Daniel l. Rubinfeld

270 Part 2 Producers, Consumers, and Competitive Markets
8 Profit Maximization and Competitive Supply
(dollars per
unit of
output)
Producer
Surplus
A - ___( _________ J}
MC
P
Price
(dollars per
. unit of
output)
P'
o
'1*
Output
o
Q* Output
The producer surplus for a fum is measured by the yellow area below the
price and above the marginal cost curve, between outputs 0 and q*, the profitmaximizing
output. Alternatively, it is equal to rectangle ABeD because the sum
all marginal costs up to q* is equal to the variable costs of producing q*.
When we add the marginal costs of producing each level of output from 0 to
q*, we find that the sum is the total variable cost of producing q*. Marginal cost
reflects increments to cost associated ''''ith increases in output; because fixed cost
does not vary with output, the sum of all marginal costs must equal the sum of
the firm's variable costS.6 Thus producer surplus can alternatively be defined as
the difference between the firm's reven1le and its total variable cost. In Figure 8.11, producer
surplus is also given by the rectangle ABCD, which equals revenue
(OABq*) minus variable cost (ODCq*).
versus Producer surplus is closely related to
profit but is not equal to it. In the short run, producer surplus is equal to reven~e
minus variable cost, which is variable profit. Total profit, on the other hand, IS
equal to revenue minus all costs, both variable and fixed:
Producer surplus PS = R
Profit = 7i = R
VC
VC - FC
It follows that in the short run, when fixed cost is positive, producer surplus is
greater than profit.
The extent to which firms enjoy producer surplus depends on their cos~s of
production. Higher-cost firms have less producer surplus, and IO'wer-cost fn:ns
have more. By adding up the producer surpluses of all firms, we can determm e
the producer surplus for a market. This can be seen in Figure 8.12. The market
6 The area under the marginal cost curve from 0 to '1* is TC(q*) TC(O) = IC - FC = VC
The producer surplus for a market is the area below the market price and above the
market supply curve, between 0 and output Q*.
supply curve begins at the vertical axis at a point representing the average variable
cost of the lowest-cost finn in the market. Producer surplus is the area that
lies below the market price of the product and above the supply curve between
the output levels 0 and Q*.
8.7
In the long run, a firm can alter all its inputs, including plant size. It can decide
to shut down (i.e, to exit the industry) or to begin producing a product for the
first time (Le., to enter an industry). Because vve are concerned here 'with competitiw
markets, 'we allow for free entnj and free exit. In other words, we are assuming
that finns may enter or" exit Without ~ny legal restriction or any special costs
associated with entry. (Recall from Section 8.1 that this is one of the key assumptions
underlying perfect competition.) After analyzing the long-run output decision
of a profit-maximizing firm in a competitive market, we discuss the nature
of competitive equilibrium in the long run. We also discuss the relationship
behveen entry and economic and accounting profits.
long=Run
Maximization
Figure 8.13 shows how a competitive firm makes its long-run, profit-maximizing
output decision. As in the short run, it faces a horizontal demand curve. (In
Figure 8.13 the finn takes the market price of 540 as given.) Its short-nUl average
(total) cost curve SAC and short-run marginal cost curve SMC are low enough
for the firm to make a positive profit, given by rectangle ABCD, by producing an
output of q1, where SMC = P = MR. The long-run average cost curve LAC