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Chapter8:ProfitMaximizationandCompetitiveSupply102CHAPTER8PROFITMAXIMIZATIONANDCOMPETITIVESUPPLYTEACHINGNOTESThischapteridentifiesthebehavioralincentivesoftheprofit-maximizingfirmandthenexplorestheinteractionofthesefirmsinacompetitivemarket.Eachsectionofthechapterisimportantandbuildsasolidunderstandingofthesupplysideofthecompetitivemarket.ItisnecessarytobuildthisfoundationbeforemovingontothechaptersinpartIIIofthetext.Whilethematerialinthechapteriswritteninaveryclear,easytounderstandmanner,studentsstillstrugglewithmanyoftheconceptsrelatedtohowthefirmshouldchoosetheoptimalquantitytoproduce,andhowtoapplythecostcurvediagramlearnedinthepreviouschapter.Oneoptionforlectureistospendtimeworkingwithatablesimilartotheoneusedintheexercisesattheendofthechapter.Workingthroughmanyexampleswiththistypeofatablecanhelpthestudentsunderstandthedifferenttypesofcost,aswellasthefirm’soptimallevelofproduction.Section8.1identifiesthethreebasicassumptionsofperfectcompetitionandsection8.2discussestheassumptionofprofitmaximizationasthegoalofthefirm.Bothsectionsareimportantinbuildingthefoundationforderivingthefirm’ssupplycurve,whichisdoneinsections8.3to8.5.Section8.3derivesthegeneralresultthatthefirmshouldproducewheremarginalrevenueisequaltomarginalcost.Thesectionthengoesontoidentifyperfectcompetitionasaspecialcasewherepriceisequaltomarginalrevenue,whichfollowsdirectlyfromtheassumptionofpricetakerbehaviorinsection8.1.Ifyourstudentshavehadcalculus,itishelpfultoderivethemarginalrevenueequalsmarginalcostrulebydifferentiatingtheprofitfunctionwithrespecttoq.Ifyourstudentshavenothadcalculusthenitishelpfultodosomemoreworkwiththedatatablessotheyunderstandthatprofitismaximizedwhenmarginalrevenueequalsmarginalcost.Emphasizethattheperfectlycompetitivefirmchoosesquantityandnotpriceinordertomaximizeprofit.Toputperfectcompetitioninperspective,itcanalsobehelpfultogiveabriefoverviewofmonopoly,oligopoly,andmonopolisticcompetitionbeforepresentingtheassumptionsofperfectcompetition.Restrictthisdiscussiontoidentifyinghowmanyfirmsareintheindustry,iftherearebarrierstoentry,productdifferentiation,andwhatassumptionsdoeseachfirmmakeabouthowtheotherfirmsintheindustrywillreacttotheirpriceandquantitydecisions.Thiswillstimulatethestudent’sinterestaboutupcominglectures.Sections8.4and8.5furtherexplorethefirm’sdecisiontoproducewherepriceisequaltomarginalcost,andshowthatthefirm’ssupplycurveisitsmarginalcostcurveaboveitsaveragevariablecostcurve.Althoughsomestudentswillunderstandreferencestosecond-orderconditions,expecttobeaskedwhyq0inFigure8.3isnotprofitmaximizing,althoughMR=MC.Twoadditionalpointswarrantcarefulexplanation:1)whythefirmwouldremaininbusinessifthefirmsustainsalossintheshortrun,and2)thatmaximizingprofitisthesameasminimizingloss.Althoughthesummationoffirmsupplycurvesintoamarketsupplycurveisstraightforward,theanalysisoflong-runcompetitiveequilibriumisdifficult.Difficultconceptsinclude:*whyitmaybeoptimalforthefirmtoincurlossesintheshortrunbutnotthelongrun.*whyfreeentryandexitwillreduceeconomicprofittozerointhelongrun.*whypriceisequaltominimumaveragecostinthelongrun.Itcanbehelpfultopresentanexample,algebraicandgraphical,whichstartsoutwithonlyonefirmintheindustrythatisearningpositiveeconomicprofit,andthenshowhowthemarketwillconvergeonitslongrunequilibriumpoint.Explorechangesinprice,quantityproduced,andthelevelofprofits,andrelatethechangestothefirm’sbehavioralmotivations.ThischapterintroducestwootherimportanttopicsthatwillbeelaboratedoninChapter9:producersurplusandeconomicrent.Studentsfrequentlyconfuseprofit,producersurplus,andeconomicrent.Chapter8:ProfitMaximizationandCompetitiveSupply103REVIEWQUESTIONS1.Whywouldafirmthatincurslosseschoosetoproduceratherthanshutdown?Lossesoccurwhenrevenuesdonotcovertotalcosts.Revenuescouldbegreaterthanvariablecosts,butnottotalcosts,inwhichcasethefirmisbetteroffproducingintheshortrunratherthanshuttingdown,eventhoughtheyareincurringaloss.Thefirmshouldcomparetheleveloflosswithnoproductiontotheleveloflosswithpositiveproduction,andpicktheoptionthatresultsinthesmallestloss.Intheshortrun,losseswillbeminimizedaslongasthefirmcoversitsvariablecosts.Inthelongrun,allcostsarevariable,andthus,allcostsmustbecoveredifthefirmistoremaininbusiness.2.Explainwhytheindustrysupplycurveisnotthelong-runindustrymarginalcostcurve.Intheshortrun,achangeinthemarketpriceinducestheprofit-maximizingfirmtochangeitsoptimallevelofoutput.Thisoptimaloutputoccurswhenpriceisequaltomarginalcost,aslongasmarginalcostexceedsaveragevariablecost.Therefore,thesupplycurveofthefirmisitsmarginalcostcurve,aboveaveragevariablecost.(Whenthepricefallsbelowaveragevariablecost,thefirmwillshutdown.)Inthelongrun,thefirmadjustsitsinputssothatitslong-runmarginalcostisequaltothemarketprice.Atthislevelofoutput,itisoperatingonashort-runmarginalcostcurvewhereshort-runmarginalcostisequaltoprice.Asthelong-runpricechanges,thefirmgraduallychangesitsmixofinputstominimizecost.Thus,thelong-runsupplyresponseisthisadjustmentfromonesetofshort-runmarginalcostcurvestoanother.Notealsothatinthelongruntherew