Behaviour: Profit maximisation

Introduction
• Definitions: Profit; costs; revenue
• Many possible octions:
• Revenue and cost as functions of these actions as
𝑅 𝑎1 , 𝑎2 , … , 𝑎𝑛 ;
𝐶 𝑎1 , 𝑎2 , … , 𝑎𝑛 :
The basic assumption of most economic analysis of firm behaviour is profit
maximisation.; i.e
max 𝑅 𝑎1 , 𝑎2 , … , 𝑎𝑛 − 𝐶 𝑎1 , 𝑎2 , … , 𝑎𝑛
• Two basic principles emerge from the assumption of profit maximisation
at this level.
– 1. at the optimum 𝑎∗ = 𝑎1 , 𝑎2 , … , 𝑎𝑛 ; the MC = MR: If MR > MC increase
production and vice versa
– 2. Firms with identical C and R functions have equal profits in the long run.
• For further analysis we break up the R and C functions into basic parts.
– Revenue is the quantity that a firm sells and prices of the products.
– Cost is the quantity of inputs the firm used and the price of each input.
• The firm’s profit maximisation problem can then be reduced to
the determination of
– 1. the price at which the firm wants to sell its products
– 2. the prices at which it is willing to pay for its inputs
– 3. the quantity of output it wishes to supply, and
– 4. the amount of each input it wishes to use in the process of
producing the quantity it supplies.
• i.e., the firm faces both technical and market constraints in its
optimal operation
• Technical: the feasibility of the production plan.
• Market: the effect of actions of other agents (the WTP of
consumers, the WTA wages
• Price-taking behaviour: Each firm takes the prices in the market
as given
• Such behaviour is justified when we have
– a) well-informed consumers who buy a homogeneous product
– b) fairly large number of firms that supply this homogeneous product.
 Profit maximisation behaviour
• A price-taker firm implies prices are exogenous to the firm:
𝜋 𝐩 = max 𝐩𝐲 s. t. 𝐲 in 𝐘
• where p is a vector of prices and y is the netput vector.
• Profit function: π(p) as a function of prices. Ways of presenting the profit function.
1. Short run costs :
𝜋 𝐩, 𝐳 = max 𝐩𝐲 s. t 𝐲 is in 𝐘(𝐳)
2. Divide the netput vector as output (one product) and inputs we can present it as
𝜋 𝑝, 𝐰 = max 𝑝𝑓 𝐱 − 𝐰𝐱
3. Restrict the function with respect to available costs such that
𝑐 𝐰, 𝑦 = min 𝐰𝐱 s. t. 𝐱 is in V(y)
4. which can, in the short run be restricted as
𝑐 𝐰, 𝑦, 𝒛 = min 𝐰𝐱 s. t. (𝑦, −𝐱) is in V(y)
• Basic profit maximisation behaviour: 1 output firm, lead to the following F. O. C.
𝜕𝜋 𝑝, 𝐰 𝜕𝑓 𝐱 𝜕𝑓 𝐱
=0→𝑝 − 𝑤𝑖 = 0 → 𝑝 = 𝑤𝑖 ∀𝑖 = 1,2, … , 𝑛
𝜕𝑥𝑖 𝜕𝑥𝑖 𝜕𝑥𝑖
• VMP (pfi) must be equal to the price of the factor. (vector algebra presentation
∗ ∗
𝜕𝑓(𝐱 ∗ ) 𝜕𝑓(𝐱 ∗ ) 𝜕𝑓(𝐱 ∗ )
𝑝𝐃𝑓 𝐱 = 𝐰, where 𝐃𝑓 𝐱 = , ,…,
𝜕𝑥1 𝜕𝑥2 𝜕𝑥𝑛
 The F. O. C. graphically (1 input case)
• The profit function is given as
𝜋 = 𝑝𝑦 − 𝑤𝑥
• The level sets (iso-profit) for fixed p
and w are straight lines of the form output
output
𝜋 = 𝑝𝑦 + 𝐰𝐱

given by
𝜋 𝑤 Slope = 𝐰/𝑝 𝑦 = 𝑓(𝐱)
𝑦 = + 𝑥
𝑝 𝑝
• The slope the iso-profit line: wage of
the input measured in units of output 𝜋/𝑝
• The vertical intercept is the profit
measured in units of output.
• The point whose vertical intercept is
the greatest and slope is tangent to input
the PF maximizes profit

𝑑𝑓 𝑥 𝑤
=
𝑑𝑥 𝑝
 Second order conditions (S. O. C.)
• One input case:. At x*, the PF must lie • for the case of three inputs we have:
below its tangent line (locally concave)
𝑓11 (𝐱 ∗ ) 𝑓12 (𝐱 ∗ ) 𝑓13 (𝐱 ∗ )
𝑑2𝑓 𝑥
≤0 𝐃𝟐 𝑓 𝐱 ∗ = 𝑓21 (𝐱 ∗ ) 𝑓22 (𝐱 ∗ ) 𝑓23 (𝐱 ∗ )
𝑑𝑥 2 𝑓31 (𝐱 ∗ ) 𝑓32 (𝐱 ∗ ) 𝑓33 (𝐱 ∗ )
• The multiple-input case: the matrix of 2nd
partial derivatives of the production • Therefore, the conditions are
function must be negative semi-definite at ∗ 𝑓11 𝐱 ∗ 𝑓12 (𝐱 ∗ )
x*. The Hessian matrix 𝑓11 𝐱 < 0, >0
𝑓21 (𝐱 ∗ ) 𝑓22 (𝐱 ∗ )
𝜕 2 𝑓(𝐱 ∗ )
𝟐
𝐃 𝑓 𝐱 ∗
=
𝜕𝑥𝑖 𝜕𝑥𝑗
satisfies 𝐡𝐃𝟐 𝑓 𝐱 ∗ 𝐡′ ≤ 𝟎 ∀𝐡 𝑓11 (𝐱 ∗ ) 𝑓12 (𝐱 ∗ ) 𝑓13 (𝐱 ∗ )
• Necessary and sufficient conditions: the and 𝑓21 (𝐱 ∗ ) 𝑓22 (𝐱 ∗ ) 𝑓23 (𝐱 ∗ ) < 0
leading principal minors of the Hessian must 𝑓31 (𝐱 ∗ ) 𝑓32 (𝐱 ∗ ) 𝑓33 (𝐱 ∗ )
alternate in sign. For the case of two inputs • If these hold solve the F. O. C’s for the
we have
𝑓11 (𝐱 ∗ ) 𝑓12 (𝐱 ∗ ) optimal input choice, x*.
𝟐 ∗
𝐃 𝑓 𝐱 = • The optimal input choice is a function of
𝑓21 (𝐱 ∗ ) 𝑓22 (𝐱 ∗ )
• Therefore, the conditions are price of y & w.
∗ 𝑓11 𝐱 ∗ 𝑓12 (𝐱 ∗ ) 𝐱(𝑝, 𝐰)
𝑓11 𝐱 < 0 and >0
𝑓21 (𝐱 ∗ ) 𝑓22 (𝐱 ∗ ) • Supply: y made dependent on p & w
𝑦 𝑝, 𝐰 = 𝑓 𝐱(𝑝, 𝐰)
 Difficulties
• Assumed well behaved input demand and supply functions: problems that may arise
if they are not.
1. The firm’s PF may not be differentiable: derivatives may not exist: Leontief
2. If interior solution: for boundary solutions. the Kuhn-Tucker conditions must hold.
𝜕𝑓 𝐱
𝑝 − 𝑤𝑖 ≤ 0 if 𝑥𝑖 = 0
𝜕𝑥𝑖
𝜕𝑓 𝐱
𝑝 − 𝑤𝑖 = 0 if 𝑥𝑖 > 0
𝜕𝑥𝑖
3. Profit maximizing plan may not exist: Say, the production function of the form
𝑓 𝒙 =𝑥
• CRS e.g. If we want to maximize
max 𝑝𝑥 – 𝑤𝑥
• when p > w, x infinity. A maximal exists when p  w, and the maximal level of profit
will be zero.
• Suppose we can find some (p, w) where optimal profits are strictly positive so that
• 𝑝𝒇 𝐱 ∗ − 𝒘𝐱 ∗ = 𝐱 ∗ > 𝟎
• Scale up the production by a factor t > 1; our profits will now be
• 𝑝𝒇(𝑡𝐱 ∗ ) − 𝒘𝑡𝐱 ∗ = 𝑡 𝑝𝑓(𝐱 ∗ ) − 𝐰𝐱 ∗ ] = 𝑡𝐱 ∗ > 𝐱 ∗ .
 Properties of the demand and supply functions
Factor demand functions
• F.O.C.’s are solved to yield the ordinary factor dd functions dependent on w
and p; Let
𝑥1∗ = 𝑥1∗ (𝑤1 , 𝑤2 , 𝑝)
𝑥2∗ = 𝑥1∗ (𝑤1 , 𝑤2 , 𝑝)
• What happens if the one of the prices change other things constant?
(comparative statics). Assume (simplifying) two inputs we have the following
partial derivatives:
𝜕𝑥1∗ 𝜕𝑥1∗ 𝜕𝑥2∗ 𝜕𝑥2∗ 𝜕𝑥1∗ 𝜕𝑥2∗
, , , , ,
𝜕𝑤1 𝜕𝑤2 𝜕𝑤1 𝜕𝑤2 𝜕𝑝 𝜕𝑝
• Substitute the demand functions back into the F.O.C.’s and derive
𝜕𝑥1∗ 𝜕𝑥2∗
and
𝜕𝑤1 𝜕𝑤2
to obtain
𝜕𝑥1∗ 𝑓22 𝜕𝑥2∗ 𝑓12 𝜕𝑥1∗
= 2
< 0 and =− 2
⋛0
𝜕𝑤1 𝑝 𝑓11 𝑓22 − 𝑓12 𝜕𝑤1 𝑝 𝑓11 𝑓22 − 𝑓12 𝜕𝑤1
• Why?
• Assignment: Set p = 1 and obtain the result using matrix algebra
 Hessian matrix
• The matrix of the SOC of the maximization procedure is known
as the Hessian Matrix; which is given as:
𝜕𝑥1∗ 𝜕𝑥1∗
𝜕𝑤1 𝜕𝑤2 𝑓11 𝑓12 −1
∗ ∗ =
𝜕𝑥2 𝜕𝑥2 𝑓21 𝑓22
𝜕𝑤1 𝜕𝑤2
• The Hessian matrix is symmetric and negative definite matrix
(from the S.O.C.’s)
• The inverse of a symmetric negative definite matrix is a
symmetric negative definite matrix, therefore
1. 𝜕𝑥𝑖∗ / 𝜕𝑤𝑖 ≤ 0 for i = 1, 2,..n: Diagonal entries of a - definite
matrix must be negative.
2. 𝜕𝑥𝑖∗ / 𝜕𝑤𝑗 = 𝜕𝑥𝑗∗ / 𝜕𝑤𝑖 ≤ 0 for all 𝑖 ≠ 𝑗, by symmetry of the
matrix
• 1 is intuitive not 2 but is a result of maximization
• The supply function
i. Direct approach: substitute the demand functions into the production
function: two factor case
𝑦 ∗ 𝑤1 , 𝑤2 , 𝑝 = 𝑓 𝑥1∗ 𝑤1 , 𝑤2 , 𝑝 , 𝑥2∗ 𝑤1 , 𝑤2 , 𝑝
a. differentiate w.r.t. p to obtain
𝜕𝑦 ∗ 𝜕𝑥1∗ 𝜕𝑥2∗
= 𝑓1 + 𝑓2
𝜕𝑝 𝜕𝑝 𝜕𝑝
b. differentiate F.O.C.’s with respect to p
𝜕𝑥1∗ 𝜕𝑥2∗
𝑓1 + 𝑝𝑓11 + 𝑝𝑓12 =0
𝜕𝑝 𝜕𝑝
∗
𝜕𝑥1 𝜕𝑥2∗
𝑓2 + 𝑝𝑓21 + 𝑝𝑓22 =0
𝜕𝑝 𝜕𝑝
• From this simultaneous equations system solve for
𝜕𝑥1∗ 𝑓2 𝑓12 − 𝑓1 𝑓22 𝜕𝑥2∗ 𝑓1 𝑓12 − 𝑓2 𝑓11
= 2 and 𝜕𝑝 =
𝜕𝑝 𝑝 𝑓11 𝑓22 − 𝑓21 𝑝 𝑓11 𝑓22 − 𝑓21 2
• Use these in the result in a. to get
𝜕𝑦 ∗ 𝑓2 𝑓12 − 𝑓1 𝑓22 𝑓1 𝑓12 − 𝑓2 𝑓11
= 𝑓1 2 + 𝑓2
𝜕𝑝 𝑝 𝑓11 𝑓22 − 𝑓21 𝑝 𝑓11 𝑓22 − 𝑓21 2
ii) Indirect approach (Hotelling’s Lema)
• Evaluated at the maximized profit
𝜕𝜋 ∗ 𝑝, 𝐰
= 𝑦∗
𝜕𝑝
• Proof
• Insert the direct factor demand equations into the profit
function
𝜋 ∗ 𝑝, 𝐰 = 𝑝𝑓 𝑥1∗ 𝑤1 , 𝑤2 , 𝑝 , 𝑥2∗ 𝑤1 , 𝑤2 , 𝑝 − 𝑤1 𝑥1∗ 𝑤1 , 𝑤2 , 𝑝 − 𝑤2 𝑥2∗ 𝑤1 , 𝑤2 , 𝑝
• Take its partial derivative
𝜕𝜋∗ 𝑝,𝐰 𝑤1 𝜕𝑥1∗ ∙ 𝑤2 𝜕𝑥2∗ ∙
• = 𝑓 ∙ + 𝑝 𝑓1 − + 𝑝 𝑓2 −
𝜕𝑝 𝑝 𝜕𝑝 𝑝 𝜕𝑝
• and using the F.O.C.’s
𝜕𝜋 ∗ 𝑝, 𝐰
= 𝑓 𝑥1∗ ∙ , 𝑥2∗ ∙ = 𝑦∗
𝜕𝑝
 Properties of the profit function
The profit function is
1. Non-decreasing in p and non-increasing in w, i.e.,
𝑎) 𝑝1 ≥ 𝑝0 → 𝜋 𝐰, 𝑝1 ≥ 𝜋 𝐰, 𝑝0
𝑏) 𝐰1 ≥ 𝐰 0 → 𝜋 𝐰1 , 𝑝 ≤ 𝜋 𝐰 0 , 𝑝
2. Homogeneous of degree 1 in p and w
𝜋 𝑡𝐰, 𝑝 ≤ 𝜋 𝐰, 𝑝
3. Convex in p, and i.e.,
If 𝑝2 = 𝑡𝑝0 + (1 − 𝑡)𝑝1 then 𝜋( 𝑝2 ) ≤ 𝑡𝜋(𝑝1 ) + (1 − 𝑡)𝜋(𝑝0 ).
4. Continuous.
The envelope theorem
• Taking one input-one output, the profit maximized is a function of
w and p
𝜋 ∗ 𝑤, 𝑝 = max 𝑝𝑓 𝑥 ∗ 𝑝, 𝑤 − 𝑤𝑥 ∗ 𝑝, 𝑤
Then
𝑑𝜋 ∗ 𝑤, 𝑝 𝑑𝜋 ∗ 𝑤, 𝑝
=𝑓 𝑥∗ 𝑝, 𝑤 and = −𝑥 ∗ 𝑝, 𝑤
𝑑𝑝 𝑥 ∗ =𝑥 ∗ 𝑝,𝑤
𝑑𝑤 𝑥 ∗ =𝑥 ∗ 𝑝,𝑤
 Cost minimization
The problem:
min 𝐰𝐱 s. t. 𝐱 ∈ 𝑉 𝑦 0 or s. t. 𝑓 𝐱 = 𝑦 0
• To solve we use the Lagrangean
𝐿 𝑥1 , 𝑥2 , 𝜆 = 𝑤1 𝑥1 + 𝑤2 𝑥2 − 𝜆 𝑓 𝑥1 , 𝑥2 − 𝑦 0
• The F.O.C.’ are then given as
𝜕𝐿
= 0 → 𝑤1 − 𝜆𝑓1 = 0 → 𝑤1 = 𝜆𝑓1
𝜕𝑥1
𝜕𝐿
= 0 → 𝑤2 − 𝜆𝑓2 = 0 → 𝑤2 = 𝜆𝑓2
𝜕𝑥2
𝜕𝐿
= 0 → 𝑓 𝑥1 , 𝑥2 − 𝑦 0 = 0 → 𝑓 𝑥1 , 𝑥2 = 𝑦 0
𝜕𝜆
• The S.O.C.’s are:
−𝜆𝑓11 −𝜆𝑓12 −𝑓1
−𝜆𝑓21 −𝜆𝑓22 −𝑓2 ≤ 0
−𝑓1 −𝑓2 0
• All the bordered Hessians are negative.
• The solutions to the FOC’s give us the “conditional factor demand functions”
𝑥1∗ = ℎ1∗ (𝑤1 , 𝑤2 , 𝑦 0 )
𝑥2∗ = ℎ2∗ (𝑤1 , 𝑤2 , 𝑦 0 )
𝜆∗ = 𝜆∗ (𝑤1 , 𝑤2 , 𝑦 0 )
• (Indirect) cost function: Substitute ℎ1∗ into the objective
function
𝐶 ∗ 𝑤1 , 𝑤2 , 𝑦 0 = 𝑤1 ℎ1∗ 𝑤1 , 𝑤2 , 𝑦 0 + 𝑤2 ℎ2∗ (𝑤1 , 𝑤2 , 𝑦 0 )
• Minimum cost associated with the y and w.
Properties of the cost function
• The cost function is:
1. Non-decreasing in w.
𝑓 𝐰1 ≥ 𝐰 0 , then 𝐶(𝐰1 , 𝑦) ≥ 𝐶(𝐰 0 , 𝑦)
2. Homogeneous of degree 1 in w.
𝐶(𝑡𝐰, 𝑦) = 𝑡𝐶(𝐰, 𝑦) for 𝑡 > 0.
3. Concave in w. i.e,
𝐶(𝑡𝐰 + (1 − 𝑡)𝐰, 𝑦) ≥ 𝑡𝐶(𝐰, 𝑦) + (1 − 𝑡)𝐶(𝐰, 𝑦)
4. The cost function is continuous by assumption.
• The surprising property is concavity. As a factor becomes
more expensive with other input prices constant, firms will
substitute the relatively expensive one.
 The Shepard’s lemma
• if the cost function is differentiable at (w, y),
and wi > 0 for I = 1, 2, ..., n then
𝜕𝐶 𝐰,𝑦
• 1. = ℎ𝑖 𝐰, 𝑦
𝜕𝑤𝑖
𝜕2 𝐶 𝐰,𝑦 𝜕ℎ𝑖 𝐰,𝑦
• 2. = ≤0
𝜕𝑤𝑖2 𝜕𝑤𝑖
𝜕ℎ𝑖 𝐰,𝑦 𝜕ℎ𝑗 𝐰,𝑦
• 3. = ≤0
𝜕𝑤𝑗 𝜕𝑤𝑖