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Quentin Metsys, Moneychanger and his Wife, 1514 Economics 14

Lecture 23: Profits and Market Structure

profit maximization
market structure


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Profit Maximization

We assume that the goal of firms is to maximize profits. We could compare total revenue and total cost at every level of output in order to find the profit maximizing level of output. An alternative is to compare marginal revenue and marginal cost.

marginal cost
additional cost of producing one more unit of output
marginal revenue
additional revenue obtained from selling one more unit of output

As long as the marginal revenue from selling a unit of output is greater than the marginal cost of producing that unit of output the firm will make a profit on that unit of output.

A profit maximizing firm will continue to expand production as long as marginal revenue is greater than marginal cost. Here's another example:

PriceQDTRTCMRMCProfits
$50$0$3 - - $-3
4143.50$4$0.500.50
326521.501.00
2367.5002.50-1.50
14411-23.50-7.00
05015.50-14.50-15.50
When the firm can produce fractional units of the good, profits are maximized at the quantity at which MR = MC. Graphically, this occurs where the marginal revenue and marginal cost curves intersect. Drop straight down from the point of intersection to find the profit maximizing quantity of output, Q*. To find the profit maximizing price, follow Q* up to the demand curve and over to the vertical axis.profit maximization

Market Structure

elements of market structure:

  1. number of firms in the market
  2. degree to which products produced by firms are perceived to be different
  3. ease of entry into market

Perfect Competition

  1. many buyers and many sellers
  2. identical products
  3. free entry and exit

Since there are many firms each selling exactly the same product, buyers do not care which firm they purchase the item from; all buyers look at is the price. So, a firm in a perfectly competitive market must charge the same price as all other firms or they will sell no output at all. The demand curve facing a perfectly competitive firm is horizontal at the market price.

Free entry into and free exit from the industry means that firms in a perfectly competitive market earn only a normal profit in the long run.


Monopoly

  1. many buyers and a single seller
  2. unique product
  3. entry is impossible

A monopolist faces the market demand curve. Since entry is impossible a monopolist can earn an economic profit over the long run.


Monopolistic Competition

  1. many buyers and many sellers
  2. slightly different products
  3. free entry and exit

Monopolistic competitors tend to compete on the basis of product differentiation and by introducing new products, for example, light beer, then ice beer, then low carb beer.


Oligopoly

  1. many buyers and just a few sellers
  2. identical or slightly different products
  3. entry is difficult

Oligopolists need to take into account how the other firms in the industry will react to their business decisions. For example, Ford will consider what it thinks General Motors will do when Ford is making its styling and pricing decisions for its new cars.


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Business and Economics Division
Pennsylvania State University, York Campus
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