Lecture 13

PROFIT MAXIMIZATION

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 The Nature of Firms
 A firm is an association of individuals who
have organized themselves for the
purpose of turning inputs into outputs
 Each individual will have different
objectives...
 Modeling the relation among all types of
workers, managers, shareholders can be
very complicated

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 Modeling Firms’ Behavior
 The simplest approach in economics is the
following:
– the decisions are made by a single dictatorial
manager who rationally pursues some goal
 usually profit-maximization
– The dictatorial manager can monitor perfectly that
everyone is working according to her guidelines

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 Profit Maximization
 A profit-maximizing firm chooses both
its inputs and its outputs with the sole
goal of achieving maximum economic
profits
– seeks to maximize the difference between
total revenue and total economic costs

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 Output Choice
 Total revenue for a firm is given by
R(q) = p(q)q
 In the production of q, certain economic
costs are incurred [C(q)]->cost function
 Economic profits () are the difference
between total revenue and total costs
(q) = R(q) – C(q) = p(q)q –C(q)

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 Output Choice
 The necessary condition for choosing the level of q
that maximizes profits can be found by setting the
derivative of the  function with respect to q equal to
zero

(q) = R(q) – C(q) = p(q)q –C(q)

d dR dC
 ' ( q )   0
dq dq dq

dR dC

dq dq 6
 Output Choice
 To maximize economic profits, the firm
should choose the output for which
marginal revenue is equal to marginal
cost
dR dC
MR   MC
dq dq

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 Second-Order Conditions
 MR = MC is only a necessary condition
for profit maximization
 For sufficiency, it is also required that

d 2 d' (q )
2
 0
dq q q * dq q q *

 This is standard maths… at the max the second

derivative must be negative

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 Profit Maximization
revenues & costs Profits are maximized when the slope of
the revenue function is equal to the slope of
the cost function
C
R

The second-order
condition prevents us
from mistaking q0 as
a maximum

output
q0 q*
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 Marginal Revenue
R(q) = p(q)q
dR d [ p(q ) q ] dp
marginal revenue MR (q )   p  q 
dq dq dq
The second term (dp/dq) is negative for firms that face a
downward-sloping curve. Typically these are large firms
so that prices decreases when they produce more.
The second term (dp/dq) is zero for competitive or price
taking firms. Typically these are small firms so that the
price does not depend on the quantity that the firm
produces. In this case we have that the marginal revenue
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will be equal to the price.
 Marginal Revenue
 Suppose that the demand curve for a sub
sandwich is
q = 100 – 10p
 Solving for price, we get
p = -q/10 + 10
 This means that total revenue is
R = pq = -q2/10 + 10q
 Marginal revenue will be given by
MR = dR/dq = -q/5 + 10 11
 Profit Maximization
 To determine the profit-maximizing output, we
must know the firm’s costs
 If subs can be produced at a constant a
marginal cost of $4, then
MR = MC
-q/5 + 10 = 4
q = 30
We should also check that the second derivative
of the profit function in this point is negative
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 Marginal Revenue Curve
 The marginal revenue curve shows the
extra revenue provided by the last unit
sold
 For a firm that faces a downward-
sloping demand curve, the marginal
revenue curve will lie below the demand
curve (see the formula before)

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 Marginal Revenue Curve
As output increases from 0 to q1, total
price revenue increases so MR > 0
As output increases beyond q1, total
revenue decreases so MR < 0

p1

D (p)

output
q1

MR 14
 Marginal Revenue Curve
 When the demand curve shifts, its
associated marginal revenue curve
shifts as well
– a marginal revenue curve cannot be
calculated without referring to a specific
demand curve

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 Profit Functions for price taking
firms
 A firm’s economic profit can be
expressed as a function of inputs
 = pq - C(q) = pf(k,l) - vk - wl
 Only the variables k and l are under the
firm’s control
– the firm chooses levels of these inputs in
order to maximize profits
treats p, v, and w as fixed parameters in its
decisions

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 The firm solves the following problem:
Max  ( k , l ) Max[ pf (k , l )  vk  w l ]
k ,l k ,l

 The first-order conditions for a maximum

are
/k = p[f/k] – v = 0
/l = p[f/l] – w = 0
 A profit-maximizing firm should hire any
input up to the point at which its marginal
contribution to revenues is equal to the
marginal cost of hiring the input
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 Profit Maximization and
Input Demand

 These first-order conditions for profit

maximization also imply cost
minimization
– they imply that MRTS = w/v

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 Profit Maximization and
Input Demand
 To ensure a true maximum, second-
order conditions require that
kk = fkk < 0
ll = fll < 0
kk ll - kl2 = fkkfll – fkl2 > 0

– capital and labor must exhibit sufficiently

diminishing marginal productivities so that
marginal costs rise as output expands 19
 Input Demand Functions
 The first-order conditions can be solved
to yield input demand functions
Capital Demand = k(p,v,w)
Labor Demand = l(p,v,w)
 These demand functions are
unconditional
– they implicitly allow the firm to adjust its
output to changing prices
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 Substitution and Output effect
 Now we are equipped to study how input
choices changes with input prices…
 When w falls, two effects occur
– substitution effect
if output is held constant, there will be a
tendency for the firm to want to substitute l for k
in the production process
– output effect
the firm’s cost curves will shift and a different
output level will be chosen

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 Substitution Effect
If output is held constant at q0 and w
falls, the firm will substitute l for k in
k per period the production process

Because of diminishing
RTS along an isoquant,
the substitution effect will
always be negative
q0

l per period
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 Output Effect
A decline in w will lower the firm’s MC
Price MC
MC’
Consequently, the firm
will choose a new level
of output that is higher
P

Output
q0 q1 23
 Output Effect
Output will rise to q1

k per period
Thus, the output effect
also implies a negative
relationship between l
and w

q1
q0

l per period
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 Cross-Price Effects
 No definite statement can be made
about how capital usage responds to a
wage change
– a fall in the wage will lead the firm to
substitute away from capital
– the output effect will cause more capital to
be demanded as the firm expands
production

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 Substitution and Output
Effects
 We have two concepts of demand for
any input
– the conditional demand for labor, lc(v,w,q)
– the unconditional demand for labor, l(p,v,w)
 At the profit-maximizing level of output
lc(v,w,q) = l(p,v,w)

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 Substitution and Output
Effects
 Differentiation with respect to w yields
l ( p,v ,w ) l c (v ,w , q ) l c (v ,w , q ) q
  
w w q w

substitution output
effect effect

total effect
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 Profit Functions for price taking firms

 A firm’s profit function shows its

maximal profits as a function of the
prices that the firm faces
 ( p, v, w) Max  (k , l ) Max[ pf (k , l )  vk  wl ] 
k ,l k ,l

 pf ( k ( p, v, w), l ( p, w, v))  vk ( p, w, v)  wl( p, w, v)

We use the unconditional input demands to obtain the
profit function

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Example

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 Essay Stucture
Structure:Introduction: 10 %, alwways a
questions that answers in conclusion
• Body paragraph: Pros-Cons or Advantages
and Disadvantages
• Conclusion:Answet the question in
introduction based on the body paragraph

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 Topics
• Monopoly vs Oligopoly
• Do we have monopoly in Albania?
• How is the cost of production in Albania
in comparison to other countries?

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