Market Structures-II
Price and Output Determination
Objectives of Business Firms
i. Maximization of profit
ii. Maximization of sales revenue
iii. Maximization of firm's growth rate
iv. Maximization of managerial utility function
v. Maximization of firm's net worth
vi. Satisfactory or standard profit
vii. Long-run survival and market share.
Profit Maximization as Business Objective
• The traditional economic theory assumes profit maximization as the
sole objective of business firms.
• Total profit (П) is defined as the excess of total revenue (TR) over the
total cost (TC), i.e.,
Π = TR − TC
• To achieve this goal, the firm chooses a price and an output which
maximizes TR − TC.
Profit-Maximization Conditions
• There are two conditions that must be satisfied for the profit to be
maximum.
I. Necessary or First-order conditions: The first-order condition for
profit maximization requires that marginal cost (MC) must be equal
to marginal revenue (MR), i.e., profit is maximum at the level of
output (Q) at which
MC = MR
This is a necessary condition in the sense that it must satisfy for profit
to be maximum: profit is not maximized if this condition is not
fulfilled.
II. Supplementary or Second-order condition:
• The second-order condition for profit maximization requires that the
first-order condition must be fulfilled under the condition of rising
marginal cost.
Price and Output Determination Under
Perfect Competition
Short-run Equilibrium of the Firm
• In the traditional theory of firm, the equilibrium of a firm is
determined in the following conditions:
profit maximization is assumed to the basic objective of a business firm and
profit is maximized at the level of output at which MR = MC, under rising MC.
• Given these conditions, profit-maximizing firm attains its equilibrium
at the level of output at which its MC = MR.
• The firm is in equilibrium when it produces the output that maximizes
the difference between total receipts and total costs.
• The equilibrium of the firm may be shown graphically in two ways.
• Either by using the TR and TC curves, or the MR and MC curves
• The total revenue curve is a straight R/C
TC TR
line through the origin, showing that
the price is constant at all levels of
output.
• The firm is a price-taker and can sell
any amount of output at the going
market price, with its TR increasing
proportionately with its sales.
• The firm maximizes its profit at the O X
output E, where the distance A E B
between the TR and TC curves is the
greatest.
• A firm faces a straight line or horizontal
demand curve, as shown by the line P =
MR.
• The straight horizontal demand line
implies that price equals marginal
revenue, i.e., AR = MR.
• The firm is in equilibrium at the level of
output defined by the intersection of
the MC and the MR curves at point E.
• At point E, SMC = MR. Point E
determines, therefore, the point of
firm’s equilibrium.
Short-run Equilibrium of Firm with Short-run Equilibrium of Firm with
Normal Profit Losses
Shut-down or Close-down Point
• In case a firm is making loss in the short
run, it must minimize its losses.
• In order to minimize its losses, it must
cover its short-run average variable cost
(SAVC).
• A firm unable to recover its minimum
SAVC will have to close down.
• Its SAVC is minimum at point E where it
equals its MC.
• Point E denotes the shut-down point or
break-down point because at any price
below OP, it pays the firm to close down
as it fails to recover even its variable cost.
Short-run Equilibrium of the Industry
• An industry is in equilibrium in the short run when market is cleared
at a given price, i.e., when the total supply of the industry equals the
total demand for its product.
• The price at which the market is cleared is the equilibrium price.
• When an industry reaches its equilibrium, there is no tendency to
expand or to contract the output.
• The industry demand curve DD′ and
supply curve SS′ intersect at point E,
determining equilibrium price OP.
• At price OP, D = S.
• The industry is supplying as much as
consumers demand.
• In the short-run equilibrium of the
industry, some individual firms may
make pure profits, some normal
profits and some may make even
losses, depending on their cost and
revenue conditions.
Long-run Equilibrium of the Firm and Industry
• The short run is a period in which:
i. firm’s cost and revenue curves are given,
ii. firms cannot change their size—their capital is fixed,
iii. existing firms do not have the opportunity to leave the industry and
iv. new firms do not have the opportunity to enter the industry.
Long-run is a period in which these constraints disappear.
Long run permits improvement in production technology and a larger
employment of both labor and capital, i.e., firms can change their size.
Some of the existing firms may leave and new firms may enter the industry.
• For a perfectly competitive firm to be in long-run equilibrium, the
following two conditions must be fulfilled:
Price = Marginal Cost
Price = Average Cost
• If price is equal to both marginal cost and average cost, then we have
a double condition of long-run perfectly competitive equilibrium:
Price = Marginal Cost = Average Cost
• The condition for long-run equilibrium of the firm can be written as:
Price = Marginal Cost = Minimum Average Cost
• Given the market price, OP, firms
attain their equilibrium in the
long run at point S where
AR = MR = LMC = LAC.
Price and Output Determination Under
Monopoly
Short-Run Equilibrium of the Monopoly
• According to the traditional theory of firm, a firm is said to be in
equilibrium where it maximizes its profit.
• The short-run equilibrium of monopoly can be explained by two
approaches:
i. Total revenue–total cost (TR–TC) approach and
ii. Marginal revenue–marginal cost (MR–MC) approach
AR and MR Curves under Monopoly
• The AR curve for a monopoly firm is
the same as its demand curve.
• Since a monopoly firm faces a
downward sloping demand curve,
its AR also slopes downwards to the
right.
• For example, the demand curve DM
is the same as the firm’s AR curve.
• When price is fixed, as in case of perfect competition, firm's demand
curve takes the form of a horizontal line.
• In that case, AR = MR and MR is a straight line too.
• But, in case of a monopoly firm, demand curve has a negative slope.
• Therefore, its MR curve too has a negative slope.
• There is, however, a specific relationship between AR and MR, i.e., the
slope of MR curve is twice that of that AR curve.
• Given the linear demand function, marginal revenue curve is twice as
steep as the average revenue curve.
• The TC curve shows monopoly’s
total cost at different level of
output and TR curve shows its
total revenue at different level of
output and price.
• As the Fig. shows, the monopoly
firm faces a loss till output OQ1
and beyond output OQ3.
• monopoly’s profitable range of
output lies between OQ1 and OQ3
because it is only in this range of
output that monopoly’s TR > TC.
Monopoly Equilibrium by MR–MC Approach
• It can be seen in the figure that MR
and MC curves intersect at point N.
• Point N satisfies both the conditions
of profit maximization:
• (i) MR = MC and (ii) MC curve
intersects MR curve from below.
• Point N, therefore, determines the
equilibrium output and price.
• An ordinate drawn from point N to X-axis determines the profit
maximizing output at OQ.
• The ordinate NQ extended upwards to the AR curve gives the price PQ
at which output OQ can be disposed of, given the demand function.
• Thus, the MR–MC approach to monopoly equilibrium determines
both equilibrium output and price simultaneously.
• No other output and price can increase the monopoly’s profit.
• Once equilibrium price and output are determined, given the revenue and
cost curve, the maximum monopoly profit can be easily determined as
follows:
• Per unit monopoly profit = AR − SAC.
• In Figure above, AR = PQ and SAC = MQ.
• By substitution, we get per unit monopoly profit = PQ − MQ = PM
• Given the equilibrium output OQ,
Total monopoly profit = OQ ⋅ PM
• Since OQ = P2M, total monopoly profit at equilibrium can be worked out as
P2M PM = P1PMP2
• Whether a monopoly firm earns supernormal profit or normal profit
or incurs loss depends on:
i. its cost and revenue conditions;
ii. threat from potential competitors;
iii. time period—short run or long run and
iv. government policy in respect of monopoly.
• If a monopoly firm operates at the level of output where MR = MC, its
profit depends on the relative levels of AR and AC.
• Given the level of output, there are three possibilities:
I. If AR > AC, there is economic profit for the firm,
II. If AR = AC, the firm earns only normal profit and
III. If AR < AC, the firm makes losses.
Two Common Misconceptions about Monopolies
A Monopoly does not Necessarily Make Profit in the
Short run
• There is no guarantee that a monopoly firm
will always make profits in the short run.
• In fact, whether a monopoly makes profit
or loss in the short run depends on its
revenue and cost conditions.
• It is quite likely that its SAC curve lies above
its AR curve as shown in Fig.
• At profit maximizing output (OQ), SAC
exceed AR by PM.
• The monopoly firm therefore, makes losses
to the extent of PM × OQ = P2MPP1 in the
short run.
• Monopolies cannot Charge an Arbitrary Price
• Another common misconception about monopoly is that a monopoly
firm can charge any price or an exorbitantly high price for its product.
• In fact, the demand curve faced by a monopolist, is also the industry’s
demand curve.
• And, most market demand curves are negatively sloped, being highly
elastic in the region of upper half and highly inelastic in the lower half.
• Therefore, a revenue-maximizing monopoly firm cannot charge any
price.
• If it does so, it will lose it revenue and profit.
Monopoly Equilibrium in the Long Run
• In the long run monopolist would make
adjustment in the size of his plant.
• The monopolist would choose that
plant size which is most appropriate for
a particular level of demand.
• He can further increase his profits by
adjusting the size of the plant.
• So in the long run he will be in
equilibrium at the level of output
where given MR curve cuts the LMC
curve.
• For the monopolist to maximize profits in the long run, the following
conditions must be fulfilled:
MR = LMC = SMC
SAC = LAC
P ≥ LAC
• The last condition implies in long-run monopoly equilibrium price of
the product should be either greater than long-run average cost or at
least equal to it.
• The price cannot fall below long-run average cost because in the long
run the monopolist will quit the industry if it is not even able to make
normal profits.
