26.02.

2020

Lecture

PROFIT MAXIMISATION

Supply
Output Markets
Goods
Services

FIRMS

Input Markets:
Labor (wages)
Demand Capital (profit, interest)
Land (rent)
Gumpper – July 2007 2

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The Behavior of
Profit-Maximizing Firms:

Firms make three basic

decisions:

 How much output to supply?

 How to produce that output?
 How much of each input to
demand ?

Profit

 The difference between total

revenue and total costs:

Profit = Total Revenue (TR) - Total Cost (TC)

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The Production Costs:

The production costs– the value of inputs sustained in getting

the individual product.

What factors influence the level of production costs???

Fixed and Variable Costs

 Total output is a function of variable inputs and

fixed inputs.
 Therefore, the total cost of production equals the
fixed cost (the cost of the fixed inputs) plus the
variable cost (the cost of the variable inputs)

 Therefore, Total cost can be separated into

variable cost, VC(q), and fixed cost, FC
TC = FC + VC(q) = TC(q)

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 A cost is variable if it depends on quantity

produced
 Examples: paper costs for a publisher, flour costs
for a baker, bottle costs for a wine-maker

 A cost is fixed if it does not depend on the quantity

produced. Cost paid by a firm that is in business
regardless of the level of output

 Examples: the rent, administrative costs

TC = FC + VC(q) = TC(q)

C C C
TC
VC VC

FC FC

Q Qmax Q Qmax Q

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Variable cost (VC) can be separated into: variable cost of

labour VCL(q) and variable cost of materials VCM(q):

VC = VCL(q) + VCM(q) = VC(q)

 Average Total Cost (ATC) is the cost per unit of

output, or average fixed cost (AFC) plus average
variable cost (AVC). This can be written:

TC
ATC  AFC  AVC or
Q

Average total cost tells what is the average cost of all inputs of
producing one unit of output at the given level of production.

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Average variable cost (AVC) the ratio of variable cost

(of materials and labour) to the output:

AVC = VC(q)/q = AVC(q)

Average variable cost tells what is the average cost of

variable inputs (materials and labour) of producing one unit
of output at the given level of production.

Average fixed cost(AFC) is the ratio of fixed cost to the

amount of output:
AFC = FC/q = AFC(q)

REMEMBER:
AC(q) > AVC(q)
Because AC is the sum of AVC and AFC.

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Average costs
TC
AC =
Q
TC = FC + VC : Q
TC = FC+ VC
Q Q Q
AC = AFC + AVC
AVC AC
C C C AVC

AFC

Q Q Q

 Marginal Cost (MC) is the cost of

expanding output by one unit.

 The increase in total cost that results

from producing one more unit of output,
the additional costs of the next unit.

MC = ∆TC / ∆q
When the function of total cost is given:
MC = dTC/ dq = MC(q)

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MC

AC
AVC
min AC
min AVC

min MC

Q1 Q2 QT Qmax Q

QT - technological optimization

Maximisation of
profits:
(perfect competition model)

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Perfectly Competitive Markets

 Characteristics of Perfectly
Competitive Markets

1)Price taking

2)Product homogeneity

3)Free entry and exit

Perfectly Competitive Markets

 Price Taking
 The individual firm sells a very small
share of the total market output and,
therefore, cannot influence market
price.

 The individual consumer buys too small

a share of industry output to have any
impact on market price.

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Perfectly Competitive Markets

 Product Homogeneity
 The products of all firms are perfect
substitutes.

 Examples
 Agricultural products, oil, copper, iron,
lumber

Perfectly Competitive Markets

 Free Entry and Exit

 Buyers can easily switch from one
supplier to another.

 Suppliers can easily enter or exit a

market.

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Marginal Revenue, Marginal Cost,

and Profit Maximization

 Determining the profit maximizing

level of output
 
Profit ( ) = Total Revenue - Total Cost
 Total Revenue (TR) = P * Q
 Total Cost (TC) = VC + FC
 Therefore:
 = TR - TC

Marginal Revenue, Marginal Cost,

and Profit Maximization

 Marginal revenue is the additional

revenue from producing one more unit of
output.
TR
MR 
q
 Marginal cost is the additional cost from
producing one more unit of output.

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Demand and Marginal Revenue Faced

by a Competitive Firm
Price Price
$ per Firm $ per Industry
bushel bushel

$4 d $4

Output Output
100 200 (bushels)
100 (millions
of bushels)

Marginal Revenue, Marginal Cost,

and Profit Maximization

 The Competitive Firm

 The competitive firm’s demand
 Individual producer sells all units for $4
regardless of the producer’s level of output.
 If the producer tries to raise price, sales are
zero.

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Marginal Revenue, Marginal Cost,

and Profit Maximization

 The Competitive Firm

 The competitive firm’s demand
 If the producers tries to lower price he
cannot increase sales
 P = D = MR = AR

How much to produce?

TC, TR Upper
breakeven TR
point

Max. profit

TC
Lower
breakeven
point

0 Q

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TC, TR
TR

TC QD/G - breakeven points

0 Q
P, AC
AC

P = MR

Losses Profit Losses

Q
QD QG

Breakeven points:
PROFIT [Π(q)=0] , so: TR(q) = TC(q)

because: TR(q)/q = TC(q)/q

THEN:

AC(q) = p
 The Competitive Firm
 Profit Maximization

MC(q) = MR = P

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TC, TR
Profit maximisation
TR

TC QD/G - breakeven points

0 Q
MC
P, AC, MC
AC

P = MR

min AC QT - technological optimum

QE - economical optimum

Q
QD QT QE QG

Profit

P MC
AC
AVC
P = MR
Total profit

Unit profit

QT QE Q

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The loss

P MC
AC
AVC

Total loss Unit Loss

P = MR

Q1 QT Q

The minimal price and shutdown point

P MC
AC
AVC
P = MR

Pmin

Pshutdown

Qshut Qmin QE Q

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Choosing Output in the Short Run

 Summary of Production Decisions

 Profit is maximized when MC = MR
 If P > ATC the firm is making profits.
 If AVC < P < ATC the firm should produce at
a loss.
 If P < AVC < ATC the firm should shut-down.

A Competitive Firm’s
Short-Run Supply Curve

 Observations:
 P = MR
 MR = MC
 P = MC

 Supply is the amount of output for

every possible price.

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A Competitive Firm’s
Short-Run Supply Curve
Price
($ per
unit) Supply = MC above AVC
MC
P2 ATC

P1 AVC

P = AVC

Shut-down
Output
q1 q2

A Competitive Firm’s
Short-Run Supply Curve

 Observations:
 Supply is upward sloping due to
diminishing returns.
 Higher price compensates the firm for
higher cost of additional output and
increases total profit because it applies to
all units.
 The short-run market supply curve shows the
amount of output that the industry will produce in
the short-run for every possible price.

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THE TASKS

Interpret values of individual costs

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TASK 2:
There are given functions of the variable labour cost (VCL) and
variable cost of materials (VCM)

VCL = 0,2 * Q^2

VCM = 2 * Q
where: Q – output in tons, VCL i VCM – costs in ths.zl.
Fixed costs FC = 80 ths. zł.

1. Write the function of total cost TC

2. Write the function of marginal costs MC
3. Write the function of average total cost ATC
4. Calculate at which amount of output, the average total cost
ATC will be the smallest (technological optimum).

Ad1.
TC = VCL + VCM + FC
TC = 0,2 * Q^2 + 2*Q + 80

Ad2.
MC = dTC / dQ
MC = 0,4 * Q + 2

Ad3.
AC = TC / Q
AC = 0,2 * Q + 2 + 80/Q

Ad4.
MC = AC
0,4*Q + 2 = 0,2 * Q + 2 + 80/Q
Q=20 tons

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TASK 3:
If the price of 1 ton of product = 12 ths. zł., and
function of total cost: TC = 0,2 * Q^2 + 2 * Q + 80,

Calculate lower and upper breakeven points, and the

economical optimum point (maximisation of profits)
P = AC
AC = TC / Q = 0,2 Q + 2 + 80 / Q = P = 12
0,2 Q – 10 + 80/Q = 0
0,2Q^2 – 10Q + 80 = 0
Qd= 10 ton
Qg = 40 ton

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