Lecture 12

Principles of Microeconomics: ECO 101

Profit Maximization
Sumaiya Nabi Khan
Profit Maximization
Profits are like the net earnings or take-home pay of a business.

Firms maximize profits because that maximizes the economic benefits to the owners of
the firm. Allowing lower-than-maximum profits is like asking for a pay cut, which few
business owners will voluntarily undertake.

Profit maximization requires the firm to maintain its internal operations efficiently
(prevent waste, choose efficient production process, and so forth), and to make sound
decisions in the market place (buy the correct quantity of inputs at least cost and choose
the optimal level of output).
Profit Maximization
Profit is defined as total revenue minus total cost.

Π = TR – TC

Total revenue simply means the total amount of money that the firm receives from sales
of its product or other sources.

Total cost means the cost of all factors of production.

Total Revenue and Marginal Revenue
Total revenue (TR) is the total amount of money the firm collects by selling its output.
If P is the price and q is the quantity the firm sells, then
TR = Pq

Average revenue is total revenue (P × Q) divided by the quantity (Q). Therefore, for all
firms, average revenue equals the price of the good.
PQ
AR 
Q
Marginal revenue is the change in total revenue from increasing quantity by one unit.
That is,
TR
MR 
q
Four Broad Categories of Market Types
Based on the degree of competition in the market there are four broad categories of
market types:

Perfect Competition
Monopoly
Monopolistic Competition
Oligopoly
Perfect Competition: Characteristics
Under perfect competition, there are many small firms, each producing an identical or
homogenous product.

The firms are too small relative to its market that it cannot affect the market price. They
always take the market price as given because it cannot lower the market price by selling
more or raise the market price by selling less. The firms are called price takers.

So, for a price-taking firm, the additional revenue generated by producing one more unit
(MR) is always the market price (P).

MR = P
Perfect Competition: Characteristics
The firms in perfect competition face a completely horizontal demand curve (completely
elastic) even though the market demand curve is downward slopping. A perfect competitor
has such a small fraction of the market that it can sell all it want at the market price.
Profit Maximization Problem
The cost data for output from 0 to 8 gallons is given in the following table for a firm
called the Vaca Family Dairy Farm operating in competitive market. If a gallon of milk
sells
for $6, that is market price is fixed at price P= $6:

1. Calculate the total revenue for each quantity.

2. Calculate profit for each quantity. How much should the firm produce to
maximize profit?
3. Calculate marginal revenue and marginal cost for each quantity. At what
quantity do these values become equal? How does this relate to your answer to part
(2)?
Profit Maximization Problem

Quantity (Q) Total Cost

(gallons) (TC)
0 3
1 5
2 8
3 12
4 17
5 23
6 30
7 38
8 47