Profit Maximization and Market Structures in Economics (L1)

Profit

Total Revenue (TR) - Total Cost (TC).

Total Revenue

Price Quantity = PQ.

Total Cost

Total Cost is a function of Quantity [C(Q)].

Marginal Cost

The additional cost incurred by producing an additional unit of output. = ∆TC/∆Q.

Marginal Revenue

Change in Total Revenue (TR) generated by selling an additional unit of output.

Marginal Revenue Formula

MR = ∆TR/∆Q.

Profit Maximizing Condition

Continue producing until MR = MC.

Profitable Firm Condition

If TR > TC, the firm is profitable.

Break Even Condition

If TR = TC, the firm breaks even.

Loss Condition

If TR < TC, the firm incurs a loss.

Shutdown Decision

A firm should only decide to produce a good or service if the revenue it would receive is at least enough to cover the avoidable cost.

Long-Run Shutdown Condition

Firm should shutdown if TR < TC.

Short-Run Shutdown Condition

Firm should shutdown if TR < VC.

Market Structure

Perfect Competition (many firms), Imperfect Competition, Monopoly (one firm)

Perfect Competition

A perfectly competitive industry is an industry in which all producers are price-takers.

Price Takers

Takes market price as given. Has no individual impact on market price.

Necessary Conditions for Perfect Competition

For an industry to be perfectly competitive, it must contain many producers, none of whom have a large market share.

Producer's Market Share

The fraction of the total industry output accounted for by that producer's output.

Perfectly Competitive Industry

An industry can be perfectly competitive only if consumers regard the products of all producers as equivalent.

Homogeneous Product

Consumers regard the products of different producers as the same good.

Free Entry and Exit

There is free entry and exit into and out of an industry when new producers can easily enter into or leave that industry.

Barriers to Entry or Exit

There are no barriers to entry or exit in the long-run.

Short-Run Limitations

Free entry and exit does not exist in the short-run because some inputs are fixed and cannot be altered.

MR in Perfect Competition

Under perfect competition: MR = Price.

Average Revenue (AR)

Revenue per unit of output, calculated as AR = TR/Q = (P*Q)/Q = P.

AR in Perfect Competition

Under Perfect Competition: AR = MR = Price.

Profit-Maximizing Quantity of Output

The profit-maximizing point is where MC crosses the MR curve (horizontal line at the market price).

Production Decision

Produce quantity where Price (MR) = Marginal Cost (MC).

Profit Maximizing Condition

For a perfectly competitive firm: P = MC.

Shutdown Decision

Shutdown if Price < Average Variable Cost (P < AVC).

Total Cost (TC)

TC = Variable Cost (VC) + Fixed Cost (FC).

Profit Calculation

= TR - VC - FC.

Shutdown Condition

A firm should produce only if: Profit(from producing) ≥ Profit (not producing).

Average Variable Cost (AVC)

Should only produce if average revenue (P) is greater than or equal to the average variable cost (AVC).

Short-Run Supply Curve

The short-run supply curve for an individual firm in a perfectly competitive market is the portion of the marginal cost curve that lies above the average variable cost curve.

Production Decision for Perfectly Competitive Firms

Produce quantity where Price (MR) = Marginal Cost (MC)

Profit maximizing condition for a perfectly competitive firm

P = MC

Shutdown Decision in the long-run

Shutdown and exit the industry if Price < Average Total Cost

Zero Economic Profit in the Long-Run

Perfectly competitive firms earn zero economic profit due to free entry and exit

Long-run Market Equilibrium condition

P = MC = ATC

Long-run profits condition

(P - ATC)*Q = 0

Firm profitability conditions

If P > ATC, the firm is profitable; If P = ATC, the firm breaks even; If P < ATC, the firm incurs a loss

Shutdown condition in the short-run

P < AVC

Shutdown condition in the long-run

P < ATC

Profit Maximizing Level of Output condition

If produce, maximize profits where MR = P = MC

Profits

= P*Q-C(Q)