Chapter 6

Analysis of
Profit
 Introduction
 In a free market system, economic profit (excess of revenues over cost) play
an important role in guiding the decisions made by the thousands of
competing, independent economic units, firms.
 It acts as a signal to producers to increase or decrease the rate of output or to
enter or leave an industry.
 It is a reward for entrepreneurial activity
 It helps to determine the type and quantity of goods and services that are
produced and sold
 To decide the demand for various factors of production- labor, capital, and
natural resources.
 Profit maximization
Managers seek a pricing and output strategy that will maximize the present value
of the future profit stream of the firm.
The determination of this maximizing price – output strategy mainly depends on:
 The production capacity
 Technology :Innovation and advancements allow for improved efficiency and
output.
 The cost of producing various levels of output
 The nature of the demand and
 The potential for immediate and longer term competition
 Market Structure and
Price Output
• Profit maximization assumption depends on the price and
output decision with respect to different market structure.
• In an economic sense, a market is a system by which buyers and
sellers bargain for the price of a product, settle the price and
transact their business to buy and sell a product.
• The market for a commodity may be local, regional, national or
international. What makes a market is a set of buyers, a set of
sellers and commodity. While buyers are willing to buy and
there is a price for the commodity.
 Cont’d
• The determination of price-output of a commodity depends on the
number of sellers and the number of buyers.
• The number of sellers of a product in a market determines the nature
and degree of competition in the market. The nature and degree of
competition make the structure of the market.
• The market structure influences firms price – output decisions . Later
on price and output decision affects the level of profit since the
degree of competition determines a firm’s degree of freedom in
determining the price of its product.
 Cont’d
• The higher the degree of competition, the lower the firm’s
degree of freedom in pricing decision and control over the price
of its own product and vice versa.
 Profit Analysis under Pure
Competition Market Structure
The pure competition market structure has the following
characteristics:
 A very large number of buyers and sellers.
 A homogeneous product produced by each firm.
 Free entry and exit from the market
 No collusion among firms in the industry.
 Complete knowledge of all relevant market information by each firm.
 A firm is price taker
 Price and Output Determination in
the Short-Run
• A short run is, a period in which firms can neither change their
size nor quit, nor can new firms enter the industry.
• In the short-run, it is possible to increase (or decrease) the
output (supply) by increase (or decrease) the variable inputs. In
the short run, therefore, supply curve is elastic.
• In perfect competition, MR is equal to AR, and both are equal to
the price. Therefore, the MR curve is the same as the AR curve,
which is a horizontal line at the market price.
 Cont’d
Assume ABC trading faces the following TR and TC functions
TR=8Q
TC= Q2+4Q+2
• Find the output level that maximizes the profit of the firm
 Cont’d
•Solution- When profit is maximized MR=MC. Recall- MR and MC are defined as the first derivative of TR and TC
functions respectively. Thus
•MR= dTR/ dQ = 8
•
•MC = dTC/ dQ
• = 2Q+4
•Profit to be maximized MR=MC 8=2Q+4
• 8-4=2Q
• 4/2=2Q/2 Q=2
 Cont’d
• Total profit () is maximized when Q sets 2 (it is also necessary to check the second derivative of the
profit function to be certain that we have found a maximum not a minimum value.
•  = TR-TC = PQ - TC
• 8Q-(Q2+4Q+2)
• = -Q2+4Q-2
• d = -2Q1+4=0
• dQ
• d2 = -2
• dQ2
• Because the second derivative is negative, we know that we have found a maximum value for the
profit function.
 Price - Output Determination in the
Long Run
Under long run conditions, average cost will tend to be just
equal to price and all excessive profits will be eliminated. If P
exceeds AC, more firms will enter the industry, supply will
increase, and price will be driven down towards the equilibrium,
zero profit level.
In addition as more firms bid for available factors of production
labor, capital managerial talent, the cost of these factors will
tend to rise.
As a result in the long-run equilibrium all firms will tend to have
identical costs, and prices will tend to equal AC.
 Cont’d
• The long run profit maximization level of output under pure
competition, equilibrium will be achieved at a point where
P=MR=MC=AC.
 Profit analysis under monopolistic
Market Structure
The term monopoly is defined as a market structure
characterized by one firm producing a highly
differentiated product in a market with significant barriers
to entry.
The cross elasticity of demand for a monopoly product is
either zero or negative.
A monopolized industry is a single firm industry thus firm
and industry are identical in a monopoly setting.
 The major sources for emergence
and survival of monopoly power
oLegal constriction or barriers to entry of
new firms
oControl over key raw material
oEfficiency or Economic of scale
 Price and Output Determination in
the Short Run
• Cost conditions, i.e. AC and MC curves, in a competitive and
monopoly market are generally identical, revenue conditions are
different.
• Revenue conditions, i.e., AR and MR curves, are different under
monopoly.
• Unlike a perfectly competitive firm, which faces a horizontal
(perfectly elastic) demand curve, a monopoly firm faces a
downward-sloping demand curve. This distinction arises due to
market power and price setting ability.
 Cont’d
• The Marginal Revenue (MR) curve lies below the Average
Revenue (AR) curve, which is also the demand curve.
Additionally, the slope of the MR curve is twice as steep as the
slope of the AR curve.
 Cont’d
• The following example illustrates algebraically price and output
determination by a monopoly firm in the short run.
• Suppose demand and total cost functions for a monopoly firm
are given as follows.
• Demand function : Q=100-0.2P
• Price function : P=500-5Q
• Cost function : TC=50+20Q+Q2
 Cont’d
• We have noted earlier that MR and MC are the first derivation of
TR and TC functions, respectively. TC function is given, but TR
function is not. So, let us find TR function first,
TR=P.Q since P= (500-5Q) Q Total Revenue (TR) equals TR=500Q-
5Q2
Now MR can be obtained by differentiating the TR-function
MR = dTR = 500 - 10Q
dQ
 Cont’d
 Like wise, MC can be obtained by differentiating the TC function
MC = dTR = 20 + 2Q
dQ
 Now that MR and MC are known, profit maximizing output can be easily obtained. Recall
that profit is maximum where MR=MC. As given above,
MR=500-10Q
MC=20+2Q
and by substitution, we get profit maximizing output as
500-10Q=20+2Q
480=12Q
 Cont’d
• Q=40
• The output Q =40 is the profit maximizing level of output
• Now profit maximizing price can be obtained by substituting 40
for Q in the price function
• Thus, P=500-5(40)
• =300
 Cont’d
 Profit maximizing price is $300 and Total profit () can be obtained as follows
 =TR -TC
• By substitution, we get
 = 500Q-5Q2 - (50+20Q+Q2)
=500Q-5Q2-50-20Q-Q2
• By substituting profit maximizing output (40) for Q, we get
 = 500(40)-5(40) (40) – 50 - 20(40) – (40*40)
= 20,000-8,000-50-800-1600
= $ 9,550
Total maximum profit is $ 9,550.
 Price and Output Determination in
the Long Run
In the long run a monopolist gets an opportunity to expand
the size of its firm with a view to enhance its long-run
profits.
Factors Affecting Expansion
• Size of the Market
• Expected Economic Profit
• Risk of Legal Restrictions
 Perfect vs Monopoly
Monopoly Perfect
 Produces more than a monopoly; equilibrium is
 Produces less than under pure competition.
where average total cost (ATC) is minimized.
 Can benefit from economies of scale (efficient  Less opportunity for large-scale economies
plant sizes, centralization of functions).
compared to a monopoly.
 May maintain higher prices and restrict output to  Prices are typically lower due to competition driving
maximize profits.
firms to minimize costs and maximize efficiency.
 Can use advertising to increase demand,  Limited ability to influence demand or market size
potentially expanding market size.
through advertising.
 Large size might lead to administrative  Smaller firms might face fewer coordination issues
inefficiencies and coordination problems.
but may not achieve the same efficiencies as large
 Increased output in monopoly might require monopolists.
drawing resources from other industries,  Increases in industry output do not generally
potentially raising prices elsewhere.
involve shifting resources from other sectors,
avoiding potential price increases in other markets.
Thank You!