Module 1: Part 2

The Profit Maximizing Framework: Set-up and Revenues/Demand

Broadly, our objective is to help you develop a set of tools that will allow you to make
more effective decisions.

The Profit Maximizing Framework:

To begin, what is the objective (y) for a firm when making decisions?

We will assume that the firm’s objective is to maximize profits:

Does this assumption seem reasonable?

Profit maximization is likely the most appropriate objective for our general framework,
but if you have a different objective then set up the problem accordingly.

Define: profits = total revenue – total costs

Where: total revenues = price * quantity: TR = P*Q

Suppose we are interested in deciding how much output to produce for this period.

That is, our decision variable is Q – quantity of output.

So our problem becomes: choose Q to max TR – TC

The key to making this decision is understanding the economic constraints that shape the
relationship between our decision – output – and the two components of profits – total
revenues and total costs.

These economic constraints will form the bulk of our work. Our plan will be to examine
them briefly here, and then elaborate on them throughout the rest of the course.

Link between Q and TR:

So, our primary question here is: when we produce more output what happens to our
total revenue?

It sounds simple, but upon closer inspection it is quite complex.

The relationship between Q and TR depends critically on demand: the relationship

between Q and P.

To see this, consider the following table:

Quantity Price TR = P*Q
0 10 0
1 9 9
2 8 16
3 7 21
4 6 24
5 5 25
6 4 24
7 3 21
8 2 16
9 1 9

The key is that P and Q are NOT independent of each other: if you want to sell more
output, all else equal, you will need to lower price.

Thus, the simplistic notion that if I sell 1 more unit my revenues will go up by the price is
generally wrong, because it neglects the negative relationship between price and Q.

Let’s represent the information in the table with a few equations:

The demand curve:

A relationship between P and Q:

P = 10 – Q: when Q = 0, P = 10, Q = 1, P = 9, and so on…

So, the key question you should be asking yourself is how do we find this equation:
specifically how do we know that the intercept is 10 and the slope is –1.

Now, for the total revenue equation that shows the relationship between Q and TR:

Recall: TR = P*Q

Now, we need to incorporate the demand equation into TR: we do this by substituting
the demand curve into TR for P:

TR = (10-Q)*Q = 10Q-Q2

And this equation is represented in the table: When Q = 1 TR = 9, and so on.

So the TR equation above gives us half the picture – it shows us how our decision (output
choice) will impact revenues and hence profits.

That is, the TR equation shows us the upside of our decision: here is how our revenues
could change when we change our output.
Note that the only information we need is our estimated demand curve: so if we can
estimate a demand curve we can proceed with our work…

Now we need to examine the link between output and costs…