CH 19

Chapter Nineteen
Profit-Maximization
Economic Profit
A firm uses inputs j = 1,m to make
products i = 1,n.
Output levels are y1,,yn.
Input levels are x1,,xm.
Product prices are p1,,pn.
Input prices are w1,,wm.
The Competitive Firm
The competitive firm takes all output

prices p1,,pn and all input prices w1,
,wm as given constants.
Economic Profit
The economic profit generated by
the production plan (x1,,xm,y1,,yn)
is
p1y1 pnyn w 1x1 w mxm .
Economic Profit
Output and input levels are typically
flows.
E.g. x1 might be the number of labor
units used per hour.
And y3 might be the number of cars
produced per hour.
Consequently, profit is typically a
flow also; e.g. the number of dollars
of profit earned per hour.
Economic Profit
How do we value a firm?
Suppose the firms stream of
periodic economic profits is
and r is the rate of
interest.
Then the present-value of the firms
is
economic profitstream
1
2
PV 0
1r
(1 r ) 2
Economic Profit
A competitive firm seeks to maximize
its present-value.
How?
Economic Profit
Suppose the firm is in a short-run
~
circumstance in which x 2 x 2 .
Its short-run production function is
~
y f ( x1 , x 2 ).
Economic Profit
Suppose the firm is in a short-run
~
circumstance in which x 2 x 2 .
Its short-run production function is
~
y f ( x1 , x 2 ).
~
The firms fixed cost is FC w 2x 2
and its profit function is
~
py w 1x1 w 2x 2 .
Short-Run Iso-Profit Lines

A $ iso-profit line contains all the
production plans that provide a profit
level $.
A $ iso-profit lines equation is
~
py w 1x1 w 2x 2 .

A $ iso-profit line contains all the
production plans that yield a profit
level of $.
The equation of a $ iso-profit line is
~
py w 1x1 w 2x 2 .
I.e.
~
w1
w 2x 2
y
x1
.

~
w1
w 2x 2
y
x1
p
p
has a slope of
w1
and a vertical intercept of
~
w 2x 2
.
p

y
g
n
i
s
a
e
r fit
c
n
I
pro
w1
Slopes
p
x1
Short-Run Profit-Maximization
The firms problem is to locate the
production plan that attains the
highest possible iso-profit line, given
the firms constraint on choices of
production plans.
Q: What is this constraint?
The firms problem is to locate the
production plan that attains the
highest possible iso-profit line, given
the firms constraint on choices of
production plans.
Q: What is this constraint?
A: The production function.
y
The short-run production function and

~ .
x
x
technology set for 2
2
~ )
y f ( x1 , x
2
Technically
inefficient
plans
x1
y
g
n
i
s
a
e
r fit
c
n
I
pro
~ )
y f ( x1 , x
2
w1
Slopes
p
x1
y
w1
Slopes
p
y*
*
x1
x1
y
~ , the short-run
Given p, w1 and x 2 x
2
* ~
*
profit-maximizing plan is ( x1 , x 2 , y ).

w1
Slopes
p
y*
*
x1
x1
y
y*
~ , the short-run
Given p, w1 and x 2 x
2
* ~
*
profit-maximizing plan is ( x1 , x 2 , y ).
And the maximum

possible profit
is .
w1
Slopes
p
*
x1
x1
At the short-run profit-maximizing plan,
y the slopes of the short-run production
function and the maximal
iso-profit line are
equal.
w
1
*
Slopes
y
p
*
x1
x1
At the short-run profit-maximizing plan,
y the slopes of the short-run production
function and the maximal
iso-profit line are
equal.
w
1
*
Slopes
y
p
w1
MP1
p
~ , y* )
at ( x* , x
1
*
x1
x1
w1
MP1
p
p MP1 w1
p MP1 is the marginal revenue product of
input 1, the rate at which revenue increases

with the amount used of input 1.
If p MP1 w1 then profit increases with x 1.
If p MP1 w1 then profit decreases with x 1.
Short-Run Profit-Maximization; A
Cobb-Douglas Example
Suppose the short-run production
~ 1/ 3 .
x
function is y x1/3
1
2
The marginal product of the variable
input 1 is MP y 1 x 2/ 3x
~ 1/ 3 .
1
1
2
x1 3
The profit-maximizing condition is
p * 2/ 3 ~ 1/ 3
MRP1 p MP1 ( x1 )
x2 w1 .
3
p * 2/ 3 ~ 1/ 3
x 2 w 1 for x1 gives
Solving ( x1 )
3
3w 1
* 2/ 3
( x1 )
.
~ 1/ 3
px
2
p * 2/ 3 ~ 1/ 3
Solving ( x1 )
3
3w 1
* 2/ 3
( x1 )
.
~ 1/ 3
px
2
That is,
~ 1/ 3
px
2
( x*1 ) 2/ 3
3w 1
p * 2/ 3 ~ 1/ 3
Solving ( x1 )
3
3w 1
* 2/ 3
( x1 )
.
~ 1/ 3
px
2
That is,
so
~ 1/ 3
px
2
( x*1 ) 2/ 3
3w 1
*
x1
3/ 2
1/ 3 3 / 2
~
p
px 2
~ 1/ 2 .
2
3w 1
3w 1
*
x1
3w 1
3/ 2
1/ 2
~
x2
is the firms
short-run demand
for input 1 when the level of input 2 is
~ units.
fixed at x
2
*
x1
3w 1
3/ 2
1/ 2
~
x2
is the firms
short-run demand
for input 1 when the level of input 2 is
~ units.
fixed at x
2
The firms short-run output level is thus
* 1/ 3 ~ 1/ 3
y ( x1 ) x 2
*
3w 1
1/ 2
1/ 2
~
x2 .
Comparative Statics of Short-Run

Profit-Maximization
What happens to the short-run profitmaximizing production plan as the

output price p changes?

Profit-Maximization
The equation of a short-run iso-profit line
~
is
w1
w 2x
2
y
x1
so an increase in p causes
-- a reduction in the slope, and
-- a reduction in the vertical intercept.

Profit-Maximization
y
~ )
y f ( x1 , x
2
y*
w1
Slopes
p
*
x1
x1

Profit-Maximization
y
~ )
y f ( x1 , x
2
y*
w1
Slopes
p
*
x1
x1

Profit-Maximization
y
~ )
y f ( x1 , x
2
y*
w1
Slopes
p
*
x1
x1

Profit-Maximization
An increase in p, the price of the

firms output, causes
an increase in the firms output
level (the firms supply curve
slopes upward), and
an increase in the level of the firms
variable input (the firms demand
curve for its variable input shifts
outward).

Profit-Maximization
The Cobb-Douglas example: When
1/ 3~ 1/3
y x1 x 2
then the firms short-run
demand for its variable input 1 is
*
x1
3/ 2
p
y
3w 1
1/ 2
3w 1
1/ 2
~
x2
~ 1/ 2 .
x
2
and its short-run

supply is

Profit-Maximization
1/ 3~ 1/3
y x1 x 2
*
x1
3/ 2
p
y
3w 1
1/ 2
3w 1
1/ 2
~
x2
~ 1/ 2 .
x
2
and its short-run

supply is
x*1 increases as p increases.

Profit-Maximization
1/ 3~ 1/3
y x1 x 2
*
x1
3/ 2
p
y
3w 1
1/ 2
3w 1
1/ 2
~
x2
~ 1/ 2 .
x
2
and its short-run

supply is
x*1 increases as p increases.

*
y increases as p increases.

Profit-Maximization
What happens to the short-run profitmaximizing production plan as the

variable input price w1 changes?

Profit-Maximization
The equation of a short-run iso-profit line
~
is
w1
w 2x 2
y
x1
so an increase in w1 causes
-- an increase in the slope, and
-- no change to the vertical intercept.

Profit-Maximization
y
~ )
y f ( x1 , x
2
y*
w1
Slopes
p
*
x1
x1

Profit-Maximization

~ )
y f ( x1 , x
2
y*
w1
Slopes
p
*
x1
x1

Profit-Maximization

~ )
y f ( x1 , x
2
w1
Slopes
p
y*
*
x1
x1

Profit-Maximization
An increase in w1, the price of the

firms variable input, causes
a decrease in the firms output level
(the firms supply curve shifts
inward), and
a decrease in the level of the firms
variable input (the firms demand
curve for its variable input slopes
downward).

Profit-Maximization
1/ 3~ 1/3
y x1 x 2
*
x1
3/ 2
p
y
3w 1
1/ 2
3w 1
1/ 2
~
x2
and its short-run
~ 1/ 2 .
x
2
supply is

Profit-Maximization
1/ 3~ 1/3
y x1 x 2
*
x1
3/ 2
p
y
3w 1
1/ 2
3w 1
1/ 2
~
x2
and its short-run
~ 1/ 2 .
x
2
supply is
x*1 decreases as w1 increases.

Profit-Maximization
1/ 3~ 1/3
y x1 x 2
*
x1
3/ 2
p
y
3w 1
1/ 2
3w 1
1/ 2
~
x2
and its short-run
~ 1/ 2 .
x
2
supply is
x*1 decreases as w1 increases.

y* decreases as w1 increases.
Long-Run Profit-Maximization
Now allow the firm to vary both input
levels.
Since no input level is fixed, there
are no fixed costs.
Both x1 and x2 are variable.
Think of the firm as choosing the

production plan that maximizes
profits for a given value of x2, and
then varying x2 to find the largest
possible profit level.
The equation of a long-run iso-profit line
is
w1
w 2x 2
y
x1
so an increase in x2 causes
-- no change to the slope, and
-- an increase in the vertical intercept.
y
y f ( x1 , x2 )
x1
y
y f ( x1 , 3x 2 )
y f ( x1 , 2x 2 )
y f ( x1 , x2 )
Larger levels of input 2 increase the

productivity of input 1.
x1
y
y f ( x1 , 3x 2 )
y f ( x1 , 2x 2 )
y f ( x1 , x2 )
The marginal product

of input 2 is
diminishing.
x1
y
y f ( x1 , 3x 2 )
y f ( x1 , 2x 2 )
y f ( x1 , x2 )

of input 2 is
diminishing.
x1
y
p MP1 w 1 0 for each short-run
production plan.
y f ( x1 , 3x 2 )
y f ( x1 , 2x 2 )
y* ( 3x2 )
y* ( 2x2 )
y f ( x1 , x2 )
y ( x 2 )
x*1 ( x 2 )
x*1 ( 3x2 )
x*1 ( 2x2 )
x1
y
production plan.
y f ( x1 , 3x 2 )
y f ( x1 , 2x 2 )
y* ( 3x2 )
y* ( 2x2 )
y f ( x1 , x2 )

of input 2 is
diminishing so ...
y ( x 2 )
x*1 ( x 2 )
x*1 ( 3x2 )
x*1 ( 2x2 )
x1
y
production plan.
y f ( x1 , 3x 2 )
y f ( x1 , 2x 2 )
y* ( 3x2 )
y* ( 2x2 )
y f ( x1 , x2 )
the marginal profit

of input 2 is
diminishing.
y ( x 2 )
x*1 ( x 2 )
x*1 ( 3x2 )
x*1 ( 2x2 )
x1
Profit will increase as x2 increases so

long as the marginal profit of input 2
p MP2 w 2 0.
The profit-maximizing level of input 2

therefore satisfies
p MP2 w 2 0.
Profit will increase as x2 increases so

long as the marginal profit of input 2
p MP2 w 2 0.
The profit-maximizing level of input 2

therefore satisfies
p MP2 w 2 0.
And p MP1 w1 0 is satisfied in any

short-run, so ...
The input levels of the long-run

profit-maximizing plan satisfy
p MP1 w 1 0 and p MP2 w 2 0.
That is, marginal revenue equals

marginal cost for all inputs.
1/ 3~ 1/ 3
y x1 x 2 then the firms short-run
*
x1
3/ 2
p
y
3w 1
1/ 2
3w 1
1/ 2
~
x2
~ 1/ 2 .
x
2
and its short-run

supply is
Short-run profit is therefore
~
py* w 1x*1 w 2x
2
p
p
3w 1
1/ 2
1/ 2
~
x 2 w1
3w 1
3/ 2
~ 1/ 2 w x
~
x
2
2 2
~
py* w 1x*1 w 2x
2
p
p
3w 1
1/ 2
p
p
3w 1
1/ 2
1/ 2
~
x 2 w1
3w 1
3/ 2
~ 1/ 2 w x
~
x
2
2 2
p p
1/ 2
~
x 2 w1
3w 1 3w 1
1/ 2
~
w 2x
2
~
py* w 1x*1 w 2x
2
p
p
3w 1
1/ 2
p
p
3w 1
1/ 2
2p p
3 3w 1
1/ 2
~
x2 w1
3w 1
3/ 2
~ 1/ 2 w x
~
x
2
2 2
p p
1/ 2
~
x2 w1
3w 1 3w 1
1/ 2
~ 1/ 2 w x
~
x
2
2 2
1/ 2
~
w 2x
2
~
py* w 1x*1 w 2x
2
p
p
3w 1
1/ 2
p
p
3w 1
1/ 2
2p p
3 3w 1

1/ 2
~
x2 w1
3w 1
3/ 2
~ 1/ 2 w x
~
x
2
2 2
p p
1/ 2
~
x2 w1
3w 1 3w 1
1/ 2
~ 1/ 2 w x
~
x
2
2 2
3 1/ 2
4p
~ 1/ 2 w x
~ .
x
2
2 2
27w 1
1/ 2
~
w 2x
2
3 1/ 2
4p
~ 1/ 2 w x
~ .
x
2
2 2
27w 1
What is the long-run profit-maximizing

level of input 2? Solve
1
0 ~
x2 2
to get
~ x*
x
2
2
3 1/ 2
4p
~ 1/ 2 w
x
2
2
27w 1
p3
27w 1w 2
2
input 1 level? Substitute
x*2
27w 1w 2
2
to get
into
*
x1
3w 1
3/ 2
~ 1/ 2
x
2
input 1 level? Substitute
p
x*2
27w 1w 2
2
into
*
x1
3w 1
1/ 2
3/ 2
~ 1/ 2
x
2
to get
p
*
x1
3w 1
3 / 2
2
27w 1w 2
2
27w 1 w 2
output level? Substitute
x*2
27w 1w 2
2
to get
p
into y
3w 1
*
1/ 2
~ 1/ 2
x
2
output level? Substitute
x*2
p
into y
3w 1
27w 1w 2
2
1/ 2
~ 1/ 2
x
2
to get
p
*
y
3w 1
1/ 2
1/ 2
27w 1w 22
p2
.
9 w 1w 2
So given the prices p, w1 and w2, and
3 1/ 3
the production function y x1/
1 x2
the long-run profit-maximizing production
plan is
p2
.
,
,
27w 12w 2 27w 1w 22 9 w 1w 2
( x*1 , x*2 , y* )
p3
p3
Returns-to-Scale and ProfitMaximization
If a competitive firms technology

exhibits decreasing returns-to-scale
then the firm has a single long-run
profit-maximizing production plan.
Returns-to Scale and ProfitMaximization

y
y f(x)
y*
Decreasing
returns-to-scale
x*
If a competitive firms technology

exhibits exhibits increasing returnsto-scale then the firm does not have
a profit-maximizing plan.

y
ng
i
s
a
e
r
c
n
I
it
f
o
r
p
y f(x)
y
y
Increasing
returns-to-scale
x
So an increasing returns-to-scale
technology is inconsistent with firms
being perfectly competitive.
What if the competitive firms

technology exhibits constant
returns-to-scale?

y
ng
i
s
a
e
r
c
n
I
it
f
o
r
p
y f(x)
Constant
returns-to-scale
y
x
So if any production plan earns a

positive profit, the firm can double
up all inputs to produce twice the
original output and earn twice the
original profit.

Therefore, when a firms technology
exhibits constant returns-to-scale,
earning a positive economic profit is
inconsistent with firms being
perfectly competitive.
Hence constant returns-to-scale
requires that competitive firms earn
economic profits of zero.

y
y f(x)
=0
y
Constant
returns-to-scale
y
x
Revealed Profitability
Consider a competitive firm with a
technology that exhibits decreasing
returns-to-scale.
For a variety of output and input
prices we observe the firms choices
of production plans.
What can we learn from our
observations?
If a production plan (x,y) is chosen

at prices (w,p) we deduce that the
plan (x,y) is revealed to be profitmaximizing for the prices (w,p).
y
( x , y ) is chosen at prices ( w , p )
w
Slope
p
y
y
( x , y ) is chosen at prices ( w , p ) so
( x , y ) is profit-maximizing at these prices.
w
Slope
p
y
y
w
Slope
p
y
y
( x , y ) would give higher
profits, so why is it not

chosen?
y
w
Slope
p
y
y

chosen? Because it is
not a feasible plan.
x
y
w
Slope
p
y
y

chosen? Because it is
not a feasible plan.
x
x
So the firms technology set must lie under the
iso-profit line.
y
w
Slope
p
y
y
The technology
set is somewhere
in here
x
x
So the firms technology set must lie under the
iso-profit line.
y
( x , y ) maximizes profit at these prices.
w
Slope
p
( x , y ) would provide higher
profit but it is not chosen

y
x x
y
w
Slope
p
y

because it is not feasible
x x
y
w
Slope
p
y

because it is not feasible so
the technology set lies under
the iso-profit line.
x x
y
w
Slope
p
y
The technology set is

also somewhere in
here.
x x
y
The firms technology set must lie under

both iso-profit lines
y

both iso-profit lines
The technology set

is somewhere
in this intersection
Observing more choices of

production plans by the firm in
response to different prices for its
input and its output gives more
information on the location of its
technology set.
y

all the iso-profit lines
( w , p )
( w , p )
y
y
( w , p )
y

( w , p )
( w , p )
y
y
( w , p )
y

( w , p )
( w , p )
y
y
( w , p )
y f(x)
What else can be learned from the

firms choices of profit-maximizing
production plans?
y

( w , p )
( w , p )
( x , y ) is chosen at prices
( w , p ) so
p y w x p y w x .
( x , y ) is chosen at prices
( w , p ) so
p y w x p y w x .
p y w x p y w x and
p y w x p y w x so
p y w x p y w x and
p y w x p y w x .
Adding gives
( p p ) y ( w w ) x
( p p ) y ( w w ) x .
( p p ) y ( w w ) x
(p p ) y ( w w ) x
so
( p p )( y y ) ( w w )( x x )
That is,
py wx
is a necessary implication of profitmaximization.
py w x

Suppose the input price does not change.
Then w = 0 and profit-maximization
implies py 0; i.e., a competitive
firms output supply curve cannot slope
downward.
py w x

Suppose the output price does not change.
Then p = 0 and profit-maximization
implies 0 w x; i.e., a competitive
firms input demand curve cannot slope
upward.

CH 19

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CH 19

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Chapter Nineteen

Input levels are x1,,xm.

Product prices are p1,,pn.

Input prices are w1,,wm.

The Competitive Firm

The competitive firm takes all output

Short-Run Iso-Profit Lines

Short-Run Iso-Profit Lines

Short-Run Iso-Profit Lines

and a vertical intercept of

Short-Run Iso-Profit Lines

The short-run production function and

p MP1 is the marginal revenue product of

input 1, the rate at which revenue increases

Comparative Statics of Short-Run

What happens to the short-run profitmaximizing production plan as the

Comparative Statics of Short-Run

Comparative Statics of Short-Run

Comparative Statics of Short-Run

Comparative Statics of Short-Run

Comparative Statics of Short-Run

An increase in p, the price of the

Comparative Statics of Short-Run

and its short-run

Comparative Statics of Short-Run

and its short-run

x*1 increases as p increases.

Comparative Statics of Short-Run

and its short-run

x*1 increases as p increases.

Comparative Statics of Short-Run

What happens to the short-run profitmaximizing production plan as the

Comparative Statics of Short-Run

Comparative Statics of Short-Run

Comparative Statics of Short-Run

Comparative Statics of Short-Run

Comparative Statics of Short-Run

An increase in w1, the price of the

Comparative Statics of Short-Run

Comparative Statics of Short-Run

x*1 decreases as w1 increases.

Comparative Statics of Short-Run

x*1 decreases as w1 increases.

Both x1 and x2 are variable.

Think of the firm as choosing the

Larger levels of input 2 increase the

The marginal product

The marginal product

p MP1 w 1 0 for each short-run

p MP1 w 1 0 for each short-run

The marginal product

p MP1 w 1 0 for each short-run

the marginal profit

Profit will increase as x2 increases so

The profit-maximizing level of input 2

Profit will increase as x2 increases so

The profit-maximizing level of input 2

And p MP1 w1 0 is satisfied in any

The input levels of the long-run

That is, marginal revenue equals

and its short-run

Short-run profit is therefore

What is the long-run profit-maximizing