2. Firm Behavior
• We know what a firm can produce in terms of
output with any amount of input (production
function)
• We know how much producing any amount of
output will cost a firm given our knowledge of
the production function (cost function)
• Now we must make a key behavioral
assumption about firms:
– Firms choose output levels so as to maximize
profit
4. Intuition behind profit maximization
FOC
• Imagine that you run a small business and are
trying to determine how much output to
produce. Do you solve for a total cost function
and then for the FOC for profit maximization?
Probably not. More likely, you experiment with
different output levels and use a decision-rule to
pick the best output level.
– If you expand output by one unit and profit increases,
try expanding by another unit.
– When profit declines with an additional unit of
output, you stop expanding.
– This simple decision rule amounts to expanding when
MR>MC and contracting when MR<MC. In other
words, the optimal Q (where you stop) occurs when
MR=MC.
6. Marginal revenue
• The extra revenue the firm gets for each
additional unit sold
• Always equal to or less than the price
P What does this graph look like for a price taker?
For a linear demand function such as P=a-bq, it
is always true that the marginal revenue is given
by MR(q)=a-2bq
Demand faced by firm
MR(Q)
Q
a/(2b) a/b Because this is a linear
demand function
8. Profit Maximization
Assume the firm is a price-taker so that is can sell as much as
it wants at the prevailing market price: P(Q)=P
TC(Q) TR(Q)=PQ
$ Here we see two points at which the
FOC for a profit maximum are satisfied,
but one clearly maximizes the firm’s
losses and not its gains
Profit
MC(Q2)=MR=P
MC(Q1)=MR=P
Loss
Q
Q1 Q2
10. A side note on cost functions
• STC=FC+VC
• SATC=STC/q=AFC+SAVC=FC/q+VC/q
• Knowing SATC & SAVC will be important in
determining firm’s short run profit
maximization behavior (i.e., output choices)
$
SATC
AFC
SAVC
q
12. Marginal revenue and elasticity of
When P goes down to
P’
demand
P
P Elastic region Unit elastic point
P
A Inelastic region
P’
B P(Q) When demand is
Q MR(Q) elastic, an expansion of
Q output leads to higher
A=lost revenue TR. When demand is
resulting from $ inelastic, an expansion
selling output at of output leads to
lower price lower TR. Given that
B=additional reducing output lowers
TR(Q) TC, clearly a firm
revenue from
selling more units should reduce output
Q when it faces inelastic
A>B when demand is inelastic. A<B when demand
demand is elastic
14. Markups & elasticity
P
Demand curve a price-
Punchline: firms that are taker faces:
price takers have no P=MR
market power; they have
zero markup Demand faced by firm is not
Firms facing a less than the market demand (unless the
perfectly elastic demand curve firm is a monopolist)
will have positive markups Q
(market power)
15. Types of Market Structures
• Markets are characterized by different degrees
of competitiveness (same as saying different
degrees of market power, different markups)
Perfectly competitive market Monopoly
-No market power -Most market power
-No markup -Potentially large markup
Oligopoly Duopoly
16. Perfect Competition in the Short Run
• Assume firms are price takers:
P
D=MR=AR=P
Q
• Determine the firm’s supply curve
– Choose Q such that MR(Q)=MC(Q)
17. Firm-level supply in SR under perfect
competition
• Because MR(Q)=P, choose Q such that
MC(Q)=P:
P
MC(Q) Recall the SOC for
MR>MC(Q) profit
D=MR=P maximization: MC
must be increasing
at the optimal q.
q2 here is the
profit maximizing
output level.
q1 q2
19. Shutdown price
• Why is PSD=min(SAVC)?
P SATC(Q) SAVC(Q)
SMC(Q)
P’
PSD
Q
q*
20. Shutdown price
P SATC(Q) SAVC(Q)
SMC(Q)
P’’ MR=P’’
PSD
Q
q*
Here, P’’<ATC(q*). At price P’’, this firm earns a loss. Will this firm continue to operate?
The answer is maybe. At P’’, the price exceeds the firms’ variable costs, meaning that it
can pay for its variable inputs and earn enough to recoup some but not all of its fixed
costs. Some firms in this position will choose to remain in the market, recoup some
fixed costs, and hope for an increase in the market price (perhaps because other firms
in a similar position exit the market). Other firms in this position will exit the market.
This is why the firm’s output rule says “if the firm produces positive output….”
21. Shutdown price
P SATC(Q) SAVC(Q)
SMC(Q)
PSD
MR=P’’’
Q
q*
Here, P’’’<AVC(q*)<ATC(q*). At P’’’, this firm earns a loss, but it fails to even recoup the costs
of its variable inputs. Recall that the cost per unit of output of only the variable inputs is AVC.
If P<AVC, the costs of variable inputs exceeds revenue, but you can always drive variable
costs to zero by simply producing nothing. This also drives revenues to zero, but this is better
than throwing money away on variable costs that you can’t recoup. At prices below PSD, all
firms should shutdown. Because the P=MC and MC (P) is below AVC everywhere to the left
of min(SAVC) (where the SAVC curve intersects the MC curve), the firm never operates at
prices below min(AVC).
22. Intuition behind the shutdown price
• Suppose you were holding a bake sale to raise
money for your student organization. You
choose to sell brownies for $1.00/brownie.
You buy eggs, cocoa, flour, vanilla, sugar, and
butter. You choose the output level at which
MC=$1, but at this output level you
AVC=$2.00. This means that for every brownie
you sell, you are paying $2.00 for ingredients
(eggs, cocoa, flour, vanilla, sugar, and butter)
but only recouping $1. This is a BAD bake sale.
23. Intuition behind the shutdown price
• Now suppose the price of brownies is $2.50.
Here, you recoup the costs of ingredients for
each brownie ($2.00 still) and earn $0.50 on
top of that. Suppose, however, that Student
Life charges $50/day for a table on the quad.
Your SATC at this output level is $2.75. This
means that the $0.50 you earn on top of
variable costs goes part but not all of the way
towards helping you recoup your fixed costs
(here, AFC=$0.75, so you are $0.25 short of
breaking even).
26. Firm’s output rule
Firm earns
P SATC(Q) SAVC(Q)
positive profit SMC(Q)
PBE
Firm earns short run
PSD losses and may or
may not continue to
Firm shuts operate
down
Q
q*
27. The Firm’s Supply Curve
P SATC(Q) SAVC(Q)
SMC(Q)
P5
P4
PBE P3
P2
PSD
P1
Q
0 q1 q2 q3 q4
Consider the firm’s output at a variety of different prices. Recall that the firm’s
decision rule when it is a price taker sets MC(Q)=P. As a result, its supply curve is
its marginal cost curve above the SAVC curve. At prices below PSD, the firm
supplies zero units of output.
29. Why do some firms stay in the market
when earning losses in the SR?
P
S’
P SATC(Q)
SMC(Q)
S
P* PBE SAVC(Q)
PSD PSD
D
Q
Q
If the price is between PSD and PBE, this firm earns a loss in the short run. Presumably
other firms in the same position (if all firms have the same production technologies,
they will have the same cost curves). Some choose to exit. This causes the market
supply (the horizontal sum of individual firm supply curves) to shift to the left. The
equilibrium price goes up. Eventually we expect the equilibrium price P* to equal
the breakeven price because at this price there will be neither entry nor exit of
firms. In the long run, any firm earning a loss would shut down.
39. Example: LR firm supply function
P
S’
Notice that in the LR, r does affect the supply
W ↑ or r ↑ curve because K is a variable input, so its price
S (r) affects marginal costs. Show that the
supply curve equals the firm’s marginal cost
curve.
Q
40. Producer’s surplus
• Producer’s surplus refers to the gains accruing
to the producer from producing and selling q
units of output at price P
• Producer’s surplus is a short-run concept
• Is producer’s surplus the same as the firm’s
profit? No.
P
S
P*
Intercept Producer’s surplus: the gains accruing to
is not the firm from selling units of output 0
always 0 D through q*
q* Q
47. Profits in LR for price-takers
Market level MC
P S S’ Firm-level AC
P1
P*
D
Q Qfirm-level
QMES q1
Q1 Q*
When firms earn positive profits, new firms enter. As we just saw, new entrants will shift the
market level supply curve to the right. This will continue to happen until there are no profits
to be had. When does this occur? In the long run, the price can only fall until P=P*. At P* in
the LR, P=AC so profit equals zero. The market supply curve shifts from S to S’. This has an
important implication. In the long run, all firms will produce at their minimum efficient
scale. That is, all firms produce an output level that minimizes their costs-per-unit of output
of production. (Note that S and S’ are short run industry supply curves.)
49. Long run market supply curves
Ssr MC
P S’sr AC
P’
P*LR Slr
D D’
Q Qfirm-level
Q1 * Q2 * QMES
Suppose there is an increase in market demand from D to D’. In the short run, the price
will go up to P’. At P’, firms will enjoy positive profits. As such, new firms will enter.
Assuming that the entry of new firms has no effect on existing firms’ cost structures,
the price will eventually fall back down to P*LR at a higher equilibrium output level. This
implies that the long run market supply curve is horizontal and given by Slr above.
50. Long run market supply curves AC
1
Ssr S’sr
P AC0
Slr
P*LR
D D’
Q Qfirm-level
QMES
Suppose instead that the industry is a significant consumer of an important input. If new firms
enter, they bid up the price of this important input for all firms. As we have seen, this changes
the firms’ cost structures and shifts the average cost curves upward. This, however, implies
higher long run equilibrium prices as market output expands. That is, the market supply curve
in the long-run is upward sloping.
There may be other reasons why new entrants drive up the costs for all firms other than the
demand for important inputs. Likewise, new entrants might also lower the costs for all firms.
Why?
52. Perfectly competitive markets
• The market supply we have described to this
point is the market supply in perfectly
competitive markets, but we have not fully
characterized perfectly competitive markets.
• Perfect competition is a model of market
behavior. Because all models are just sets of
assumptions, we must make explicit the
assumptions characterizing perfectly
competitive markets.
53. Assumptions of perfectly competitive
markets
1. Large number of firms each selling a
homogeneous product (i.e., selling an identical
product)
2. Firms are price-takers: individual firm output
choices have no effect on prices
3. Perfect information: prices are known to all
firms and consumers
4. Transactions are costless: guarantees free entry
and exit of firms and inputs
• Maintained assumption in all models of market
structure is that firms are profit maximizers
55. Allocative Efficiency
• A market equilibrium is allocatively efficient if
the marginal cost to society from consuming
output level q is equal to the marginal benefit
to society of producing output level q.
P S=MC
Gains from
trade of
each unit of
output
D=MB
Q
56. Allocative efficiency
P
S=MC
Another way to say that the market
Consumer
equilibrium is allocatively efficient is to
surplus
say that the welfare gains to society from
Producer exchange, the consumer and producer
surplus surplus, are maximized. This is the same
as Pareto efficiency in this context.
D=MB
Q
57. Inefficient allocation
P
S=MC
CS
P’
Deadweight loss
PS
D=MB
Q
Q’
Suppose for some reason output was restricted to Q’. At that output level, consumers are
willing to pay P’ for the good, so the price will be P’. The gains accruing to producers are the
producer’s surplus. These gains are large relative to those enjoyed by consumers (CS), who
must pay the higher price. Note that there are gains from trade (either to consumers or
producers) that are not realized. This is known as the deadweight loss, and it is given by the
green triangle above.
