Less Profit
MR = P
More Profit
Quantity
17
If Market Price Changes, So Does Profit-Maximizing
Quantity
Price
MC curve appears to be the supply curve of the firm.
MC
MR = P
MR = P
Quantity
18
If the company's fixed cost had been any more than
$293.50 per day (say, 300), it would have made a loss at
every possible level of output.
Employees per Output Total revenue Total cost Profit (A) Profit (B)
day (packs/day) ($/day) ($/day) ($/day) ($/day)
0 0 0 300 -80 -300
1 40 100 324 -4 -224
2 100 250 348 122 -98
3 130 325 372 173 -47
4 150 375 396 199 -21
5 165 412.50 420 212.50 -7.5
6 175 437.50 444 213.50 -6.5
7 181 452.50 468 204.50 -15.6
19
Fixed cost: A k
sunk cost. Can
Example: The making of fortune cookies change anywa
doesn’t affect
o Should the firm shuts down in the short-run? decision makin
(Irrelevent)
o As long as it still had to pay its fixed cost, however, its best
bet would have been to continue producing 175 packs per
day, because a smaller loss is better than a larger one .
Fixed cost does not change the optimal output!!

o If a firm in that situation expected conditions to remain the
same, it would want to get out of the fortune cookies
business as soon as it does not need to pay fixed cost (for
example, its equipment lease expired).
20
AC/AVC curve must
Profits in a graph appears and AC is below
MR=P. If only MC and MR
curve is given, not enough
information to calculate
Profit p = TR – TC the profit and decide
whether to choose the
Price p = P x Q– ATC x Q output at Q=8
MC
p = (P – ATC) x Q If AC is above MR=P, still
need to find the AVC first
Why? We need to compare
Price with AVC
Note: AVC must be even
lower than AC
$50 MR = P
P
Profit = $194 = ($50- $25.75) X 8
Average Total Cost (ATC)
$25.75 AC
$17
Quantity
0 1 2 3 4 5 6 7 8 9 10 21
Firm Should Continue Operating if TR>TVC,
or equivalently, if p>AVC
22
Firm’s Shut-Down Condition
Always choose output at P=MC ?
No! There are exceptions to this rule.
23
Keep in mind that we always have the option to produce 0.
Let Q* be the output chosen based on P=MC(Q).
Produce Q* if
Profit (Q=Q*) ≥ Profit (Q=0)
Produce 0 if
Profit (Q=Q*) < Profit (Q=0)
24
Profit (Q=Q*) ≥ Profit (Q=0)
TR(Q=Q*) – TC(Q=Q*) ≥ TR(Q=0) – TC(Q=0)
PQ*– TVC(Q=Q*) – FC(Q=Q*) ≥ 0 – TVC(Q=0) – FC(Q=0)
PQ*– TVC(Q=Q*) ≥ 0 ∵ FC(Q=Q*)=FC(Q=0)

∵ TVC(Q=0)=0
TR(Q=Q*) = PQ*
Assumtion: Under perfect
competition
25
Entry and Exit with
Uncertainty and Sunk Costs
o Sunk Cost = a cost that once incurred and can never be recovered.
o Fixed cost is sunk in the short run. Our choice of Q does not
change the amount of fixed cost.
FC(Q=0)=FC(Q=1)=FC(Q=2)=…
o That is, short run production decision is to maximize profit net of

fixed cost.
Note: Does not involve fixed
TR(Q)-TVC(Q)
cost
o Produce as long as TR(Q)-TVC(Q) ≥ 0

o Discontinue operation otherwise.
26
Average Variable Cost and Average Total
Cost
PQ*– TVC(Q=Q*) ≥ 0
iff PQ* ≥ TVC(Q=Q*)
If Q*>0, P ≥ TVC(Q=Q*)/Q*
27
Optimal output, with the short-run shut-
down condition:
1. Choose Q at which P=MC(Q). Call it Q*.

2. Check: if P<AVC(Q*), set output to zero.
Otherwise, produce Q*.
The firm’s short-run shut-down condition may be

restated in a second way:
Discontinue operations in the short run if the
product price is less than the minimum value
of its average variable cost (AVC).
28
In final exam: for drawing
curve, MC curve is
Marginal and expected to pass through
the minimum of ATC and
Average Cost Curves minimum of AVC (MUST)
oThe MC curve intersects the AVC

curve at its minimum point.
o When marginal cost is below
average variable cost, the AVC
curve is falling.
o When marginal cost is above
average variable cost, the AVC
curve is rising.
o So, AVC and MC curves must
meet at the minimum of the
AVC curve.
o For the same reason, ATC and
MC curves meet at the minimum
of the ATC curve.
29
Firm’s Short-Run Supply Curve
o The firm’s short-run shut-down condition may thus be
restated in a second way:
• Discontinue operations in the short run if the
product price is less than the minimum value of its
average variable cost (AVC).
A firm’s short-run supply curve is the

section of MC curve that is above AVC.
30
Profit and Producer Surplus
• Producer surplus is the area between price and MC curve.
• Producer surplus = TR-(area below MC)
• the area below MC
equals TVC
• Producer surplus=
TR-TVC
• Profit=TR-TVC-FC
• Profit=producer surplus
- fixed cost
31
Short and Long Run
o The Short Run = the time period before entry or exit
occurs.
o Short run: Still have some kind of fixed factors of
production
o The Long Run = the time it takes for substantial new
investment and entry or exit to occur.
o How long is long run?

o It will vary from industry to industry.
o Long run: Firms coming in and leaving freely
o No fixed cost
32
Long Run: When to Enter and Exit
an Industry
o In competitive markets a firm will be Note: Firms would supply
o profitable when P > AC and at MC above AVC
o unprofitable when P < AC.
Compare P with AC instead
of AVC in the long run
o So, in the long run, firms will
The supply in the market
o enter profitable industries (P > AC ) and depends on the output
o exit unprofitable ones (P < AC). decision and no. of firms
o Note that at the intermediate point (P = AC) profits and loss are
zero, and there is no entry or exit.
o That is, there is no entry or exit if profits is zero.
o In the long-run equilibrium, there should be no entry or exit.
33
Zero Profits
o Economists refer to Zero Profits or “normal” profits as
the profit level where the firm is covering all of its costs
including enough to pay labor and capital, and their
opportunity costs.
34
“Economic” vs. “Accounting” Profit
o Remember, not all costs require monetary payment!
o An explicit cost is a cost that requires a money outlay.
o An implicit cost is a cost that does not requires an outlay
of money.
o Economic profit is total revenue minus total costs
including implicit costs.
o Accounting profit is total revenue minus explicit costs.
35
Zero Profits
o Example: if you quit your accounting job ($45,000/year
income) to start your own company ($45,000/year left
over after costs are paid), what is your economic profit?
o We would say it’s zero: you are earning just enough to

cover your costs, including your foregone accounting job
salaries (Opportunity cost)
36
Zero Profits
o Other examples of implicit costs include foregone rent (if
you are using your own property as the working place),
foregone interest income (if you use your own life
savings as the start-up money) and many others.
o Firms will need to consider these costs if they want to
make good decisions.
o From now on, we’ll assume that our cost curves take
these opportunity costs into account.
o And therefore a zero profit isn’t a bad thing as all kinds
of opportunities costs are covered!
37
Entry and Exit in the Long Run
o If a firm could costlessly enter and exit an industry, then
this basic rule applies:
o enter when P > AC and
o exit when P < AC.
o As long as firms earn positive profits, new firms will

enter. This process stop until all firms earn zero profits.
o As long as firms earn negative profits, existing firms will
exit. This process stop until all firms earn zero profits.
38
Entry and Exit in the Long Run
o A firm will enter when P > AC and will expand
production along MC curve when prices rises above this
level
o Firms' long term supply curve: Portion of MC above the

AC curve because AC is equal to AVC (For a firm only
not the industry)
39
Deriving Industry Long-run Supply Curves
o The shape of the long-run supply curve for a particular industry
is determined by the change in costs as industry output
increases or decreases.
o There are three types of long-run industry supply curves.
1. Increasing Cost Industry = an industry in which costs
increase with greater output; shown with an upward sloping
supply curve.
2. Constant Cost Industry = an industry in which costs do not
change with greater output; shown with a flat supply curve.
3. Decreasing Cost Industry = an industry in which industry
costs decrease with greater output; shown with a
downward sloping supply curve.
40
Increasing, Constant, and
Decreasing Cost Industries Note: They are long-run
industry supply curve, not
supply curve
Price
Long-run Supply, Increasing Cost Industry
Long-run Supply, Constant Cost Industry
Long-run Supply, Decreasing Cost Industry
Demand
Quantity
41
Long run equilibrium
o No firms would come in and no firms would leave and so the

no. of firms remains unchanged I.e. equilibrium
o All firms are earning zero economic profit
42
Long run equilibrium
The market A representative firm

MC AC
S
P0
43
An increase in demand (D0 to D1)
Firms earn positive profit in the short run.

MC AC
S
profit
P1
P0
D1
D0
44
Constant Cost Industry
o New firms entering the industry will add to the demand
for the factors of input.
o In a constant cost industry, the additional demand has
no impact on the price of the input.
o It could due to the fact that the quantity demanded
for factors of input is small (or insignificant) relative
to the total demand of similar input.
o As a result, a representative firm’s MC and AC curve
remain the same.
45
The additional demand has no impact on the
price of the input.

MC AC
S0
S1
P1
P0
D1
D0
Connecting the two long-run equilibrium points, you get a

horizontal long-run supply. 46
price of the input.
The market
Known: demand changed. The long-run

equilibrium points help trace the long-run
supply curve.
E0
P0 E1
Q0 Q1
47
price of the input.
The market

supply curve.
E0
P0 E1 Long-run supply
Q0 Q1
48
Increasing Cost Industry
o New firms entering the industry will add to the demand for the
factors of input.
o In an increasing cost industry, the additional demand will cause the
price of the input to rise.
o It could due to the fact that the quantity demanded for factors of
input is large (or significant) relative to the total demand of
similar input.
o As the resources are limited, increase in demand for inputs would
rise its price
o MC and AC curve shift up
o An Increasing Cost Industry is an industry characterized by greater

costs as production expands.
49
The additional demand raises the price of
the input.

MC AC
S0
S1
P1
P0
D1
D0
Connecting the two long-run equilibrium points, you get an

upward sloping long-run supply. 50
the input.
The market

supply curve.
P1 E0
P0 E1
Q0 Q1
51
the input.
The market
supply curve.
Long-run supply
P1 E0
P0 E1
Q0 Q1
52
Decreasing Cost Industries
oA Decreasing Cost Industry is an industry characterized by
lower costs as production expands.
o industry clusters help reduce costs as production
increases
o More specialized resources in one place improve
each other’s efficiency
o Dalton, Georgia: carpet capital of the world
o Hollywood, CA, USA: movie capital of the world
o Silicon Valley, California: a high-tech cluster
53

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Costs and Profit Maximization

Special Thanks to Dr. Ka-fu Wong1

Perfectly competition Monopoly

Market The demand for your lobster

82,000,000 Quantity Quantity

o Definition. A fixed factor of production is an input whose

As there is a unique mapping of the number of workers and

Employees per Output Total revenue Total cost Profit

The profit maximizing output level (Q*) for the perfectly

Price MC rises with production because it gets more costly to

MR is constant because no matter how much we sell, the next

Profit is Maximized Where MC

Fixed cost does not change the optimal output!!

No! There are exceptions to this rule.

Let Q* be the output chosen based on P=MC(Q).

TR(Q=Q*) – TC(Q=Q*) ≥ TR(Q=0) – TC(Q=0)

PQ*– TVC(Q=Q*) – FC(Q=Q*) ≥ 0 – TVC(Q=0) – FC(Q=0)

PQ*– TVC(Q=Q*) ≥ 0 ∵ FC(Q=Q*)=FC(Q=0)

o That is, short run production decision is to maximize profit net of

o Produce as long as TR(Q)-TVC(Q) ≥ 0

iff PQ* ≥ TVC(Q=Q*)

1. Choose Q at which P=MC(Q). Call it Q*.

The firm’s short-run shut-down condition may be

oThe MC curve intersects the AVC

A firm’s short-run supply curve is the

o How long is long run?

o In the long-run equilibrium, there should be no entry or exit.

o We would say it’s zero: you are earning just enough to

o As long as firms earn positive profits, new firms will

o Firms' long term supply curve: Portion of MC above the

Long-run Supply, Increasing Cost Industry

Long-run Supply, Constant Cost Industry

Long-run Supply, Decreasing Cost Industry

o No firms would come in and no firms would leave and so the

o All firms are earning zero economic profit

The market A representative firm

The market A representative firm

The market A representative firm

Connecting the two long-run equilibrium points, you get a

Known: demand changed. The long-run

Known: demand changed. The long-run

o An Increasing Cost Industry is an industry characterized by greater

The market A representative firm

Connecting the two long-run equilibrium points, you get an

Known: demand changed. The long-run

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TR(Q=Q) – TC(Q=Q) ≥ TR(Q=0) – TC(Q=0)

PQ– TVC(Q=Q) – FC(Q=Q*) ≥ 0 – TVC(Q=0) – FC(Q=0)

PQ– TVC(Q=Q) ≥ 0 ∵ FC(Q=Q*)=FC(Q=0)