Profit-Maximization in Short-Run (Pure competitive Market)

   Since the purely competitive firm is a price-taker, then to increase its revenue in short run it can change only quantity output.  Thus it can adjust its output by changes in amount of variable resources (materials, labor) it uses. So to maximize its revenues or to minimize its losses our firm has to adjust its quantity of resources used.
   There are two ways how to calculate the level of output for which our firm, in a pure competitive market, will get highest revenues. One of the methods is to compare total revenues and total costs, and another one is to compare marginal revenues and marginal costs. By the way, these methods can be applied not just in pure competitive market but also in pure monopoly, monopolistic competitive market and oligopoly.

Total Revenue- Total Cost Approach
       Total cost increases with output, because more production require more resources, but the rate of increase in the total cost varies with the efficiency of the firm. Specifically, the cost data reflect law of diminishing returns. Initially it increases with smaller amounts but after a point total cost rise by increasing amounts. Total revenue covers all costs (including normal profit) but there isn’t an economic profit. Economists call break-even point: an output value for which a firm makes a normal profit but not an economic profit. Any output between two break-even points produces an economic profit. The firm achieves maximum profit, where the vertical distance between Total Revenue and Total Cost is greatest.

Marginal Revenue- Marginal Cost Approach
   In this approach the firm compares marginal revenue (MR) and (MC) of each successive unit of output. The firm will produce any output for which marginal revenue is greater than marginal benefit because the firm will add more revenue from selling that item than the costs of producing it.
MR=MC Rule
   In the initial stages of production, when output is relatively low then the Marginal Revenue (MR) is usually greater than Marginal Cost (MC). So it’s profitable to produce in this range of output. But with additional units of output where quantity produced is relatively high, rising marginal cost will become greater than the marginal revenue. That’s why firms will try to avoid output quantity in this range. A point, where marginal revenue equals with marginal cost, separates these two regions.  In the short run, the firm will maximize profits or minimize its loss by producing that quantity of output where marginal cost equals with marginal benefit. This profit maximizing rule is known as MR=MC Rule.
Characteristics of MR=MC rule
    There are some important features of MR=MC rule and they can be stated as follows:

• The rule is applied only if producing is preferable to shutting down.
• The rule of profit maximization is applied to all firms whether they are purely competitive, monopolistic, monopolistically competitive, or oligopolistic.
• In pure competitive market our rule is transformed into P=MC, because demand faced by this seller is perfectly elastic. In this case marginal cost is equal to marginal revenue. So only in pure competitive market we may substitute P (price) instead of MR.

Profit Maximization Rule   
   How to determine the profit maximization output? It’s quite easy, all output values for which marginal revenue is greater than marginal cost add to total revenue, so the maximizing output is the last value for which marginal revenue is bigger than marginal cost. In Short Run the firm produces its goods until total revenue is greater than negative Average fixed Cost, however, if it is smaller, then it is better to shut down. Take care, “shut down” doesn’t mean to get off from market, because in short run a firm can’t leave the market.
   An example of Total Revenue and Total Cost -Quantity Demanded Graph(maximum economic profit is taken randomly, since no values are present) :

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Short-Run labor output realationship, Law of diminishing returns!

Firm’s cost of producing of a specific good or service depends of quantity of resources needed to produce that goods. Price is determined by resource supply and demand. To examine labor-output relationship we should know some terms:

• Total Product (TP) is the total quantity or total output of a specific good or service.
• Marginal Product (MP) is the extra output of a product associated with adding a unit of variable resource, in our case it is labor. Thus we can write the following formula:

 

• Average Product (AP) is output per unit of resource employed (labor in our case):

 

In the short run we can maximize “for a time” the output by adding labor to the fixed plant. But how much will output rise when a firm adds labor?

Law of Diminishing Returns

  Law of diminishing returns also called low of diminishing marginal utility, states that as a successive unit of variable unit(let’s say labor) is added to a fixed resource(capital, land or firm), the marginal product (MP) will eventually decline.  For example if additional workers are hired to work with a constant amount of machineries, the output will rise by smaller and smaller amounts.

Examples:

     Let’s say that a farmer has 100 hectares of planted tomatoes.  If the farmer will cultivate this land once he will get 100kg per hectare, if he cultivates it twice he will get 150 kg per hectare, a third cultivation may result in 170 kg per hectare, the fourth one will rise the output only by 5 kg per hectare, so he will get 175 kg/hectare. So succeeding cultivations add less output. If there wouldn’t be like that then the world’s need for food could be fulfilled by intense cultivation of these 100 hectares.  If diminishing returns wouldn’t occur the world could be fed from 1 m². Just keep adding seeds, fertilizers and harvester.

Another example of law of diminishing returns could be taken from a firm for producing doors for cars. This firm has a fixed number of machineries. So if only 2 or 3 workers are hired then the total output would be very low. Because they will have to do many different jobs and advantage of specialization won’t occur. Workers will lose time for switching from one job to another and machineries may stay a lot of time idle. So the firm will be understaffed and there will be underproduction of goods.

This firm may hire more labor then the equipment will be used efficiently. There won’t be any time lost by switching the jobs. As we add more workers the production will be more efficient and the marginal product will rise.

The rise in marginal product won’t go indefinitely. If still more workers will be added, beyond a point, the firm may be overcrowded. Workers will have to wait to use machineries. Total output will increase at a diminishing rate, because since we have a firm fixed-sized firm, each additional worker will have less additional capital to work with, as more labor is hired.  The marginal product will decline because there will be more labor than the amount of capital available. If we still add more labor then the quantity produced will decline, so the marginal product will get negative and at a point(extreme one) will fall to zero.

Law of diminishing returns assumes that all units of labor are with the same qualities, same innate abilities, education, training and work experience. Marginal product decreases not because the workers whom we add are inferior, but because more workers are used in comparison with the amount of firm and equipment.