Page 151 - DECO101_MICRO_ECONOMICS_ENGLISH

Micro Economics

Notes The second order condition for profit maximisation requires that the second derivative of p with
respect to Q be negative. That is
(
2
2
2
(
d p dTR ) dTC )
= - < 0 .......... (4)
dQ 2 dQ 2 dQ 2
2
2
(
dTR ) dTC )
(
< .......... (5)
dQ 2 dQ 2
According to equation (5) the algebraic value of the slope of the MC function must be greater
than the algebraic value of the MR function. Under perfect competition, MR is constant (MR
curve is horizontal). So that equation (5) requires that the MC curve be rising at the point where

MR=MC for the firm to maximise its total profi ts.
The top panel of Figure 10.4 shows d which is the demand curve for the output of a perfectly
competitive firm. The marginal cost cuts the SATC at its minimum point. The firm is in equilibrium

(maximises its profits) at the level of output defined by the intersection of the MC and the MR

curves (point E in Figure 10.4). To the left of E profit has not reached its maximum level because

each unit of output to the left of X brings revenue greater than its marginal cost. To the right of
e
X each additional unit of output costs more than the revenue earned by its sale so that a loss is
e
made and total profit is reduced.

Figure 10.4
P
SMC
SATC
Price & Cost P E d = P = MR

A
B

Q
0
X e Output

The fact that a firm is in short run equilibrium does not necessarily mean that it makes excess

profits – whether the firm makes excess profits or losses depends on the level of the ATC at the
short run equilibrium. If the ATC is below the price at equilibrium (Figure 10.5), the fi rm earns
excess (equal to the area PABE). If, however, the ATC is above the price (Figure 10.6), the fi rm
makes a loss (equal to the area FPE C). In the latter case the fi rm will continue to produce only
e
if it covers its variable costs. Otherwise it will close down, since by discontinuing its operations
the firm is better off: it minimises its losses. The point at which the firm covers its variable costs

is called “the closing down point”. In Figure 10.7 the closing down point of the firm is denoted
by point W. If price falls below P the fi rm does not cover its variable costs and is better off if it
w
closes down.

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