Maximizing Profit under Competition

… a core concept in Economic Analysis and Atlas102

Concept description

Alex Tabarrok (reference below, video on right) describes the key characteristics of a firm operating under conditions of Perfect Competition.

Competitive firm

Tabarrok summarized the characteristics of a firm operating under conditions of perfect competition:

Choosing the price to sell the output

Tabarrok uses the example of an owner of small stripper well to illustrate the two key features of a firm operating in a perfectly competitive market:

• The firm has no control over price – demand for the product is perfectly elastic (quantity produced will not affect market price)
• The firm’s only choice is over the quantity to produce and sell

What is profit?

In his next video (right), Tabarrok reviews the requirements for making a profit.

Profit = Total Revenue – Total Cost

Total Revenue = Price x Quantity (P x Q)

Total Cost (TC) = Fixed Costs + Variable Costs

Costs include opportunity costs

Costs measured by economists differ from those measured by accountants. Economic analysis includes Opportunity Cost (such as foregone interest for the capital invested in the business).

Choosing the level of output to maximize profit

When the firm produces an additional unit of output, there are additional revenues and additional costs. Profit maximization is about comparing the additional revenues and additional costs.

Marginal Revenue (MR) = the addition to total revenue from selling and additional unit of output

Marginal Cost (MC) = the addition to total cost from producing and additional unit of output

Profits are maximized at the level of output where MR = MC

What is the size of the profit?

In his next video (right) Tabarrok explains how to use the average cost curve to calculate the size of profit (and whether it is positive or actually a loss) and to show it on a graph. The average cost is the total cost, TC, divided by the quantity produced, Q.

Average Cost (AC) = the cost per unit of output = TC/Q

This can be rearranged to read:

Profit = (P – AC) x Q

and this can be viewed on a graph as follows:

Note that maximizing profit does not mean that profit is positive. If the price is below the Break-even Price, the firm will be operating at a loss, which will be the rational course of action when the price for the product is above the marginal cost of producing it and fixed costs are truly fixed. See also Entry, Exit, and Sunk Costs.

Practice questions

From http://www.mruniversity.com/node/230468, and http://www.mruniversity.com/node/230512, and http://www.mruniversity.com/node/264181, accessed 3 May 2016.

1. A competitive firm maximizes profit by choosing
   1. Price
   2. Quantity
   3. Both price and quantity
   4. Either price or quantity, but not both
   5. None of the above.
2. A competitive market has which of the following characteristics?
   1. Lots of small-scale sellers
   2. Lots of small-scale buyers
   3. Product that is similar across sellers
   4. A & C only
   5. All of the above.
3. In a competitive market, sellers sell their product
   1. At the world price
   2. Just below the world price
   3. Just above the world price
   4. At a price dependent on the quantity chosen.
4. On January 27, 2011, the price of Ford Motor Company stock hit an almost 10-year high at $18.79 per share. (Two years prior, in January 2009, Ford stock was trading for about a tenth of that price.) Suppose that on January 27, 2011, you owned 10,000 shares of Ford stock (a small fraction of the almost 3.8 billion shares). Suppose you offered to sell your stock for $18.85 per share, just slightly above the market price. How many shares would you sell?
   1. 10,000
   2. 7,300
   3. 1 
   4. 0
5. Suppose instead that on January 27, 2011, you wanted to sell your 10,000 shares of Ford stock but you reduced your asking price to $18.75 per share? How many shares would you sell?
   1. 10,000
   2. 7,300 
   3. 1
   4. 0
6. Given your answer to the previous question, should you sell your shares at $18.75? 
   1. Yes
   2. No
7. Which characteristic below best describes the demand curve that you as an individual seller of Ford stock face?
   1. A perfectly elastic demand curve
   2. A perfectly inelastic demand curve
   3. None of the above.
8. The economic definition of profit differs from the accounting definition of profit in that the economic definition includes
   1. Fixed costs
   2. Variable costs
   3. Opportunity costs
   4. Sunk costs
   5. None of the above
9. Whenever money is used to purchase capital, interest costs are incurred. Sometimes those costs are explicit – like when Alex borrowed the money from the bank – and sometimes those costs are implicit – like when Tyler had to forgo the interest he could have earned had he left his funds in a savings account. If an economist and accountant calculated Alex and Tyler’s costs, for whom would they have identical numbers and for whom would the numbers differ?
   1. Economist and accountant would agree on Alex’s costs and disagree on Tyler’s.
   2. Economist and accountant would agree on Tyler’s costs and disagree on Alex’s. 
   3. In the aforementioned disagreement on cost of one of the activities, which profession would calculate a larger cost? 
   4. Economist
   5. Accountant
10. Which type of cost is dependent on the amount of quantity produced by a firm?
    1. fixed costs
    2. variable costs
    3. sunk costs
    4. none of the above
11. A competitive firm maximizes profit by choosing a level of output where the world price is equal to the firm’s
    1. Marginal revolution
    2. Marginal revenue
    3. Marginal cost
    4. Average cost
    5. Fixed costs
    6. Variable costs
12. For a competitive firm supplying wheat, if the world price (P) equals the firm’s min average cost (min AC), then profits will be
    1. greater than 0
    2. less than 0
    3. 0 
    4. Indeterminate from the given information
13. Given the cost function for Simon, a housepainter in a competitive local market, below, answer the questions that follow. (You may want to calculate average cost.) What is the minimum price per room at which Simon would be earning positive economic profit?  
    1. $62.51
    2. $48.34
    3. $60.01
    4. $76.68 
    5. $35.30
14. True or False: When a competitive firm maximizes profit, profits are always greater than 0.
    1. True
    2. False
15. You’ve been hired as a management consultant to WaffleCo, a maker of generic-brand frozen waffles. They’re each trying to figure out if they should produce a little more output or a little bit less in order to maximize their profits. The firms all have typical marginal cost curves: They rise as the firm produces more. Your staff did all the hard work for you of figuring out the price of the firm’s output is $4 per box and the marginal cost of producing one more unit of output is $2 per box at its current level of output. However, they forgot to collect data on how much the firm is actually producing at the moment. Fortunately, that doesn’t matter. In your final report, you need to decide if the firm should produce more, less, or stay at the current output level. What do you recommend? 
16. 1. Produce more
    2. Produce less
    3. Stay at the current level of output 

Atlas topic, subject, and course

Producer Theory and Competition (core topic) in Economic Analysis and Atlas102 Economic Analysis.

Source

Alex Tabarrok, Introduction to the Competitive Firm (7-minute video), Principles of Economics – Microeconomics, Marginal Revolution University, at http://www.mruniversity.com/courses/principles-economics-microeconomics/deeper-look-tradeable-allowances, accessed 6 May 2016.

Alex Tabarrok, Maximizing Profit under Competition (13-minute video), Principles of Economics – Microeconomics, Marginal Revolution University, at http://www.mruniversity.com/courses/principles-economics-microeconomics/deeper-look-tradeable-allowances, accessed 6 May 2016.

Alex Tabarrok, Maximizing Profit and the Average Cost Curve (12-minute video), Principles of Economics – Microeconomics, Marginal Revolution University, at http://www.mruniversity.com/courses/principles-economics-microeconomics/profit-maximization-average-cost, accessed 6 May 2016.

Page created by: Ian Clark, last modified 7 May 2016.

Image: Alex Tabarrok, minute 0.14 of Introduction to the Competitive Firm (7-minute video), Principles of Economics – Microeconomics, Marginal Revolution University, at http://www.mruniversity.com/courses/principles-economics-microeconomics/deeper-look-tradeable-allowances, accessed 6 May 2016.