Saturday, August 27, 2011

The short-run profitability of a competitive firm


A competitive firm making positive profit.

Graph
 

The average and marginal revenue curves are drawn as a horizontal lines at a price equal to $ 40. In the short run the competitive firm maximizes its profit by choosing the output q* = 8, corresponding to point A at which its MC = P or MR. The profit of the firm is measured by the rectangle ABCD. Any lower output such as q1 or higher output as q2, will lead to lower profits. For example at a lower output q1 = 7 MR revenue is greater the MC, so profit could be increased by increasing output. The shaded area between q1 = 7 and q* shows the lost profit associated with producing q1

At a high output q2 MC is greater than MR. Therefore reducing output saves a cost that exceeds the reduction in output. The shaded area between q* and q2 = 9 shows the lost profit associated with producing at q2. The MR and MC curves cross at an output of q0 as well as q* At q0 the profit is not maximized. An increase in output beyond q0 increases profit because MC is below MR. Thus the condition for profit maximization is that MC equals to MR at a point at which the MC curve is rising rather than falling. Note that the segment BC measures the total number of units produced. The distance AB is the difference between price and average cost at the output level q*, which is average profit per unit of output.

Per unit profit = (P - AC) / (P - C)

Total profit = P - AC(Q).
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