Section 3

Profit Maximization with one

input and one output

Dr. MH Lefophane
 Production functions
 Factor- product relationship- production of Y with X.
 Objective: Profit maximization
 Therefore, prices of the input and output in addition to
the quantities of input and output are required.
 Key Question: What is the optimum amount of X to
apply and Y to produce in order to Maximize Profit?
 2 Approaches:
(1) Total Value Product (TVP).
(2) Total Factor Cost (TFC) Approach
 Profit maximisation: TVP Approach
 Total Value Product (TR)- the price of output, Y,
times amount of output, Y.
 TPP=Y
 Therefore, TVP (TR)=Py.Y or TPP. Py (derive Y &
Py)
 Under the assumption of perfect competition, a
farmer can sell as much as needed at the prevailing
market price.
 The shape of the TVP is the same as the shape of the
TPP because under perfect competition, the price of
output is assumed to be constant.
 Profit maximisation: TVP Approach
 TVP (TR)= Py.Y
dTVP (TR) = Py.d(Y)
d(Y) d(Y)
 Therefore: MVP (MR)= Py
 MVP (MR)- is the change in total value product
associated with 1 unit increase in output.
 MVP is the slope of the TVP (TR) function
 Optimum amount of output- the amount of output
that maximises the individual farmer’s profit.
(MR=Py).
.
 Profit maximization: TFC Approach
 TRC=TFC=the price of input times amount of input.
TFC=Px.X (Derive X & Px)
dTFC = Px.d(X) d(TFC) =MFC
d(X) d(X) d(x)
 Therefore: MFC= Px
 MFC- defined as the change in total cost associated with one unit
increase in input usage.
 MFC is the cost of the incremental unit of X.
 MFC= Slope of the TFC function
 The amount of input that maximises the individual farmer’s
profit (MFC= Px).
 Profit maximization: TFC Approach
 Under the assumption of perfect competition, a
farmer can purchase as much as input as needed
at the prevailing market price.
 The market price for the input, factor, or resource
is called the Total Factor Cost (TFC) or Total
Resource Cost (TRC).
 TRC increases as the level of input purchased
increases.
 This is because under perfect competition the
price of output is constant.
 Profit maximisation: TV & TC Approaches

 A farmer aims to maximize the net returns or profit.

 Profit (π)= TVP- TFC. ……………….(1)

=Py.Y- Px.X………………..(2)
d(π) = Py.d(Y)- Px. d(X)
d(x) d(x) d(x)
0= Py. d(y)- Px
d(x)
d(y) =MPP
d(x)
Therefore, Py.MPP=Px
Py.MPP= VMP; Therefore, VMP=Px=MFC
(Profit maximization condition).
 Profit maximisation: Summary
 MFC=Px (Condition for input optimization)
 MVP= Py (Condition for output optimization)
 VMP= Px=MFC (Condition for profit
maximization.
 MPP=Px (Factor-Product Price ratio)

Py
 Ep= TFC

TVP
 Condition for profit maximization
 Condition for profit maximization:
 VMP= Px=MFC
 MPP=Px (Factor-Product Price ratio)
Py
 Ep= TFC
TVP
 Profit maximisation: MPP and EPP
 VMP= Px (Derive MPP)
Py.MPP =Px
Py Py
MPP=Px (Factor-Product Price ratio)
Py
 This means that the condition for profit maximised requires
MPP to be equal to input/output price ratio or factor/ product
price ratio (Px/Py).
 Dividing both sides of the equation MPP=Px/Py by APP will
result in MPP/APP=TFC/TVP=Ep.
 This means that the condition for profit maximisation also
occurs where the elasticity of production is equal to the ratio of
TFC to TVP.
TVP= Py.Y (Derive AVP) AVP=Py.APP
 Necessary and Sufficient Conditions for Profit
Maximization
 The sufficient condition for profit maximization:
 Slope of the function be equal to zero
 Necessary condition= the first-order condition or the
first derivative test.
 Sufficient condition= the second-order condition or
the second derivative test.
 Summary:
 Necessary condition: VMP=Px=MFC
 Sufficient condition: VMP=0; The VMP function
must be less than the MFC. This condition is met if
VMP slopes downward and MFC is constant.
 Condition for profit maximization
 Condition for profit maximization:
 VMP= Px=MFC
 MPP=Px (Factor-Product Price ratio)
Py
 Ep= TFC
TVP
 Profit maximisation: Decision rule
 VMP= is the return obtained from the incremental
unit of X or the value to the manager of the
incremental unit of X.
 The equation VMP=MFC=Px is a decision rule
which tells the farmer how much input should be
used to maximise profit.
 Decision rule:
 The use of inputs should be increased until the last
rand spent on the inputs returns exactly its
incremental cost.
 VMP = 1; VMP < 1; VMP > 1

MFC MFC MFC

 Profit maximisation: Decision rule
 Now suppose VMP/MFC= 1
 The equation states that the last rand spent on the input in
terms of its contribution to revenue for the farm is exactly its
cost.
 Revenue from the sale of output produced by the last unit of
inputs covers exactly the cost or price of inputs.
 The last rand returns exactly 1 rand. The last rand spent on the
inputs returns exactly its incremental cost. In this case,
necessary condition for profit maximization holds; hence, there
is no need to increase or decrease the use of the input.
 Profit maximisation: Decision rule
 Now suppose VMP/MFC=3
 The equation states that the value of the last rand spent on the
inputs in terms of its contribution to revenue of the farm is 3
times its cost. The last rand spent on the inputs returns R3 to
the famers. The value R 3.00 is called the imputed value or
implicit worth or shadow price.
 Shadow price is not the price that the farmer might pay for the
use of inputs but rather the value of a rand spent on the input.
 Profit maximisation: Decision rule
 Profit maximisation requires that the value of the rand
spent on the input to be a rand.
 If profit is maximised, the imputed value of an input will be
1, since its contribution to revenue exactly covers the cost.
 If imputed value is 3, as in this instance, profit could be
further increased by increasing the use of input until the
last rand spent on inputs is equal to 1.
 Profit maximisation: Decision rule
 Now suppose VMP/MFC= 0.5
 The equation states that the last rand spent on the input in
terms of its contribution to revenue for the farm is only half
its cost.
 Revenue from the sale of output produced by the last unit of
inputs only covers 50% of the cost or price of inputs.
 The last rand returns only 50%. The other 50% is lost. In this
case, profits could be increased by reducing the use of inputs.