Profit Maximization and Market Dynamics

Key Characteristics of Competitive Markets

• Free Entry and Exit:
  • No barriers to entry or exit for firms.
  • Entry/exit decisions depend on profitability.

Short Run vs. Long Run Decisions

• Short Run Decisions:

  • Shutdown:
    • Temporarily halt production due to market conditions.
    • Doesn't mean permanent exit.
  • Production Decision:
    • Continue if price > average total cost (ATC).
    • Profit equation: Profit = (Price - ATC) × Quantity.
    • Focus on covering variable and some fixed costs.
  • Shutdown Condition:
    • If price < average variable cost (AVC), shut down.
    • Revenue isn’t enough to cover variable costs, resulting in a smaller loss than continued production.

• Long Run Decisions:

  • Exit:
    • Permanent market exit if non-profitable.
  • Cost Structure:
    • All costs are variable.
    • Continue if price > ATC; produces positive profit.
    • If price = ATC, earn zero economic profit.
    • Exit if price < ATC.
    • Can't sustain prolonged economic losses.

Graphical Analysis

• Cost Curves:

  • Average Variable Cost (AVC), Average Total Cost (ATC), Marginal Cost (MC).
  • Demand Curves (D1, D2, D3) illustrate different scenarios.

• Demand Curve Analysis:

  • D3:
    • Price Point P3:
      • Price > ATC & AVC.
      • Firm continues production.
  • D2:
    • Price Point P2:
      • Price > AVC but < ATC.
      • Firm incurs loss but continues as it covers variable and some fixed costs.
  • D1:
    • Price Point P1:
      • Price < AVC & ATC.
      • Firm shuts down due to inability to cover variable costs.

Decision Making Factors

• Short Run vs. Long Run:

  • Short Run:
    • Focus on minimizing losses, covering variable costs.
    • Fixed costs are sunk, can't be altered.
  • Long Run:
    • All costs variable; decisions based on overall profitability.

• Economic Profit:

  • Zero economic profit includes both implicit and explicit costs.
  • Long-term exit based on sustained economic losses.

Conclusion

• Profit maximization involves both earning profits and minimizing losses.
• Short-term decisions focus on covering variable costs; long-term decisions consider total profitability and potential market exit.