Chapter Two: Profit-Maximization

Chapter Two
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  pnyn 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 firm’s stream of
periodic economic profits is
 … and r is the rate of
interest.
 Then the present-value of the firm’s
economic profitstream
1 is
2 
PV   0  
1  r (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 firm’s 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 line’s 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  .
p p
w1 ~
  w 2x 2
y x1 
p p
has a slope of
w1

p
and a vertical intercept of
~
  w 2x 2
.
p
y i ng
a s
c e
r fit
I n    
pro    
  
w1
Slopes  
p
x1
Short-Run Profit-Maximization
 The firm’s problem is to locate the

production plan that attains the
highest possible iso-profit line, given
the firm’s constraint on choices of
production plans.
 Q: What is this constraint?
 The firm’s problem is to locate the

production plan that attains the
highest possible iso-profit line, given
the firm’s 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
s i n    
e a
r fit
I nc    
pro    ~ )
y  f ( x1 , x 2
w1
Slopes  
p
x1
y
   
   
  
w1
y* Slopes  
p
x*1 x1
~ , the short-run
Given p, w1 and x 2  x 2 * ~
y *
profit-maximizing plan is ( x1 , x 2 , y ).
   
w1
y* Slopes  
p
x*1 x1
~ , the short-run
Given p, w1 and x 2  x 2 * ~
y *
profit-maximizing plan is ( x1 , x 2 , y ).
And the maximum    
possible profit
is   . w1
y* Slopes  
p
x*1 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
y* Slopes  
p
x*1 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
y* Slopes  
w1 p
MP1 
p
* ~ *
at ( x , x , y )
1 2
x*1 x1
w1
MP1   p  MP1  w 1
p
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  w 1 then profit increases with x 1.
If p  MP1  w 1 then profit decreases with x 1.
Short-Run Profit-Maximization; A
Cobb-Douglas Example
Suppose the short-run production
3 ~ 1/ 3
function is y  x1/
1 x2 .
The marginal product of the variable
input 1 is  y 1  2/ 3~ 1/ 3
MP1   x1 x 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
Solving ( x1 ) x 2  w 1 for x1 gives
3
*  2/ 3 3w 1
( x1 )  .
px ~ 1/3
2
p *  2 / 3 ~ 1/ 3
3
*  2/ 3 3w 1
( x1 )  .
px ~ 1/3
2
That is, ~ 1/ 3
* 2 / 3 px 2
( x1 ) 
3w 1
p *  2 / 3 ~ 1/ 3
3
*  2/ 3 3w 1
( x1 )  .
px ~ 1/3
2
That is, ~ 1/ 3
* 2 / 3 px 2
( x1 ) 
3w 1
3/ 2 3/ 2
 ~ 1/ 3   p 
*  px 2  ~ 1/ 2
so x1      x2 .
 3w 1   3w 1 
3/ 2
*  p  ~ 1/ 2
x1    x2
is the firm’s
 3w 1 
short-run demand
for input 1 when the level of input 2 is
~ units.
fixed at x 2
3/ 2
*  p  ~ 1/ 2
x1    x2
is the firm’s
 3w 1 
short-run demand
for input 1 when the level of input 2 is
~ units.
fixed at x 2
The firm’s short-run output level is thus
1/ 2
* * 1/ 3 ~ 1/ 3  p  ~ 1/ 2 .
y  ( x1 ) x 2    x 2
 3w 1 
Comparative Statics of Short-Run
Profit-Maximization
 What happens to the short-run profit-
maximizing production plan as the
output price p changes?
Profit-Maximization
The equation of a short-run iso-profit line
is w1   w 2x~
y x1  2
p p
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
x*1 x1
Profit-Maximization
y
~ )
y  f ( x1 , x 2
y*
w1
Slopes  
p
x*1 x1
Profit-Maximization
y
~ )
y  f ( x1 , x 2
y*
w1
Slopes  
p
x*1 x1
Profit-Maximization
 An increase in p, the price of the
firm’s output, causes
– an increase in the firm’s output
level (the firm’s supply curve
slopes upward), and
– an increase in the level of the firm’s
variable input (the firm’s 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 firm’s short-run
demand for its variable input 1 is
3/ 2
*  p  ~ 1/ 2
x1    x2 and its short-run
 3w 1 
1/ 2 supply is
*  p  ~ 1/ 2 .
y   x 2
 3w 1 
Profit-Maximization
1/ 3 ~ 1/ 3
3/ 2
*  p  ~ 1/ 2
 3w 1 
1/ 2 supply is
*  p  ~ 1/ 2
y   x2 .
 3w 1 
x*1 increases as p increases.
Profit-Maximization
1/ 3 ~ 1/ 3
3/ 2
*  p  ~ 1/ 2
 3w 1 
1/ 2 supply is
*  p  ~ 1/ 2
y   x2 .
 3w 1 
x*1 increases as p increases.
y* increases as p increases.
Profit-Maximization
 What happens to the short-run profit-
maximizing 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 
p p
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
x*1 x1
Profit-Maximization
y    
   
  
~ )
y  f ( x1 , x 2
y*
w1
Slopes  
p
x*1 x1
Profit-Maximization
y    
   
  
~ )
y  f ( x1 , x 2
w1
Slopes  
y* p
x*1 x1
Profit-Maximization
 An increase in w1, the price of the
firm’s variable input, causes
– a decrease in the firm’s output level
(the firm’s supply curve shifts
inward), and
– a decrease in the level of the firm’s
variable input (the firm’s demand
curve for its variable input slopes
downward).
Profit-Maximization
1/ 3 ~ 1/ 3
3/ 2
*  p  ~ 1/ 2
 3w 1 
1/ 2 supply is
*  p  ~ 1/ 2 .
y   x 2
 3w 1 
Profit-Maximization
1/ 3 ~ 1/ 3
3/ 2
*  p  ~ 1/ 2
 3w 1 
1/ 2 supply is
*  p  ~ 1/ 2
y   x2 .
 3w 1 
x*1 decreases as w1 increases.
Profit-Maximization
1/ 3 ~ 1/ 3
3/ 2
*  p  ~ 1/ 2
 3w 1 
1/ 2 supply is
*  p  ~ 1/ 2
y   x2 .
 3w 1 
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 
p p
so an increase in x2 causes
-- no change to the slope, and
-- an increase in the vertical intercept.
y
y  f ( x1 , x 2 )
x1
y
y  f ( x1 , 3x 2 )
y  f ( x1 , 2x 2 )
y  f ( x1 , x 2 )
x1
Larger levels of input 2 increase the
productivity of input 1.
y
y  f ( x1 , 3x 2 )
y  f ( x1 , 2x 2 )
y  f ( x1 , x 2 )
The marginal product
of input 2 is
diminishing.
x1
y
y  f ( x1 , 3x 2 )
y  f ( x1 , 2x 2 )
y  f ( x1 , x 2 )
of input 2 is
diminishing.
x1
p  MP1  w 1  0 for each short-run
y
production plan.
y  f ( x1 , 3x 2 )
y  f ( x1 , 2x 2 )
y* ( 3x 2 )
y* ( 2x 2 )
y  f ( x1 , x 2 )
y* ( x 2 )
x*1 ( x 2 ) x*1 ( 3x 2 ) x1
x*1 ( 2x 2 )
y
production plan.
y  f ( x1 , 3x 2 )
y  f ( x1 , 2x 2 )
y* ( 3x 2 )
y* ( 2x 2 )
y  f ( x1 , x 2 )
y* ( x 2 ) of input 2 is
diminishing so ...
x*1 ( x 2 ) x*1 ( 3x 2 ) x1
x*1 ( 2x 2 )
y
production plan.
y  f ( x1 , 3x 2 )
y  f ( x1 , 2x 2 )
y* ( 3x 2 )
y* ( 2x 2 )
y  f ( x1 , x 2 )
the marginal profit
y* ( x 2 ) of input 2 is
diminishing.
x*1 ( x 2 ) x*1 ( 3x 2 ) x1
x*1 ( 2x 2 )
 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  w 1  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
3/ 2
*  p  ~ 1/ 2
 3w 1 
1/ 2 supply is
*  p  ~ 1/ 2
y   x2 .
 3w 1 
Short-run profit is therefore …
~
  py*  w 1x*1  w 2x 2
1/ 2 3/ 2
 p  ~ 1/ 2  p  ~ 1/ 2  w x
~
 p  x2  w1  x 2 2 2
 3w 1   3w 1 
~
  py*  w 1x*1  w 2x 2
1/ 2 3/ 2
 p  ~ 1/ 2  p  ~ 1/ 2  w x
~
 p  x2  w1  x 2 2 2
 3w 1   3w 1 
1/ 2 1/ 2
 p  ~ 1/ 2 p  p  ~
 p  x2  w1    w 2x 2
 3w 1  3w 1  3w 1 
~
  py*  w 1x*1  w 2x 2
1/ 2 3/ 2
 p  ~ 1/ 2  p  ~ 1/ 2  w x
~
 p  x 2  w1  x 2 2 2
 3w 1   3w 1 
1/ 2 1/ 2
 p  ~ 1/ 2 p  p  ~
 p  x 2  w1    w 2x 2
 3w 1  3w 1  3w 1 
1/ 2
2p  p  ~ 1/ 2  w x
~
   x 2 2 2
3  3w 1 
~
  py*  w 1x*1  w 2x 2
1/ 2 3/ 2
 p  ~ 1/ 2  p  ~ 1/ 2  w x
~
 p  x2  w1  x 2 2 2
 3w 1   3w 1 
1/ 2 1/ 2
 p  ~ 1/ 2 p  p  ~
 p  x2  w1    w 2x 2
 3w 1  3w 1  3w 1 
1/ 2
2p  p  ~ 1/ 2  w x
~
   x 2 2 2
3  3w 1 
1/ 2
 4p 3
~ 1/ 2  w x
~ .
   x 2 2 2
 27 w 1
1/ 2
 4p 3
~ 1/ 2  w x
~ .
    x 2 2 2
 27 w 1
What is the long-run profit-maximizing

level of input 2? Solve
1/ 2
  1  4p  3
~  1/ 2  w
0  ~    x 2 2
 x 2 2  27w 1 
to get ~  x*  p3
x 2 2 .
27w 1w 22
input 1 level? Substitute
3 3/ 2
x*2 
p *  p  ~ 1/ 2
into x1    x 2
27w 1w 2
2  3w 1 
to get
input 1 level? Substitute
3 3/ 2
x*2 
p *  p  ~ 1/ 2
into x1    x 2
27w 1w 2
2  3w 1 
to get
3 / 2 1/ 2
*  p  p 3  p 3
x1       .
 3w 1   27w 1w 22  27w 12 w 2
output level? Substitute
1/ 2
p 3
*  p  ~ 1/ 2
x*2  into y    x 2
27w 1w 2
2  3w 1 
to get
output level? Substitute
1/ 2
p 3  p 
* ~ 1/ 2
x*2  into y    x 2
27w 1w 2
2  3w 1 
to get
1/ 2 1/ 2
*  p  p 3  p2
y      .
 3w 1   27w 1w 22  9 w 1w 2
So given the prices p, w1 and w2, and
the production function y  x1/ 3 1/ 3
1 x2
the long-run profit-maximizing production

plan is
 p 3
p 3
p 2 
( x*1 , x*2 , y* )   , ,  .
2 2 9w w
 27w 1 w 2 27w 1w 2 1 2
Returns-to-Scale and Profit-
Maximization
 If a competitive firm’s technology
exhibits decreasing returns-to-scale
then the firm has a single long-run
profit-maximizing production plan.
Returns-to Scale and Profit-
Maximization
y
y  f(x)
y*
Decreasing
returns-to-scale
x* x
Maximization
 If a competitive firm’s technology
exhibits exhibits increasing returns-
to-scale then the firm does not have
a profit-maximizing plan.
Maximization
y
as ing
Inc re y  f(x)
ro fit
p
y”
y’ Increasing
returns-to-scale
x’ x” x
Maximization
 So an increasing returns-to-scale
technology is inconsistent with firms
being perfectly competitive.
Maximization
 What if the competitive firm’s
technology exhibits constant
returns-to-scale?
Maximization
y
as ing
I nc re
ro fit y  f(x)
p
y”
Constant
y’ returns-to-scale
x’ x” x
Maximization
 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.
Maximization
 Therefore, when a firm’s 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.
Maximization
y
y  f(x)
=0
y”
Constant
y’ returns-to-scale
x’ x” 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 firm’s 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 profit-
maximizing for the prices (w’,p’).
( x  , y ) is chosen at prices ( w  , p )
y
w
Slope 
p
y
x x
( x  , y ) is chosen at prices ( w  , p ) so
y ( x  , y ) is profit-maximizing at these prices.
w
Slope 
p
y
x x
w
Slope 
p
y
y ( x  , y ) would give higher
profits, so why is it not
chosen?
x  x x
w
Slope 
p
y
chosen? Because it is
not a feasible plan.
x  x x
w
Slope 
p
y
chosen? Because it is
not a feasible plan.
x  x x
So the firm’s technology set must lie under the
iso-profit line.
w
Slope 
p
y
y
The technology
set is somewhere
in here
x  x x
So the firm’s technology set must lie under the
iso-profit line.
( x  , y ) is chosen at prices ( w  , p ) so
y ( x  , y ) maximizes profit at these prices.
w 
Slope 
p
y ( x  , y ) would provide higher
profit but it is not chosen
y
x  x  x
w 
Slope 
p
y because it is not feasible
x  x  x
w 
Slope 
p
y because it is not feasible so
the technology set lies under
the iso-profit line.
x  x  x
w 
Slope 
p
y
The technology set is
also somewhere in
y here.
x  x  x
y The firm’s technology set must lie under
both iso-profit lines
y
y
x  x x
both iso-profit lines
y
The technology set
is somewhere
y in this intersection
x  x x
 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.
all the iso-profit lines ( w  , p )
( w  , p )
( w  , p )
y
y
y
x  x x  x
( w  , p )
( w  , p )
y
y
y
x  x x  x
( w  , p )
( w  , p )
y
y y  f(x)
y
x  x x  x
 What else can be learned from the

firm’s choices of profit-maximizing
production plans?
The firm’s technology set must lie under
y
( w  , p )
y ( x  , y ) is chosen at prices
( w  , p ) so
p y  w  x   p y  w  x  .
y ( x  , y ) is chosen at prices
( w  , p ) so
p y  w  x   p y  w  x  .
x  x 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,
 p y   w  x
is a necessary implication of profit-
maximization.
 p y   w  x
maximization.
Suppose the input price does not change.
Then w = 0 and profit-maximization
implies  p y  0; i.e., a competitive
firm’s output supply curve cannot slope
downward.
 p y   w  x
maximization.
Suppose the output price does not change.
Then p = 0 and profit-maximization
implies 0  w x; i.e., a competitive
firm’s input demand curve cannot slope
upward.

Chapter Two: Profit-Maximization

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Chapter Two: Profit-Maximization

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Chapter Two

 The competitive firm takes all output

The economic profit generated by

 A competitive firm seeks to maximize

 A $ iso-profit line contains all the

 A $ iso-profit line contains all the

 The firm’s problem is to locate the

 The firm’s problem is to locate the

p  MP1 is the marginal revenue product of

 Now allow the firm to vary both input

 Both x1 and x2 are variable.

The equation of a long-run iso-profit line

 The input levels of the long-run

 That is, marginal revenue equals

The Cobb-Douglas example: When

What is the long-run profit-maximizing

the long-run profit-maximizing production

 Consider a competitive firm with a

 If a production plan (x’,y’) is chosen

 Observing more choices of

 What else can be learned from the

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