Profit Maximization

6 June 2017

Explain why a profit maximizing firm produces the output that equates marginal revenues to marginal costs (MR=MC). In a perfectly competitive market, producers are price-takers and consumers are price-takers. There are many producers, none having a large market share and the industry produces a standardized product, also free entry and exit of the industry. They produce using the optimal output rule: produce where marginal revenue equals marginal cost as Smith (1904) demonstrated.

Figure 1: Types of Market Structure where the behavior of any given firm and the arket it occupies are analyzed using one of four models of market structure: monopoly, oligopoly, perfect competition, or monopolistic competition based on two dimensions: products are differentiated or identical and the number of producers in the industry; one, a few, or many. A firm is profitable if total revenue exceeds total cost or,if the market price exceeds its break-even price minimum average total cost.

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If market price exceeds the break-even price, the firm is profitable; if not, the firm is unprofitable; if it is equal, the firm breaks even. Fixed costs are irrelevant to the firm’s ptimal short-run production decision. When the market price is equal to or exceeds the shut-down price, the firm produces at MR = MC. When the market price falls below the shut-down price, the firm ceases production in the short run. Figure 2: Profit maximizing in a Perfect Market or The Price-Taking Firm’s Profit- Maximizing Quantity of Output.

At the profit-maximizing quantity of output, market price = marginal cost, at the point where the marginal cost curve crosses the marginal revenue curve, which is a horizontal line at market price. Here, the profit- aximizing point is at an output of 5 eggs, the output quantity at point E. A monopoly is a sole firm producer of a good that has no close substitutes so it raises its price above the competitive level by reducing output equating market power.

Profits persist in the long run because of a barrier to entry by control of natural resources, increasing returns to scale, technological superiority and government-created barriers. An increase in production by a monopolist has two effects on revenue: quantity effect where one more unit is sold, increasing total revenue by the price at hich the unit is sold also a price effect demonstrating that in order to sell the last unit, the monopolist must cut the market price on all units sold decreasing total revenue.

Profit-maximizing monopolists choose the output level at which marginal revenue is equal to marginal cost not toprice to achieve the greatest revenue possible as Marshall (1909) postulates. Consequently, the monopolist produces less and sells output at a higher price than a perfectly competitive industry, earningprofits in the short and long run. At low levels of output, the quantity effect is tronger than the price effect: as the monopolist sells more, it has to lower the price on only very few units, so the price effect is small.

Figure 3: Monopolies: Under perfect competition, the price and quantity are determined by supply and demand. Here, the equilibrium is at C, where the price is moves up the demand curve from C to M, raising the price to PM. As output rises, total revenue falls. Accordingly, at high levels of output, the price effect is stronger than the quantity effect: as the monopolist sells more and has to lower the price on many units of output, making the price effect very large.

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