THE PROFIT-MAXIMIZING OUTPUT CHOICE

FOR A PRICE-TAKING FIRM

We can now study the problem of a price-taking firm that seeks to maximize its economic
profit. Assuming that the firm produces and sells a quantity of output Q, its economic
profit (denoted by ) is _ TR(Q) _ TC(Q), where TR(Q) is the total revenue derived
from selling the quantity Q and TC(Q) is the total economic cost of producing the
TABLE 9.1 Top Wealth Creators, Fourth Quarter, 2011 through Third Quarter, 2012
Company EVA (millions of dollars) EVA margin EVA momentum
Exxon Mobil $36,325 8.5% _0.2%
Apple $29,007 18.5% 10.0%
Chevron $21,731 9.7% _0.8%
Microsoft $16,493 22.8% _1.0%
Walmart Stores $10,522 2.3% 0.3%
Johnson & Johnson $ 8,069 12.2% 1.7%
Google Inc. $ 8,024 16.9% 2.4%
General Electric $ 7,636 7.6% 1.7%
Philip Morris International $ 7,416 23.8% 1.7%
IBM $ 7,369 7.0% 1.3%
9.2 PROFIT MAXIMIZATION BY A PRICE-TAKING FIRM 339
quantity Q.8 Total revenue equals the market price P multiplied by the quantity of output
Q produced by the firm: TR(Q) _ P Q.Total cost TC(Q) is the total cost curve discussed
in Chapter 8; it tells us the total cost of producing Q units of output.
Because the firm is a price taker, it perceives that its volume decision has a negligible
impact on market price. Thus, it takes the market price P as given. Its goal is to
choose a quantity of output Q to maximize its total profit.
To illustrate the firm’s problem, suppose that a rose grower anticipates that the
market price for fresh-cut roses will be P _ $1.00 per rose.Table 9.3 shows total revenue,
total cost, and profit for various output levels, and Figure 9.1(a) graphs these numbers.
Figure 9.1(a) shows that profit is maximized at Q _ 300 (i.e., 300,000 roses per
month). It also shows that the graph of total revenue is a straight line with a slope of 1.
Thus, as we increase Q, the firm’s total revenue goes up at a constant rate equal to the
market price, $1.00.
For any firm (price taker or not), the rate at which total revenue changes with
respect to a change in output is called marginal revenue (MR). It is defined by
_TR/_Q. For a price-taking firm, each additional unit sold increases total revenue by
an amount equal to the market price—that is, _TR/_Q _ P. Thus, for a price-taking
firm, marginal revenue is equal to the market price, or MR _ P.
As we learned in Chapter 8, marginal cost (MC), the rate at which cost changes with
respect to a change in output, can be defined similarly to marginal revenue: MC _
_TC/_Q. Figure 9.1 shows that for quantities between Q _ 60 and the profit-maximizing
quantity Q _ 300, producing more roses increases profit. Increasing the quantity in this
range increases total revenue faster than total cost: _TR/_Q _ _TC/_Q, or P _ MC.
When P _ MC, each time the rose producer increases its output by one rose, its profit
goes up by P _ MC, the difference between the marginal revenue and the marginal cost
of that extra rose.
Figure 9.1 shows that for quantities greater than Q _ 300, producing fewer roses
increases profit. Decreasing quantity in this range decreases total cost faster than it
decreases total revenue—that is, marginal revenue is less than marginal cost, or P _ MC.
When P _ MC, each time the producer reduces its output by one rose, its profit goes
up by MC _ P, the difference between the marginal cost and the marginal revenue of
that extra rose.9
TABLE 9.3 Total Revenue, Cost, and Profit for a Price-taking Rose Producer
marginal revenue The
rate at which total revenue
changes with respect to
output.
8Economists commonly use the Greek letter to denote profit. In this book, does not refer to the number
3.14 used in geometry.
9Or, equivalently, each extra rose produced decreases profit by P _ MC.
Q TR(Q) TC(Q) _
(thousands of (thousands of (thousands of (thousands of
roses per month) $ per month) $ per month) $ per month)
0000
60 60 95 _35
120 120 140 _20
180 180 155 25
240 240 170 70
300 300 210 90
360 360 300 60
420 420 460 _40
340 CHAPTER 9 PERFECTLY COMPETITIVE MARKETS
If the producer can increase its profit when either P _ MC or P _ MC, quantities
at which these inequalities hold cannot maximize its profit. It must be the case,
then, that at the profit-maximizing output,
(9.1)
Equation (9.1) tells us that a price-taking firm maximizes its profit when it produces a
quantity Q* at which the marginal cost equals the market price.
Figure 9.1(b) illustrates this condition. The rose grower’s marginal revenue curve
is a horizontal line at the market price of $1.00. The profit-maximizing quantity
occurs at Q _ 300, where this MR curve intersects the MC curve. This tells us that when
the rose grower faces a market price of $1.00 per fresh-cut rose, its profit-maximizing
decision is to produce and sell 300,000 fresh-cut roses per month.
Figure 9.1(b) also illustrates that there is another quantity, Q _ 60, at which
MR _ MC. The difference between Q _ 60 and Q _ 300 is that at Q _ 300, the marginal
cost curve is rising, while at Q _ 60 the marginal cost curve is falling. Is Q _ 60
also a profit-maximizing quantity? The answer is no. Figure 9.1(a) shows us that Q _ 60
represents the point at which profit is minimized rather than maximized. This shows
that there are two profit-maximization conditions for a price-taking firm:
• P _ MC.
• MC must be increasing.
P _ MC
Total revenue, total cost, and total profit
(thousands of dollars per month)
Quantity (thousands of roses per month)
(a)
(b)
$300
210
90
60 300
Price (dollars per rose)
Quantity (thousands of roses per month)
$1
0
60 300
MR = P
TC
MC
TR
Total profit 
FIGURE 9.1 Profit Maximization
by a Price-Taking Firm
Panel (a) shows that the firm’s
profit is maximized when
Q _ 300,000 roses per year.
Panel (b) shows that at this point
marginal cost is MC _ P. Marginal
cost also equals price when
Q _ 60,000 roses per year, but
this point is a profit minimum.
9.3 HOW THE MARKET PRICE IS DETERMINED: SHORT-RUN EQUILIBRIUM 341
If either of these conditions does not hold, the firm cannot be maximizing its profit.
It would be able to increase profit by either increasing or decreasing its output.

9.3
HOW THE
MARKET
PRICE IS
DETERMINED:
SHORT-RUN
EQUILIBRIUM
The previous section showed that a price-taking firm such as Nevado Roses would
maximize its profit by producing an output level at which the market price equals marginal
cost. But how does the market price get determined in the first place? In this
section, we study how the market price is determined in the short run. The short run is
the period of time in which (1) the number of firms in the industry is fixed and (2) at
least one input, such as the plant size (i.e., quantity of capital or land) of each firm, is
fixed. For example, in the market for fresh-cut roses, short-run swings in the market
price from one month to the next are determined by the interaction of a fixed number
of firms (several hundred very small firms), each of which operates with a fixed
amount of land, a fixed quantity of greenhouses, and a fixed quantity of rose bushes.
With land, greenhouses, and rose plants fixed, rose producers control their output
through pinching and pruning decisions, as well as through the amounts of fertilizer
and pesticide they apply to the rose plants. These decisions determine how many
fresh-cut rose stems will be available to meet demand throughout the year.
We will see that the profit-maximizing output decisions of individual producers
such as Nevado Ecuador will give rise to short-run supply curves for these firms. If we
then add together the short-run supply curves for all of the producers currently in the
industry, we will obtain a market supply curve. The market price is then determined
by the interaction of this market supply curve and the market demand curve.
THE PRICE-TAKING FIRM’S SHORT-RUN
COST STRUCTURE
Our goal in the next several sections is to learn how to construct an individual firm’s
short-run supply curve. To do this, we need to explore the cost structure of a typical
firm in the industry.
The firm’s short-run total cost of producing a quantity of output Q is
This equation identifies three categories of costs for this firm.
• TVC(Q) represents total variable costs. These are output-sensitive costs—that is,
they go up or down as the firm increases or decreases its output. Total variable
costs include materials costs and the costs of certain kinds of labor (e.g., factory
labor). Total variable costs are zero if the firm produces zero output and thus are
examples of nonsunk costs. If a rose producer decided to shut down its rose growing
operations, it would avoid the need to spend money on fertilizer and pesticide.
These costs would thus be nonsunk.
• SFC represents the firm’s sunk fixed costs. A sunk fixed cost is a fixed cost that
a firm cannot avoid if it temporarily suspends operations and produces zero output.
For this reason, sunk fixed costs are often also called unavoidable costs. For
example, suppose that a rose grower has signed a long-term lease (e.g., for five
STC(Q) _ eSFC _ NSFC _ TVC(Q), when Q 7 0
SFC, when Q _ 0
sunk fixed cost A fixed
cost that the firm cannot
avoid if it shuts down and
produces zero output.