- •Chapter 8 profit maximization and competitive supply teaching notes
- •Review questions
- •1. Why would a firm that incurs losses choose to produce rather than shut down?
- •3. In long-run equilibrium, all firms in the industry earn zero economic profit. Why is this true?
- •4. What is the difference between economic profit and producer surplus?
- •5. Why do firms enter an industry when they know that in the long run economic profit will be zero?
- •8. An increase in the demand for video films also increases the salaries of actors and actresses. Is the long-run supply curve for films likely to be horizontal or upward sloping? Explain.
- •9. True or false: a firm should always produce at an output at which long-run average cost is minimized. Explain.
- •10. Can there be constant returns to scale in an industry with an upward-sloping supply curve? Explain.
- •11. What assumptions are necessary for a market to be perfectly competitive? In light of what you have learned in this chapter, why is each of these assumptions important?
- •13. The government passes a law that allows a substantial subsidy for every acre of land used to grow tobacco. How does this program affect the long-run supply curve for tobacco?
- •Exercises
- •4. Use the same information as in Exercise 1 to answer the following.
Chapter 8: Profit Maximization and Competitive Supply
Chapter 8 profit maximization and competitive supply teaching notes
This chapter identifies the behavioral incentives of the profit-maximizing firm and then explores the interaction of these firms in a competitive market. Each section of the chapter is important and builds a solid understanding of the supply side of the competitive market. It is necessary to build this foundation before moving on to the chapters in part III of the text. While the material in the chapter is written in a very clear, easy to understand manner, students still struggle with many of the concepts related to how the firm should choose the optimal quantity to produce, and how to apply the cost curve diagram learned in the previous chapter. One option for lecture is to spend time working with a table similar to the one used in the exercises at the end of the chapter. Working through many examples with this type of a table can help the students understand the different types of cost, as well as the firm’s optimal level of production.
Section 8.1 identifies the three basic assumptions of perfect competition and section 8.2 discusses the assumption of profit maximization as the goal of the firm. Both sections are important in building the foundation for deriving the firm’s supply curve, which is done in sections 8.3 to 8.5. Section 8.3 derives the general result that the firm should produce where marginal revenue is equal to marginal cost. The section then goes on to identify perfect competition as a special case where price is equal to marginal revenue, which follows directly from the assumption of price taker behavior in section 8.1. If your students have had calculus, it is helpful to derive the marginal revenue equals marginal cost rule by differentiating the profit function with respect to q. If your students have not had calculus then it is helpful to do some more work with the data tables so they understand that profit is maximized when marginal revenue equals marginal cost. Emphasize that the perfectly competitive firm chooses quantity and not price in order to maximize profit.
To put perfect competition in perspective, it can also be helpful to give a brief overview of monopoly, oligopoly, and monopolistic competition before presenting the assumptions of perfect competition. Restrict this discussion to identifying how many firms are in the industry, are there barriers to entry, is there product differentiation, and what assumptions does each firm make about how the other firms in the industry will react to their price and quantity decisions. This will stimulate the student’s interest about upcoming lectures.
Sections 8.4 and 8.5 further explore the firm’s decision to produce where price is equal to marginal cost, and show that the firm’s supply curve is its marginal cost curve above its average variable cost curve. Although some students will understand references to second-order conditions, expect to be asked why q0 in Figure 8.3 is not profit maximizing, although MR = MC. Two additional points warrant careful explanation: 1) why the firm would remain in business if the firm sustains a loss in the short run, and 2) that maximizing profit is the same as minimizing loss.
Although the summation of firm supply curves into a market supply curve is straightforward, the analysis of long-run competitive equilibrium is difficult. Difficult concepts include:
why it may be optimal for the firm to incur losses in the short run but not the long run.
why free entry and exit will reduce economic profit to zero in the long run.
why price is equal to minimum average cost in the long run.
It can be helpful to present an example, algebraic and graphical, which starts out with only one firm in the industry that is earning positive economic profit, and then show how the market will converge on its long run equilibrium point. Explore changes in price, quantity produced, and the level of profits, and relate the changes to the firm’s behavioral motivations.
This chapter introduces two other important topics that will be elaborated on in Chapter 9: producer surplus and economic rent. Students frequently confuse profit, producer surplus, and economic rent.