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| Graphing Exercise: Short-Run Profit Maximization A competitive firm is a price-taker, able to sell as little or as much as it desires at the going market price. In other words, demand for a competitive firm is perfectly elastic at the going price. Its only choice, then, is how much output, if any, to produce. Throughout, firms are assumed to maximize profits. Exploration: With respect to its output choice, what is the rule a competitive firm will follow to obtain maximum profits? Click here to view the excercise. It will open in a new browser window. Then answer the questions below.If you have clicked on the link above and cannot see the interactive exercise, you may need to install a free Java plugin for you internet browser. Click here for the plugin. The graph shows the average- and marginal-cost curves of a typical competitive firm. Initially, price is £80 and the firm is producing 80 units per week. Its fixed costs are $2700 per week. To use the graph, click and drag the green triangle on the vertical axis to change the market price, hence the firm’s demand curve. Click and drag the green triangle on the horizontal axis to change the firm’s choice of output. Cost and profit data are shown in the box at right; clicking on the Show Profit/Loss button will provide a graphical illustration of the firm’s profit or loss, profit in green and losses in red. Clicking the Reset button will restore all initial values. 1. At the initial market price of £80 and output level of 80 units per week, how much profit is the firm earning? Is there any other output choice that provides a higher profit? AnswerThe firm’s total revenue and total cost are both $6,400, indicating a profit of zero. Click the Show Profit/Loss button to illustrate changes in the firm’s profit as it moves away from this point. Click and drag on the green triangle on the quantity axis in either direction. The firm loses money at any other output level: The farther one moves away from a quantity of 80 units, the higher the firm’s losses. 2. Holding price constant at £80, compare price and marginal cost at various output levels. How should the firm adjust its output if price exceeds marginal cost? How should the firm adjust its output if price falls short of marginal cost? AnswerClick Reset. Drag the Output slider to the left. Marginal cost is less than price at output levels less than 80 units per week. Profit will increase if output is increased. Drag the slider to the right past 80 units per week. For these output levels, marginal cost exceeds price and profit will increase by reducing output. Maximum profit is achieved at 80 units, the output level at which price (hence marginal revenue) equals marginal cost. 3. Suppose price rises to £100. How should the firm respond? Will its profits increase or decrease? AnswerAdjust the firm’s demand curve up by dragging the green triangle on the vertical axis up to £100. By watching the firm’s profit total in the box, maximum profits are achieved at an output level of 92 units per week, an increase of 12 over the initial level. Profits rise to £1724.80 per week. 4. If price suddenly falls to £60 per week, should the firm shut down? AnswerDrag the price triangle down to £60. Adjust the firm’s output level to find maximum profits (minimum losses in this case) at an output level of 65 per week. At this output level, losses are £1454.69 and price equals marginal cost. If it were to shut down instead, the firm would lose £2700, an amount equal to its fixed costs. 5. Experiment on your own. What is the rule for profit maximization? AnswerDrag the price to any level above £40. Maximum profits (minimum losses) are achieved at the output level at which price equals marginal cost. |