ECO 3104

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ECO 3104

• Lecture 13

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Profit Maximization

• Analysis of firm is based on the concept of
  profit maximization
• profit revenue - cost
• cost is economic cost
• assume that firms act as if they sought to
  maximize profits
• as if is important doesnt matter if theory
  is a close caricature of reality, but rather does
  observed behavior fit predictions that follow
  from profit maximization

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Profit Maximization

• Justifications for Profit Maximization Assumption
• survival of the fittest
• even if firms dont consciously maximize profits,
  those that make a loss will not survive and ones
  which avoid losses will remain
• selection criteria is realization of positive
  profit

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Profit Maximization

• Justifications for Profit Maximization Assumption
• In a single-owner firm the owner gets all of the
  residual after paying inputs their opportunity
  cost
• has incentive to maximize profits, since increase
  in profit is equivalent to an increase in his
  income

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Profit Maximization

• Justifications for Profit Maximization Assumption
• In corporations, there is a separation of
  ownership and control which leads to a
  principal-agent problem
• managers can be given incentives to take actions
  that maximize profit
• Bonuses tied to profit
• Stock options
• If managers deviate too far from maximizing
  profit, they will lose their job
• Firing by board of directors
• Takeover bids

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Marginal Revenue, Marginal Cost,and Profit
Maximization

• Determining the profit maximizing level of output
• Profit (p) Total Revenue - Total Cost
• Total Revenue (R) P(q)
• Total Cost (C) C(q)
• Therefore

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Profit Maximization in the Short Run
Cost, Revenue, Profit (s per year)
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Output (units per year)
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Marginal Revenue, Marginal Cost,and Profit
Maximization

• Marginal revenue is the additional revenue from
  producing one more unit of output.
• Equals slope of total revenue curve
• Marginal cost is the additional cost from
  producing one more unit of output.
• Equals slope of total cost curve

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Marginal Revenue, Marginal Cost,and Profit
Maximization

• Comparing R(q) and C(q)

Cost, Revenue, Profit (s per year)

• From 0-q0, profit is negative
• C(q)gt R(q)
• FC VC gt R(q)
• MR gt MC
• Indicates higher profit at higher output

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Output (units per year)
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Marginal Revenue, Marginal Cost,and Profit
Maximization

• Comparing R(q) and C(q)
• Output levels q0 - q
• R(q)gt C(q)
• MR gt MC
• Indicates higher profit at higher output
• Profit is increasing

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Marginal Revenue, Marginal Cost,and Profit
Maximization

• Comparing R(q) and C(q)
• Output level q
• R(q) C(q)
• MR MC
• Profit is maximized

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Marginal Revenue, Marginal Cost,and Profit
Maximization

• Comparing R(q) and C(q)
• Output levels beyond q
• R(q)gt C(q)
• MC gt MR
• Profit is decreasing

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Marginal Revenue, Marginal Cost,and Profit
Maximization

• Therefore, it can be said
• Profits are maximized when MC MR.

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Marginal Revenue, Marginal Cost,and Profit
Maximization
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Marginal Revenue, Marginal Cost,and Profit
Maximization
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Marginal Revenue, Marginal Cost,and Profit
Maximization

• Application multi-plant firms
• if a single firm operates more than one plant,
  how should it allocate production between the
  plants?
• follow MRMC rule for all plants
• want to operate plants at output levels such that
  marginal cost is equal across plants
• if MC was not equal for all plants, could
  reorganize production and cut total cost

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End of Lecture 13