Marginal Cost and Supply

Profit Maximization Economists assume that firms pursue the highest profit given certain cost constraints. Therefore, they will produce at the output level which maximizes their profits.

Profit = Total Revenue (TR) Total Cost (TC) TR = P x q, where P is the market price and q stands for per firm output level.
The profit maximizing objective is applicable in both the short-run and long-run. In this chapter, we analyze the pricing behaviour of PRICE TAKERS (perfectly competitive firms). As firms take the market price (P) as given, they, individually, CANNOT affect it. P changes if and only if ALL firms take the same action collectively. In other words, there

is only 1 given P in this case. P is also the marginal revenue (MR) of firms.

= (TR) (TC)
TR = P x q, P q
(P) P

1 PP
1

(MR)
By Vincent Leung

Marginal Cost and Supply

Negative profit is known as loss. Please be reminded that the following analysis only applicable in perfectly competitive markets. The structure of different markets will be covered in Topic D. The pricing behaviour of a monopoly will be discussed in Elective 1. A price line reflects the given market price under different output level (please refer to the diagram below). D

by Vincent Leung

Now, we may plot the price line and MC curve together. $ Firm A MC

STEP 1
P

Arbitrarily pick up an output level q1. Will Firm A produce ? Will it produce MORE ? q1 A q1 Ans : YES, because at q1, P > MC. YES, because after q1, P is still > MC.

(variable) profit

STEP 2

q1

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Now, Firm A is producing at q2. Will it produce MORE ?

A q2

Ans : YES, because after q2, P is still > MC.

STEP 3
(variable) profit

q2

Now, Firm A is producing at q*. Will it produce MORE ? A q* Ans : NO, because after q*, P < MC.

(variable) profit

STEP 4

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q*

Marginal Cost and Supply

In fact, q* is the output level that maximizes a firms profit. We may find that, at q*, P = MC.

P = MC is the criterion that yields the highest profit.

In exams, candidates will be given a market price and a marginal cost schedule. Students are required to find out q* (the profit-maximizing output level). Find q* from the following data. q* q*, P = MC.

P = MC
q* q*

P ($)
80 80 80 80 80

MC ($)
60 70 80 90 100

q (units)
500 600 700 800 900

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Marginal Cost and Supply

IF P increases

Good X $ MC

P1 P Q Q* Q1

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Marginal Cost and Supply

IF P decreases

Good X $ MC

P1 P Q Q1 Q*

by Vincent Leung

Marginal Cost and Supply

MC = P = ($) Quantity supplied (unit) 0 2 4 6 8 10

0 2 4 6 8 10

As firms produce until MC = P, the marginal cost schedule of a firm can be interpreted as its supply schedule in the production of a good.
It is because we can tell the quantity of the good the firm plans to produce from the marginal cost schedule given the price of the good.

MC = P

by Vincent Leung

Marginal Cost and Supply

Similarly, as firms produce until MC = P, a firms marginal cost curve of a good is its supply curve of that good. MC is known as producers reservation price. A producers minimum willingness to produce for a good depends on the MC derived from that good.

MC = P
MC Good X
P ($) MC MC5 MC4 MC3 MC2 MC1 0 Q1 Q2 Q3 Q4 Q5 P ($) S = MC P5 = MC5 P4 = MC4 P3 = MC3 P2 = MC2 P1 = MC1 0 Q1 Q2 Q3 Q4 Q5 Q Q

Good X

by Vincent Leung