Economics for Managers

Profit Maximizing Rules

Learning Objective

 At the end of this session, and the next, you

should be able to:
– Use the profit-maximizing rules under different
market structures to arrive at strategic output
decisions for the firm
The Answers to all our Questions!

 ‘Optimal Quantity’: why look at costs alone? Should

we not look at selling price/ revenue?
 So, finally, we are going to do that. We are going to
look at costs, revenues and profits
 But to do that we will introduce two broad types of
‘market structures’: one in which the firm has no
leverage over prices (is a ‘price taker’) and the other
where it can influence prices through output
decisions (is a ‘price finder/ maker’)
Profit Maximization

 A rational producer is out to maximize Profits

 Profit is maximized when the difference
between TR and TC is maximum
 Let us represent this graphically
Profit Maximization

TR
TC/ TR

1. Is this a short run TC

TC curve or long run TC
curve?
2. Is this the TR curve for a
price taker or price
maker?

Quantity
And for a price maker?

Price Taker Price Maker/

TR Finder

TC?
TC/ TR

TC/ TR
TR????
TC

Quantity Quantity
And for a price maker

Price Taker Price Maker/

TR Finder
TC/ TR

TC

TC/ TR
TC
TR

Quantity Quantity
Profit Maximization
At what level of
output is profit
maximized?
Price Taker Price Maker/
TR Finder
TC/ TR

TC

TC/ TR
TC
TR

Quantity Quantity
Profit Maximization

 Profit is maximized when TR is greater than TC and

the difference between TR and TC is maximum
 What does this mean in terms of slopes and
marginal reasoning?

The core rule: MC=MR

Profit maximization: Graph

 Draw….
Profit Maximization

 Profit is maximized when TR is greater than TC and

the difference between TR and TC is maximum
 Draw the graph of Profit.
 Algebraically, ∏(profit)= TR –TC; maximum when
 ∆ ∏/ ∆Q = 0;
 ∆ ∏/ ∆Q=∆TR/∆Q - ∆TC/∆Q = 0; MR-MC= 0
 At this level of Q* slopes of TC (that is MC) and TR
(that is MR) are equal
 Again therefore we have the marginal reasoning
theme; so profit is maximized when MC = MR
How will the Plot MC, MR look?

 How will the ‘marginal’ curves turn out to be?

Profit Maximization

Price Taker Price Maker

MC/ MR

MC
MC

MR TC/ TR
MR

Quantity Quantity
If you were to plot MC and MR

 We can define the optimal output as that

level of output at which MC=MR (dTC/dQ =
dTR/dQ)
 Is this condition sufficient?

Core rule: MC = MR
Second Order Condition

 Is this condition sufficient? No. There are two

points at which this condition is satisfied
(dTC/dQ = dTR/dQ)
 Second order condition: Point beyond which
MC exceeds MR. (d2TC/dQ2 > d2TR/dQ2)

 Third condition: Now, is a third condition

required?
Profit Maximizing Rules

 Is this condition sufficient? No. There are two

points at which this condition is satisfied
(dTC/dQ = dTR/dQ)
 Second order condition: Point beyond which
MC exceeds MR. (d2TC/dQ2 > d2TR/dQ2)

 Third condition: Does the MR cover the ATC

at this optimal level?
Economics for Managers

Profit Maximizing Rules,

Market Structures and
Firm Behavior
Market Structures

 If every firm conforms to the profit maximizing rules, what

will happen in the aggregate? What will be the
equilibrium price? What will be the profits for the firms?
 What the equilibrium price will be depends on the relative
strengths of the players who constitute the forces of
demand and supply
 The relative strengths of the players on the Supply side
depends on the kind of Market Structure they are
operating in
 We will first look at this dynamic for price takers;
perfectly competitive markets
Basic Model of Perfect Competition

 Assumptions and Characteristics

Perfect information
Homogeneous products
All sellers and buyers are price takers
Sellers and buyers cannot, and thus do not behave
strategically
Easy entry and exit
Large number of small sellers and buyers
Now:

 Consider a context in which the market is

perfectly competitive and thus the firm is a
price taker; that is, it responds to changes in
price; it is reactive.
 Since, then, MR = P (P does not change with
firm’s Q), the Profit maximizing rule MR = MC
becomes P = MC (since MR = P)
Core rule: MC = MR
Perfectly Competitive Market
Dynamics

 So, as Price changes, the firm must react to

these changes and re-fix output to a new
optimum by again finding the new Q* at
which MC = new P
 Graphically?
The Individual Firm’s Supply
Schedule

Price Taker Shut- down

point: P =ATC; P
= AVC
MC/ MR

MC

As P rises
MR = P2
MR = P1
optimal Q for
MR = P0 firm increases
MC = MR is
the core rule

Quantity
Market Supply curve

 Aggregation of individual supply curves gives

the market supply curve
 And the two forces of Market Demand and
Market Supply interact to determine the
equilibrium price
 Let us look at an example of supply side
dynamics in a perfectly competitive markets,
at a firm level
Equilibrium in Perfectly
Competitive Markets

 Look back at our Excel Sheet. Let the family

of cost function represent that for a given
seller firm X
 In a perfectly competitive market structure,
can P* be equal to 15? [Refer sheet ‘P in
Perf Comp’] P =MC=Min ATC
Supply Side Dynamics in a
Perfectly Competitive Market

 Firm X can make substantial profits at P* =

15 by choosing an appropriate Q* [=???]

 P= MC= Min ATC

Supply Side Dynamics in a
Perfectly Competitive Market

 Firm X can make substantial profits at P* =

15 by choosing an appropriate Q* [=???]
 Optimum Q* = 73 at which
– Profit is maximized
– MC = MR = P* P=MC=Min ATC
If our firm can
do this, so can
other new and
existing firms
Supply Side Dynamics in a
Perfectly Competitive Market

 Firm X can make substantial profits at P* =

15 by choosing an appropriate Q* [=???]
 Market supply increases and P* falls
– How will our firm react? And why?
Supply Side Dynamics in a
Perfectly Competitive Market

 New P* is formed because of increased market

supply, and finally ….
 P* = MC = min ATC = ??
Note: P* = MC is the core profit maximizing rule. And MC = min ATC is again the core rule for optimum
production level
Supply Side Dynamics in a
Perfectly Competitive Market

 P* = MC = min ATC = 10…actually 9.5 rounded to

10
 P* is driven down to minimum ATC

P =MC =Min ATC

Equilibrium in Perfectly
Competitive Markets

 In the short run firms could possibly make

abnormal, or windfall, profits (for example,
supply disruption due to a natural disaster in
large area)
 But in the long run the market equilibrium
settles at a price (P*) such that for every firm
MC = P*= Min ATC at the Q* chosen by the
firm
Diagram reference

From the P & R text, 8.14

Long run competitive Equilibrium.
Economic Profits

 If P* = ATC then why should the firm be in existence?

 Because the ‘costs’ that economists talk about are
different from the ‘costs’ that accountants talk about.
 Opportunities foregone by not putting their resources
to their best possible use- Opportunity costs..
 Economic costs include all opportunity costs and cost
of capital. Thus if Rs.100 is invested and a ‘normal
return’ for that level of riskiness is 10% economic
costs include Rs. 10 as costs
Economic Profits

 Therefore economic profits are over and

above economic costs.
 For firms in a perfectly competitive market,
economic profits are zero.