Profit maximization by firms

ECO61 Udayan Roy Fall 2008

Revenues and costs

A firms costs (C) were discussed in the previous chapter A firms revenue is R = P Q
Where P is the price charged by the firm for the commodity it sells and Q is the quantity of the firms output that people buy We discussed the link between price and quantity consumed the demand curve earlier

Now it is time to bring revenues and costs together to study a firms behavior

Profit-Maximizing Prices and Quantities

A firms profit, P, is equal to its revenue R less its cost C
P=RC

We assume that a firms actions are aimed at maximizing profit Maximizing profit is another example of finding a best choice by balancing benefits and costs
Benefit of selling output is firms revenue, R(Q) = P(Q)Q Cost of selling that quantity is the firms cost of production, C(Q)

Overall,

P = R(Q) C(Q) = P(Q)Q C(Q)

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Profit-Maximization: An Example
Noah and Naomi face weekly inverse demand function P(Q) = 200-Q for their garden benches Weekly cost function is C(Q)=Q2 Suppose they produce in batches of 10 To maximize profit, they need to find the production level with the greatest difference between revenue and cost

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Profit-Maximization: An Example
P R C PQ C P (200 Q) Q Q 2 P 200Q Q 2 Q 2 200Q 2Q 2 P 2(100Q Q 2 ) 2(502 502 100Q Q 2 ) P 2(502 [502 100Q Q 2 ]) P 2(502 [502 2 50 Q Q 2 ]) P 2(502 [50 Q]2 )
Note that [50 Q]2 is always a positive number. Therefore, to maximize profit one must minimize [50 Q]2. Therefore, to maximize profit, Noah and Naomi must produce Q = 50 units. This is their profit-maximizing output. When Q = 50, = 2 502 = 5000. this is the biggest profit Noah and Naomi can achieve.

Figure 9.2: A Profit-Maximization Example

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Choice requires balance at the margin

In general marginal benefit must equal marginal cost at a decision-makers best choice whenever a small increase or decrease in her action is possible

Example

Marginal Revenue
Here the firms marginal benefit is its marginal revenue: the extra revenue produced by the DQ marginal units sold, measured on a per unit basis

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Marginal Revenue and Price

An increase in sales quantity (DQ) changes revenue in two ways:
Firm sells DQ additional units of output, each at a price of P(Q). This is the output expansion effect: PDQ Firm also has to lower price as dictated by the demand curve; reduces revenue earned from the original Q units of output. This is the price reduction effect: QDP

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Figure 9.4: Marginal Revenue and Price

Price reduction effect of output expansion: QDP. Non-existent when demand is horizontal

Output expansion effect: PDQ

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Marginal Revenue and Price

The output expansion effect is PDQ The price reduction effect is QDP Therefore the additional revenue per unit of additional output is MR = (PDQ + QDP)/DQ = P + QDP/DQ When demand is negatively sloped, DP/DQ < 0. So, MR < P. When demand is horizontal, DP/DQ = 0. So, MR = P.

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Demand and marginal revenue

Profit-Maximizing Sales Quantity

Two-step procedure for finding the profit-maximizing sales quantity Step 1: Quantity Rule
Identify positive sales quantities at which MR=MC If more than one, find one with highest P

Step 2: Shut-Down Rule

Check whether the quantity from Step 1 yields higher profit than shutting down

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Profit
Profit equals total revenue minus total costs.
Profit = R C Profit/Q = R/Q C/Q Profit = (R/Q - C/Q) Q Profit = (PQ/Q - C/Q) Q Profit = (P - AC) Q

Profit: downward-sloping demand of price-setting firm

Costs and Revenue Marginal cost ProfitE maximizing price B

profit

Average cost

Average cost D

Demand

Marginal revenue 0 QMAX Quantity

Profit: downward-sloping demand of pricesetting firm

Recall that profit = (P - AC) Q Therefore, the firm will stay in business as long as price (P) is greater than average cost (AC).

Shut down because P < AC at all Q: downward-sloping demand of price-setting firm

Costs and Revenue

Average total cost

Demand 0 Quantity

Profit Maximization: horizontal demand for a price taking firm

Costs and Revenue

The firm maximizes profit by producing the quantity at which marginal cost equals marginal revenue.

MC

MC2

AC
P = MR1 = MR2 P = AR = MR

MC1

Q1

QMAX

Q2

Quantity

Shut down because P < AC at all Q: horizontal demand for a price taking firm
Costs and Revenue MC

AC

ACmin
P = AR = MR

Quantity

Supply Decisions
Price takers are firms that can sell as much as they want at some price P but nothing at any higher price
Face a perfectly horizontal demand curve
not subject to the price reduction effect

Firms in perfectly competitive markets, e.g. MR = P for price takers

Use P=MC in the quantity rule to find the profit-maximizing sales quantity for a price-taking firm Shut-Down Rule:
If P>ACmin, the best positive sales quantity maximizes profit. If P<ACmin, shutting down maximizes profit. If P=ACmin, then both shutting down and the best positive sales quantity yield zero profit, which is the best the firm can do.
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Price determination
We have seen how the price is determined in the case of price setting firms that have downward sloping demand curves But how is the price that price taking firms use to guide their production determined?
For now think of it as determined by trial and error. Pick a random price. See what quantity is demanded by buyers and what quantity is supplied by producers. Keep trying different prices whenever the two quantities are unequal The market equilibrium price is the price at which the quantities supplied and demanded are equal