PROFIT, LOSS, AND PERFECT

COMPETITION

Chapter 9
 CHAPTER OBJECTIVES

After reading this chapter you will be familiar with:

1. Marginal Revenue
2. Profit Maximization and Loss Maximization
3. The Characteristics of Perfect Competition
4. The Perfect Competitor in the Short Run and Long Run
5. The Short Run and Long Run Curves
6. Economic Efficiency
7. Economic Profits and Accounting Profits
 TOTAL REVENUE AND MARGINAL REVENUE

Hypothetical Revenue Schedule

Total Revenue (TR) - total

amount received by a seller
from the sale of a product
-product price (P) x
quantity demanded and sold
(Q)
Recall TR = P x Q
Marginal Revenue (MR) - the increase in the total revenue when output
sold goes up by 1 unit
GRAPHING DEMAND AND MARGINAL REVENUE
 ECONOMIC AND ACCOUNTING PROFITS

Accounting Profits – what is left

over from the total revenue after
a firm has paid all of its explicit
Total Revenue $ 4,300,000
cost
-Total Cost (explicit cost) 3,750,000
Accounting Profit 550,000
• Explicit Cost – cost of doing
business
• Rent, wages, cost of goods sold,
fuel, taxes, etc.
 ECONOMIC AND ACCOUNTING PROFITS

Economic Profits – what is leftover from accounting profits after a firm has subtracted its
implicit cost
• Implicit Cost – are a firm’s opportunity cost (the forgone value of the next-best
alternative)

Suppose you have invested $100,000 of your money in your business. You could have earned
$15,000 interest on this money. Instead, you and your spouse working 12 hours a day, 7 days
a week, both could have earned $70,000 working for someone else.

($15,000 + $70,000 = $85,000 implicit cost)

Accounting profit $ 85,000

- Implicit cost 85,000
Economic Profit 0
 ECONOMIC AND ACCOUNTING PROFITS

Business: Restaurant
Business: Restaurant
Year 1
Year 1
Revenue – 500,000
Revenue – 500,000 Expenses:
Expenses: (explicit costs) Explicit:
Food 100,000
Food 100,000
Labor 100,000
Labor 100,000
Bldg. Rent 200,000
Bldg. Rent 200,000 Eqp. Rent 50,000
Eqp. Rent 50,000 450,000 Implicit:

Accounting Profit 50,000 Wages (forgone) 150,000 600,000

Economic Profit -100,000
• In accounting terms, you are profitable or making profit.
• In economic terms, you are not profitable.
• Negative economic profit means that the business shouldn’t be run in
this manner.
• You are making 50,000 a year but instead of making this amount in
this restaurant, you gave up 100,000 to do this restaurant when you
could’ve made 100,000 more doing something else.
 ECONOMIC AND ACCOUNTING PROFITS

Why stay in business if your economic profits are zero?

• You are still making accounting profits.

• You wouldn’t do any better if you invested your money

elsewhere and worked for someone else.

• You are your own boss by having your own business.

 ECONOMIC AND ACCOUNTING PROFITS

When economic profits become negative, particularly if losses are substantial and appear permanent,
more and more people will close their businesses.
• They will go to work for someone else.
• They will go into a different business.
Market supply decreases and forces prices up.
• This process continues until people stop getting out.
But with economic profit (short run), more people are attracted to this type of business.
Market supply increases and forces prices down.
• This process continues until people stop getting in.
• Economic profits are zero at this point (long run).
• No one else wants to enter or leave.
We will see this graphically in a few minutes.
 PROFIT MAXIMIZATION AND LOSS MINIMIZATION

Profit Maximization Point: MC = MR

This occurs somewhere between 5 and 6 units.
We are assuming output can be produced in tenths or one hundredth of a unit (in
reality, units of output can be in the thousands).
 PROFIT MAXIMIZATION AND LOSS MINIMIZATION

Output MR MC
1 $500 $ ---
2 500 500
3 500 300
4 500 200
5 500 300
6 500 550
7 500 860
Profit Maximization Point: MC = MR (also in loss minimization)
The most profitable output is where the MC curve crosses the
D, MR curve. This occurs at an output of 5.75 units.

Total Profit = (P-ATC) x Output or (P-ATC) x Q*

Try solving the profit here --- ($500 - $465) x 5.75 = $201.25
 THE SHUT DOWN AND BREAK-EVEN POINTS

In the SR, this firm will not

accept any price below $101.

In the LR, this firm will not

accept any price below
$125.50.
 FOUR RULES

In the short run:

• If the price is below the shut-down point, the firm will
shut down.
• If the price is above the shut-down point, the firm will
operate.
In the long run:
• If the price is below the break-even point, the firm will go
out of business.
• If the price is above the break-even point, the firm will
stay in business.
QUESTIONS FOR FURTHER DISCUSSION

What is Q* when Price = $25?

Q* is where MC = MR
Q* = 7.9

Calculate profit
Profit = (P – ATC) x Q*
= ($25 - $17) x 7.9
Profit = $ 63.20
FINDING THE FIRM’S SHORT-RUN AND LONG-RUN SUPPLY
CURVES

The firm’s SR supply curve

begins at the shut-down point
and follows the MC curve
upward.

The firm’s LR supply curve

begins the break-even point
and follows the MC curve
upward.
 EFFICIENCY AND PROFIT MAXIMIZATION

How much is the firm’s most efficient

output?

This occurs where Q=10, the minimum

point on the ATC (which is the break-
even point).

How much is the most profitable

output?

This occurs at an output of 11 which is

where MC = MR.
 DEFINITION OF PERFECT COMPETITION

The 1st of four competitive modes.

A theoretical model that does not exist in the real world.
Serves as the standard by which we will measure the next three competitive models.
• Monopoly
• Monopolistic Competition
• Oligopoly
Perfect competition is a market structure with:
• Many well-informed buyers and sellers (perfect knowledge)
• Identical products
• No barriers to entering or leaving the market (perfect mobility)
• No firm is large enough to influence the price
 THE PERFECT COMPETITOR’S DEMAND CURVE

The intersection of the industry S & D curves sets the market price. Individual firm must accept this going price –is a
“price taker”.
So P* = $6
THE PERFECT COMPETITOR IN THE SHORT RUN

In the short run, the perfect competitor may make a profit or take a loss.
THE PERFECT COMPETITOR IN THE LONG RUN

In the long run, the perfect competitor breaks even

How do we then go to the long run where the firm is breaking even?
GOING FROM TAKING A LOSS IN THE SHORT RUN TO BREAKING
EVEN IN THE LONG RUN

At a price of $6, the firm is losing money and so are the other firms in the industry.
GOING FROM TAKING A LOSS IN THE SHORT RUN TO BREAKING
EVEN IN THE LONG RUN

Some firms leave the industry in the LR, reducing supply, and thus raising the price to $8. Firms now charge $8,
breaking even.
GOING FROM TAKING A LOSS IN THE SHORT RUN TO BREAKING
EVEN IN THE LONG RUN

At a price of 10, the firm is making a profit and so are other firms in the industry.
GOING FROM TAKING A LOSS IN THE SHORT RUN TO BREAKING
EVEN IN THE LONG RUN

New firms enter the industry in the LR, raising supply, and thus lowering the price to $8. firms now charge $8,
breaking even.
THE PERFECT COMPETITOR IN THE LONG RUN

Again, in the long run, the perfect competitor breaks even.

 SUMMARY: PERFECT COMPETITION

In the long run the perfect competitor is forced to operate at

the break-even point.
• This means it is operating at peak efficiency.
• The price it gets is just equal to the minimum point of its ATC (the
break-even point).
• It charges the lowest price and operates most efficiently.
THIRD METHOD OF CALCULATING PROFIT AND LOSS

Profit (or loss) is the area of the rectangle (box) between the D curve and the ATC curve.
Profit: EF (70) FG ($12.50) = ($875)
Loss: JK (600) x KL ($2.00) = -1, 200
THE PERFECT COMPETITOR: A PRICE TAKER NOT A PRICE MAKER

A firm operates at peak efficiency when it produces at the lowest possible

cost.
• Or minimum point of its ATC curve (the break-even point).
In the long run, the most profitable output is also at the minimum point of
its ATC curve because this will be where MC = MR.
Because of the degree of competition, the perfect competitor is forced to
operate at peak efficiency.
• Other forms of competition do not force to operate at peak of efficiency.
 EFFICIENCY, PRICE, AND PROFIT

A firm operates at peak of efficiency when it produces at the lowest possible cost (min ATC).
CURRENT ISSUE: THE INTERNET EFFECT: A MORE PERFECT
KNOWLEDGE AND LOWER PRICES

The internet has moved entire markets much closer to the ideal of
perfect knowledge.

The internet has also lowered the barrier to entry in many markets
bringing us much closer to the ideal perfect competition for many goods
and services.

With customer now able to instantaneously find the available prices for
many goods and services, many companies find no choice but to lower
prices.