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Profit Maximization and Competitive Supply

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Profit Maximization and Competitive Supply

Cost curve is defined as the minimum cost required by a firm to produce different amount of output. It is determined to find out the basic difficulties faced by any firm i.e., how much should any firm actually produce? In this lesson, we would try to elaborate how does a firm choose the level of output which maximizes its turnover or profit? This chapter would also emphasize on advantages of output choices for a firm to get the supply curve for it.

Like in previous chapters, this time also, we are focusing on a universal or general discussion on output for profit maximizing, which is applicable for all firms in different types of market. Later, we would discuss on the topic “Perfectly Competitive market”, wherein we would explain how all the firms could produce similar products and at the same time, the production decision does not alter the market price. This study would help those who want to enter into business and also those who are losing money in their business.

On the onset, we would explain the meaning of competitive market. On later phase, following topics will be discussed:-

  • Why it is important for any firm to maximize their profit?
  • A rule to choose profit maximizing output of any firm in all types of markets.
  • How a firm could choose the output for long and short run?
  • How to derive the supply curve for firm?
  • How to derive the industry supply curve?

8.1    Perfectly Competitive Markets

In Chapter 2, we studied about supply –demand analysis, where it is explained that how the market price is affected with the change in market conditions. Depending upon this market supply curves and market demand, the quantity and equilibrium price is obtained. Here,lays the model pertaining to perfectly competitive market. This model is quite useful in understanding the markets relating to fuels, agriculture, housing, other commodities, financial market and other services.

This model of perfectively competitive market depends on following three simpleexpectations:-

  1. Price taking
  2. Product homogeneity
  3. Free entry and exit

You have already read about these assumptions in previous chapters, so here only brief is given about them.

Price Taking

Each and every firm has its competitors in the market and an individual firm has very less contribution in total market output. So, firms directly take the market price for any product. Therefore, the firms are termed as price takers in perfectly competitive market.

Example:

Let’s say, you are a whole sale distributor of bulbs and small lights. You get the items from a manufacturer and sell them to your customers at a wholesale price or retail price. There are many distributors like you. Therefore, you have a very less scope of changing the market price of your products to beat the competition. In case you charge more cost for any product, you may fear of losing your customers. Therefore, with no option left, you are forced to take the market price and you become the price taker.

The price taking formula goes for the customers also. Customers are buying very less share of the entire result, so their buying has a very less impact on the total output. So, customers take the price of the market.

Overall, it could be assumed that the decision of any firm or any customers does not have any impact on total output. So, they take the prices of the market.

Product Homogeneity 

Price taking formula is applicable for the firms, which are producing similar types or homogenous types of products. It happens generally with agricultural products. None of the firms could increase their cost beyond the market cost because the quality of the items is similar. For instance, a person buying corn, might not ask about the production place of it. The items such as gasoline, oil, raw materials like iron, copper, lumber, steel sheet and cotton are such homogenous items and economists call these items as commodities.

Whereas, when the products are heterogeneous in nature, the firm has the scope of increasing the product cost. This is because the quality is different from other products and the firm does not have the fear of losing the sale or customers. For example, Haagen-Dazs ice-cream could be sold at a price as the firm wishes because the ingredients of this ice-cream is quite different from any other ice-cream and customers are quite fond of eating this ice-cream.

Therefore, the assumption in equalityof the product is crucial due to the reason that the single market price remains consistent along with the help of supply-demand breakdown.

Free Entry and Exit

The best thing for any firm to start any business is that entry and exit to any business is free of cost. You need not to pay any extra even if you wish to leave industry when you are unable to make profit. Therefore the customers are free to choose the suppliers as per their wish and suppliers could also enter and exit their business whenever they feel to do.

The special cost for entering into a new business is applicable for business like pharmaceutical companies. One needs to invest a lot to get patent, license to produce drugs, R&D and many other things. The companies like Merck, Pfizer are old and reputed companies and they possess necessary patent and license to produce their products. But if any company desires to come into this business, the special cost is heavy on pocket. Similarly, the aircraft industry too has a huge initial cost to start up a business. Therefore, it is not perfectly an inexpensiveindustry.

Free entry and free exit as assumption become very important for perfectively competitive market.This is because a firm is free to enter or exit from any business depending upon the position of the business. If any firm is facing loss, then it may exit from business and if it is facing huge profit, then it may think of expanding its business by hiring more labors and purchasing new equipment.

If you see that the above three assumptions of perfectly competitive market holds good, then it is easy to analyze the market condition by market demand and supply curves. However, you would find that in most of the cases all three assumptions might not hold good, but it does not implies that ideal of perfectly competitive market is not of any use. It may be useful for firms for making a comparison with the ideal perfectly competitive market.

When one can mention that the market is entirely competitive?

Other than agriculture, there are many markets, which are perfectly competitive. Each firm will face a seamlesslystraight curve of demand for all homogenous products in the industry which makes it free to enter and exit from any business. Nevertheless, there are many firms those have highly competitive markets and they possessexceedingly elastic demandingcurves, which makes it easy for them to enter and exit.

Unfortunately, we do not have a thumb rule to find out that the given market is highly economical or not. If there are many firms, you would not expect a perfectively competitive market. So, let us consider that there are three firms and the demand of the product is elastic. Then you will get a demand curve facing the firm, nearly like a horizontal and the market would seem to behave like perfectively competitive. You would read this topic in details in chapter 13. Though it seemsthat the industry is competitive but you will not find any clue where you can say that the industry is highly economical. In order to analyze this, you need to study the chapters 12 and 13.

8.2 Profit maximization 

Now, here we will learn why a company goes for profit maximization. The detailed description of profit maximization will be given in 8.3, where a rule would be given to find the ways of profit maximization for competitive as well non-competitive market. We would find out the difference between the market demand curve and demand curve of a competitive market.

Do firms maximize profit?

This hypothesis of acquiring benefit is often used in the subject of microeconomics as it is used to predict the behavior of business quite accurately and reduces unnecessary analytical complications. Here, a question arises whether the firms actually try to maximize profit?

When the firm is small owners have the sole control over all decisions and hence they keepprofit in a dominating position. However, in case of big firms, the owners do not have the control over their managers and managers actually take decision on profit of the firms, which could result in deviation from profit maximization. Managers are more concerned of the issues such as revenue maximization, growth of revenue and payment of dividends to shareholders. They are more bothered of short term profit such as promotion or large bonus at the cost of long run profit knowing the factthat stockholders are much concerned about the long term profit maximization. This is because marketing information and technical information are difficult to know. The managers also try to use strategies that could be risky for the firm.

Recently, the trend of bankruptcy especially in financial sector and the enhanced salary of CEOs have questioned the motivation levels of managers in big corporate companies. The detailed discussion is given in chapter 17. In this chapter, we would alsodiscuss the issue of inducements of executives and proprietors of the firms and companies. Here, we would learn that how much liberty a manager should enjoy to take policy decision of any company. It has been found that if any manager takes any policy decision, he or she may be replaced by the board of directors and also sometime is taken over by some other new management.  It is found that companies those do not have a long-run profit maximization strategy, do not survive and the companies which are surviving have long-run profit maximizing strategy.

So, it is obvious that profit maximizing is reasonable forfirms, especially for those who are into business for long. For example a firm may subsidize public television to generate earn goodwillof public. This will help in generatingmonetaryimportance of that particular firm in longer run of business.

Alternative Form of Organization

Now, you could understand how much profit maximization is important for any firm. Here, we will take a pause and would consider a new term or assumption of economics. It is cooperation. There are many organizations which unite to form a group or cooperation. It is actually a group or association of organization or people who come in association with each other for their mutual benefit. Say for instance, many farms may unite together to sell their milk. Here, each farm aims to maximize their level of profit as each farm is a participating member of the cooperation.

You may also get an idea about the cooperativethrough food cooperatives. It is a place where you can expect food items and grocery items at a very low cost. However, the sale is restricted to members and it is unrestricted to those receiving any kind of discount. The prices are so set that the cooperative does notfaces any kind of los but the profit is also incidental. The profit is returned to the members of the cooperative on equal share.

You would like to know about another form of cooperative i.e.,lodgingorganizations. It is more like an apartment in which property or the infrastructure is entirely controlled by the corporation. The members of this cooperation have their shares in terms of an apartment in the building in the form of long term lease. They could also participate in the different ways like being the member of organizing committee; they have the right to choose their neighbor even. In this type of cooperative, the aim is not to earn profit but to offerhousingfacility at lowest possible cost.

Condominium or condo is quite similar to co-ops, but it has some basic differences. Unlike co-ops, condominium is individually owned and not in lease. However, the common facilities like hallways, elevators, heating systems, exterior areas are maintained and used in joint collaboration of all other members of the condominium. The payment of maintenance is sharedamong the members. You may read the advantages of a condominium in the paragraph below:-

Example-1 Condominiums Versus Cooperatives In New York City

In condominium, you are sharing the common space, but you have the sole right to take every decision of your apartment. However, in co-ops, you are responsible for all outstanding dues such as mortgage and you are also subject to some complex governance rules, though all the co-ops members equally share the governance. Moreover, condo owners are free to sell their apartment to anyone whenever they fell to, but co-ops members are not allowed to do so. Theyneed to seek permission from the co-op members. Throughout the country, condos are much popular among people. But you will see a different story at New York City. Here, co-ops are much popular. You might be wondering why so? Well, it is a history. The concept of co-ops came to US in nineteenth century but the concept of condos is quite new. It came during 1960S. Moreover, the New York was already having so much of co-ops and the building governance rules were favoring co-ops.

Therefore, the conversion rate of co-ops into condos is very slow. You will find an interesting answer which came out of a recent study.The cost of a typical condo is about 15.5 % more than that of co-op and moreover you are not free to choose your neighbor when you are having a condo, which is of more concern when you are staying at New York. Therefore, people of New York prefer to stay at co-ops rather than Condos.

8.3 Marginal Revenue, Marginal Cost, and Profit Maximization

Now, we would consider profit maximization for operation of a firm. For this, we have to know about the profit maximization output decision. We all know that benefit is the alterationamongcost of total revenue and total cost. So, it is actually meaning analyzing the revenue. Say for example, the output is q and the revenue is R, then the income is equivalent to value of the produce multiplied by number of unit sold: R=Pq. Also consider C, which is the cost of the production. Therefore, the firm’s profit  is equal to

π (q)= R(q)- C(q)

(π,R and c depend upon C.)

Therefore, to enhance the profit, firms expect a great difference between revenue and cost. You will get to know more about the formula from fig.8.1. Revenue R (q) is indicated by a curved line which means that to increase sale, one has to reduce the price. The slope observed in the curve is termed as marginal revenue: the revenue obtained from one unit increase in the output.

See total Cost Curve C (q), where slope indicates the additional cost of production of one surplusdivision of the result. It is actually marginal cost of the firm. You should not that the total cost C (q) is greater when the result is equal to zeroas in short run, the cost is fixed.

 

Profit Maximization and Competitive Supply 1” = C

 

From the figure in 8.1, you could see that when the output is low, the profit is negative. This is because when the output is low, revenue is not sufficient to cover the variable and fixed cost. With the increase in the output, revenue eventually rises much higher than cost and finally the profit becomes positive.

The level of profit would continue, until it reaches the value q* at this point, the marginal revenue and marginal cost are equivalent and the perpendicularextent cost and revenue, AB, is the greatest. q*is known as the profit maximizing output level.

It is important to consider the fact that when the q* profit level is reached; cost would rise more quickly than income. i.e.,when the revenue of margin is lesser than the marginal cost.Some, the profit is decreased from its maximum value when the output value increases above the value of q*.

So, every firm, whether it is economical or not, follow the rule of maximized profit. i.e., when marginal cost is equal to marginal revenue.

Algebraically, it is written as Profit- π=R-C, is maximized at a point in which an surplusincreasein the resultmakes the profit unchanged i.e.,∆ π/∆q=0

∆ π/∆q = ∆ R/∆q – ∆ C/∆q = 0

∆R/∆q is the marginal revenue MR and ∆C/∆/q is the marginal cost MC. Thus, we could conclude that benefit is exploited given we have MR-MC=0.

Demand and Marginal Revenue for a Competitive Firm

It is evident that the total output of any firm has no impact of the price of any given product prevailingin the market. It is actually derived from supply curve and demand curve. Hence, we called a competitive firm as price taker. All price-taking firms know that their decision on production will definitely not have any impact on the price prevailing in the market.

Say for an example, farmer growing wheat on total acres of land is his decision. He may consider the cost of wheat $4 per bushel. Price of the wheat in the market willnot be affected with is acreage decision.

In order to avoid confuse, we would distinguish the market demand curve and demand curve faced of firms. Here, for ease, we would represent market output with capital Q and market demand by capital D, whereas output and demand of firm would be represented by small q and d.

The detailed analysis of demand curve of firm is illustrated in fig.8.2 (a). In the figure, the horizontal axis represents the quantity of wheat and the vertical axis represents the cost of wheat. You can compare the demand curve of the farmer and the marker from the fir 8.2 (a) and fig 8.2 (b). It is seen from the figure 8.2(b), the demand curve is sloping towards downwards because the buying capacity of customers increased with decrease in the price wheat. On the contrary, the demand curve of firm (farmer) is horizontal as the market price is not going to be affected with the price decided by farmer. A farmer may double the sale of wheat from 100 bushels but that is not going to impact the overall output as the market’s output is around 2000 million bushel. The market price of any product is determined after interaction of all the firms and keeping in mind the demand of the customers.

 

Profit Maximization and Competitive Supply 2” = C

 

Since the firm is getting a horizontal curve for demand curve, the firm could increase its output without changing or reducing the cost of wheat. So, the revenue increases by same amount as it was i.e., if one bushel of wheat is sold at $4, the revenue increases with $4. Therefore, the marginal revenue remains constant and the average revenue of the firm also remains $4.

Therefore, we could come to conclusion that

Profit Maximization by a economical Firm

Since, horizontal demand curve results in MR=P, we can simplify the profit maximization. A perfectively competitive firm should always choose the output where price is equivalent to the marginal cost. And it can be denoted as Marginal cost (q) is equivalent Marginal Revenue minus Price.

However, the above formula would be helpful in setting output as the price is fixed in competitive market. In rest of the chapter, we would again emphasize on profit maximizing out of any competitive market as it is quite important for any firm.

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