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Single firm and profit maximization

B.Cesi, Microeconomics 2019

(ch 19, except 19.11)

1
The production plan (use of inputs) maximizes the profit

Competitive market: input/output price are given

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n m
   pi yi   w j x j

B.Cesi, Microeconomics 2019

i 1 j 1

n output i=1,…,n

m inputs j=1,…,m

2
Short Run: profits may be negative even producing zero

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Fixed cost, fixed (ex ante) inputs/investment
(ex. early rent payment of the office )

B.Cesi, Microeconomics 2019

Long Run: all inputs are flexible, profit may be zero

Only variable costs depending on the produced

quantity (electricity, no use no cost)
3
 max  py  w1 x1  w2 x2
x1 , x2

y  f x1 , x2 

Feasible production plan

max  pf x1 , x2   w1 x1  w2 x2
x1 , x2

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Optimal conditions:
f x1 , x2  w1

x1 p
MP of each= relative
price of the input

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f x1 , x2  w2

x2 p

B.Cesi, Microeconomics 2019

Solve the system:

f x1 , x2  w1

x1 p x1*  x1 w1 , w2 , p 
x2*  x2 w1 , w2 , p 
f x1 , x2  w2 5

x2 p
 Short Run

y  f x1 , x2 

max  py  w1 x1  w2 x2
x1

From the profit function we obtain the isoprofit lines

w2 w1
y  x2  x1
p p p

Isoprofit line represents the all input/output combinations associated

to a constant level of profit

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 isoprofit
w1
y p

y  f x1 , x2 
y*
 w2 x2

p p

x1* x1
Vertical intercept denotes profit + fixed costs. Lines only differ with respect to
profits Higher intercept higher profits

Higher profits at north west

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Optimal condition:
f x1 , x2  w1
MP1  
x1 p

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Optimal input/output combination is at the tangency point
between the production function and the isoprofit.

B.Cesi, Microeconomics 2019

CONSIDER…
w1 w1
MP1  ; MP1 
p p
Are optimal (why not)? 8
 y

MP1 
p
w1

MP1 
p
w1

x1
MP1 
p
w1

B.Cesi, Microeconomics 2019 22/04/2020

9
 w1 It is possible to increase profit
MP1  by increasing the level of
p

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input

B.Cesi, Microeconomics 2019

w1
MP1  It is possible to increase profit
p by reducing the level of input

10
 Comparative statics
if w1 increases, then the optimal quantity of 1
decreases. Factor demand is downward sloping

w1' w1
w'1  w1


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If p decreases, the demand of factor decreases

p' p

 p'  p


If demand of factor decreases, since factor 2 is fixed,

then the supply of output y decreases. Supply curve
is upward sloping

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The change in the price of factor does not affect the
optimal choice because of the short run

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The slope of the isoprofit does not change, optimal choice
dos not change then y does not change.

B.Cesi, Microeconomics 2019

Only profit changes

In perfect competition and constant returns

to scale, equilibrium profit in the long run is
zero 13
 Intuition…
Is it possible NO constRetSc+competitive market+zero profit?

• What if profit in the long run was positive?

The firm could have the incentive to expand somehow the production

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plan (price is given), but..

B.Cesi, Microeconomics 2019

• …too big to become inefficient, this inefficiency contradicts the ConRS
for all the possible leveles of outputs
• ..if big and but efficient then it could obtain a dominant position (price
maker), but this contradicts the assumption of competitive market .
Also:
With positive profit in the short run, more firms could get in the market
(free entry)..
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then aggregate supply could shift up and then the equilibrium price
should decrease by inducing reduction the profit to zero
Lets’ find the firm’s supply in the long run with the Cobb-Douglas
production function

f x1 , x2   x x
a b

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1 2

B.Cesi, Microeconomics 2019

First order conditions

f x1 , x2 
p  w1  pax1a 1 x2b  w1  0
x1
f x1 , x2 
p  w2  pbx1a x2b 1  w2  0
x2
15
 pax1a x2b  w1 x1  0
pbx1a x2b  w2 x2  0
Given y  x1a x2b
pay  w1 x1
pby  w2 x2
Solving wrt x1 x2
pay
x 
*
1
w1
pby
x2 
*

w2
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 By substituting into the production function..

a b
 pay   pby 
y     
 w1   w2 
a b
 pa   pb  ab
y      y
 w1   w2 
Firm’s supply is:
a b
 pa  1 a b  pb  1 a b
y     
 w1   w2 

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 Given:
     
f tx1 , tx2  tx1 tx2  t x1 x2
a a b a b
b

tf x1 , x2   t x1a x2b 

with a+b=1, constant return to scale because

   
t x1a x2b  t a b x1a x2b  tf x1 , x2   f tx1 , tx2 
with a+b>1, increasing return to scale because

   
t x1a x2b  t a b x1a x2b  tf x1 , x2   f tx1 , tx2 
with a+b<1, decreasing return to scale because

   
t x1a x2b  t a b x1a x2b  tf x1 , x2   f tx1 , tx2 
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With Constant Return to scale the supply is not well defined
a b
 
 pa  1 a b  pb  1 a b  pa   pb 
y              

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 w1   w2   w1   w2 

B.Cesi, Microeconomics 2019

As long as input/output prices are consistent with the zero profit
(Remind we are in the long run)
a firm with Cobb-Douglas technology is indifferent about its level of
supply (ant level is a solution) 19