Profit maximisation

(Ch. 20)

Dr Bibhas Saha
[email protected]
 Objectives:

1. Short- and long-run technologies

2. Maximising profit by directly choosing inputs
3. Short- and long-run input demand functions
4. Output supply
 Short versus long run

´ We need to think in terms of timeframe that a firm is constrained to

operate in

´ Short run
´ 1) Technology (i.e., production function) cannot be changed [the
firm is stuck with the technology it got, even if it is not state of the
art]
´ 2) Some factors of production cannot be adjusted upwardly,
downwardly, or both ways.

´ Long run
´ Every aspect of technology can be potentially changed.
´ All inputs can be freely adjusted.
 Short run

´ Which factors will be difficult to adjust?

´ That depends on the industry, region and country.

´ Example:
´ 1) A university can find a temporary teacher on a short notice, but a film
production company may not quickly replace a screenplay writer.
´ Reason: Apart from the availability, union agreements can be a factor.

´ 2) A café can quickly install a new automatic coffee maker but may not be
able to hire another employee.

´ Assume: one of the two (or many) inputs remains fixed; cannot
be increased or decreased
 Other short-run possibilities

´ Of course, it is possible to adjust some inputs downwardly, but not upwardly

´ Example: In the US an employee can be fired in a moment’s notice. But hiring a

worker requires a minimum amount of time.
´ In the UK, the employer needs to give minimum 1 week to maximum 12 weeks’
notice.

´ When upward adjustment is possible, but not downward

´ Example: Unions object to redundancy, but new staff can be hired from temporary
labour markets.
´ New machines can be bought easily, but may not be easy to resale the old
machines.

´ But we will assume that for some input(s) neither (upward or downward) adjustment
is possible.
 Short run production: Imperfect
substitute inputs

x2

A D
𝑥̅! B C

y’ y’’

x1

Production can be increased only along points A, B, C, D.

If there are diminishing returns to factor, then production
will increase slowly.
 Short run production: Perfect
Complements inputs

x2

𝑥̅!
y’’

y’
y

x1

Production cannot be increased beyond y’’

 Short run production: Perfect
substitute inputs

x2

𝑥̅!

y’’
y y’
x1

Production can be increased without any efficiency loss,

because x2 is not essential.
 Long run

´ How long is the long run?

´ It is hard to tell.
´ [Keynes once famously said: In the long run we are all
dead.]
´ Netflix took ten years to establish itself.
´ Stand alone movie theatres disappeared after 40/50
years of existence.

´ Mathematically: Every input can be adjusted and the

best technology can be acquired.
 Our firm

´ Firms are profit-maximisers

´ Objective: Earn maximum profit [What the firm wants]
´ Action: Maximise profit [How to get that?]

´ Confusing!!
´ For small businesses both are same. But for large corporations
they can be different.

´ Corporations: Managers run the show.

´ Managers may want to maximise sales to give maximum profit
to the shareholders. (That is why we get large discounts in
supermarkets, online streaming services etc.)
 Price-taker firms

´ We assume that our firm is a profit maximiser, but it

cannot change the price of the product and the
prices of any inputs.

´ Key assumption: Firms are price takers in all (inputs

and output) markets they operate in. [Firms have no
market power]

´ These markets are perfectly competitive.

 Short-run profit maximisation
!/# !/#
´ Suppose 𝑦 = 6𝑥! 𝑥$

!/#
´ Assume x2 is fixed at 8 units. 𝑦 = 12𝑥!

´ The firm maximises profit by choosing x1:

!
"
´ 𝜋 = 𝑝𝑦 − 𝑤! 𝑥! − 𝑤$ 𝑥$ = 𝑝12𝑥! − 𝑤! 𝑥! − 8𝑤$

´ Cost of buying 8 units of x2 is a fixed input cost. Cost of

x1 is the variable input cost.
 Short-run profit maximisation
#$
´ FOC: π! 𝑥" = 0 ⟹ #/% = 𝑤"
%"

´ VMP of input 1= input price [VMP: Value of

marginal product]

&$
´ SOC: π!! 𝑥" < 0 ⟹ − & <0
'%"%
´ [Diminishing returns to factor is required]

´ Solution: Input demand for x1 :

#$ '/*
´ 𝑥" =
("
Short-run input demand

´ Cobb-Douglas technology:

´ If 𝑦 = 𝐴𝑥#$ 𝑥%& (with a<1) and x2 is fixed,

then the input demand function for x1 is
of the following form:

' #/(#+$)
´ 𝑥# = 𝐵 (!
where B is a constant
 Properties of the short-run input
demand functions

´ For any technology (regardless of Cobb-Douglas or

not), the following must be true:

´ Input demand is increasing in the product price and

decreasing in the (own) input price.

´ If p and w1 increase by the same proportion, input

demand does not change. [Homogeneous of degree
zero in p and w1]

´ Input demand changes if the real input price (w1/p)

changes.
 Short-run output supply function

´ Substitute x1 into the production function:

#/.
-' ./% ' #/%
´ 𝑦 = 12 (!
= 24 (!

´ More generally, the Cobb-Douglas supply

function is:
$/(#+$)
& $ '
´𝑦= 𝐴𝑥̅% 𝐵
(!

´ Output is positively related to p (a concave

function of price if a<1/2, and a convex function of price if
a>1/2)
Short-run profit function

( */! +( ,/!
´ Profit: 𝜋' = 𝑝24 )!
− 𝑤* )!
− 8𝑤!
"
("/$ ($
´ 𝜋' = 24 !/$ −8 ! − 8𝑤!
)!
)!$

("/$
´ = 16 !/$ − 8𝑤!
)!
Short-run profit function

´ General Cobb-Douglas:
! !
- . !%& ( !%&
´ 𝜋' = 1 − 𝑎 𝐴𝑎 𝑥̅ ! & − 𝑤! 𝑥̅!
)!!%&

´ [You can check it at home. To derive the above

expression go slowly.]

!
. !%&
´ Also check that in our example, 1 − 𝑎 𝐴𝑎- 𝑥̅! =
*
1− 24 = 16
,
x1 y
p

Concave
Because a=1/3
(<1/2)

p p p
−8𝑤!

Input demand Output supply Profit

Short-run functions
 Graphically, when flipping the axes

p p
p

When a<1/2

x1 y −8𝑤! p

Input demand Output supply Profit

Short-run (inverse) functions

 Profit function: Properties

´ Important: For all profit functions

´ Profit is a convex and increasing function of

the output price

´ If all input prices and the output price are

doubled, profit is doubled!! [ homogeneous
of degree 1]
 Profit function

´ For short-run profit function price must be above a

critical level to have positive profit, because some
inputs are fixed.

´ The shapes of the three curves are also worth

noticing.

´ Input demand and profit functions are convex

functions of the output price. The output supply
function can be concave or convex.
The long-run story

All inputs can be freely chosen

´ Problem:

max p ( K , L) = pf ( K , L) - (vK + wL)

K ,L

´ Solution: 𝐿∗ (𝑝, 𝑣, 𝑤); 𝐾 ∗ (𝑝, 𝑣, 𝑤)

´ Unconstrained optimisation problem in 2 variables

 Input choice
´ FOCs: ¶p/¶𝐿 = 𝑝 [¶𝑓/¶𝐿] – 𝑤 = 0
¶p/¶𝐾 = 𝑝 [¶𝑓/¶𝐾] – 𝑣 = 0

𝑝𝑀𝑃, = 𝑤
𝑝𝑀𝑃- = 𝑣

´VMPi = i-th input price

%&#
´FOCs also imply cost minimisation: 𝑇𝑅𝑆 = − = − 𝑤/𝑣
%&$
 Input choice
´ SOCs for a maximum:
p𝐾𝐾 = 𝑓𝐾𝐾 < 0
p𝐿𝐿 = 𝑓𝐿𝐿 < 0
p𝐾𝐾 𝜋,, − p𝐾𝐿2 = 𝑓𝐾𝐾𝑓𝐿𝐿 – 𝑓-, 2 > 0

´capital and labour must exhibit sufficiently diminishing

marginal productivities so that marginal costs rise as
output expands
´Production function must be strictly concave
 Input choice
´ Solving FOCs, we get the long-run input demand function

𝐾 ∗ = 𝐾 𝑝, 𝑣, 𝑤 and 𝐿∗ = 𝐿(𝑝, 𝑣, 𝑤)

´ NOTE: these demand functions must be homogeneous

of degree 0 in 𝑝, 𝑣, 𝑤 .

This is obvious from the FOC: 𝑝𝑀𝑃' = 𝑤 and 𝑝𝑀𝑃( = 𝑣

´ If p, v and w are all doubled input demands (and output
supply) do not change., and the output supply will (and
output) also not change;

´ but profit will be doubled. [homogeneous of degree 1]

 Example
! !
Production function y = 𝑓 𝐾, 𝐿 = 4𝐾 𝐿 . ' '

Fix 𝑣 = 4, 𝑤 = 16

* *
max 𝜋 𝐾, 𝐿 = 𝑝4𝐾 + 𝐿+ − (16𝐿 + 4𝐾)
0,2

𝜕𝜋 1 *
3
, *
3
,
= 𝑝4𝐾 + 𝐿 + − 16 = 0 → 𝑝𝐾 + 𝐿 + = 16 ⋯ ⋯ ⋯ (1)
𝜕𝐿 4
𝜕𝜋 1 3
, *
3
, *
= 𝑝4𝐾 𝐿 − 4 = 0 → 𝑝𝐾 + 𝐿+ = 4 ⋯ ⋯ ⋯ ⋯ (2)
+ +
𝜕𝐾 4

Dividing (1) by (2)

(!) (
= 4 → 𝐾 = 4𝐿 ⋯ ⋯ ⋯ (3)
($) '
 Long
Examplerun profit maximisation-input
continued:

choice

Substitute (3) into (1)

! "
+% ,-!/%
𝑝(4𝐿) 𝐿
% = 16 à = 16
'
,' -!/' ,'
= 𝐿∗ ⟹ 𝐿∗(𝑝) =
!.' !$0
𝑝 $4𝑝$
𝐾 ∗(𝑝) = 4𝐿∗ = =
128 32
,' ,' ,
𝑦∗ =𝑓 𝐾 ∗, 𝐿∗ =4 !/- !/- =
#$ !$0 $

Long-run input demand functions are a convex function of p,

But the output supply function is linear in p in this example
(because it is a Cobb-Douglas case and a+b=1/2).
 General Cobb-Douglas case

Suppose 𝑦 = 𝐴𝑥*- 𝑥!. (with a+b<1)

Then the solution to the long-run profit maximisation problem is :

(you can check at home)

* *
𝑝 *3-3. 𝑝 *3-3.
𝑥* = 𝐵* , 𝑥! = 𝐵!
𝑤**3. 𝑤!. 𝑤*- 𝑤!*3-

Input demands are convex in p (as a+b<1)

Diminishing returns to scale is NECESSARY

 General Cobb-Douglas case (check at home)

Output supply function

- .
𝑝 *3-3. 𝑝 *3-3.
𝑦= 𝐴𝐵*- 𝐵!.
𝑤**3. 𝑤!. 𝑤*- 𝑤!*3-

*
-4. *3-3.
𝑝
𝑦 = 𝐴𝐵*- 𝐵!.
𝑤*- 𝑤!.

If a+b=1/2 the output supply function will be linear in the output price
 General Cobb-Douglas case (check at home)

Profit function

𝜋 = 𝑝𝑦 − 𝑤* 𝑥* − 𝑤! 𝑥!

* * *
𝑝-4. *3-3. 𝑝 *3-3. 𝑝 *3-3.
𝜋 = 𝑝 × 𝐴𝐵*- 𝐵!. − 𝑤* 𝐵* − 𝑤! 𝐵!
𝑤*- 𝑤!. 𝑤**3. 𝑤!. 𝑤*- 𝑤!*3-

*
𝑝 *3-3.
𝜋 = (1 − 𝑎 − 𝑏) 𝐵,
𝑤*- 𝑤!. B3 is some constant

Profit is a convex function of the output price

(because a+b<1 is required)
Properties of the long-run
profit function

´ Profit is homogeneous of degree 1 in 𝑝, 𝑤* , 𝑤! .

´ Hotelling’s Lemma:
56((,)!,)$)
´ = 𝑦(𝑝, 𝑤* , 𝑤! ),
5(
56((,)!,)$) 56((,)!,)$)
´ = −𝑥* (𝑝, 𝑤* , 𝑤! ) and = −𝑥! (𝑝, 𝑤* , 𝑤! )
5)! 5)$

´ Long-run profit cannot be smaller than the short-run

profit [because of fixed input in the short-run]
 Hotelling’s Lemma

()(+,-! ,-" )
´ Hotelling’s Lemma: = 𝑦(𝑝, 𝑤/ , 𝑤0 ),
(+

´ Differentiate the profit function with respect to p:

()(+,-! ,-" ) (1 (2! (1 (2"
´ (+
= 𝑦 𝑝, 𝑤/ , 𝑤0 + 𝑝 (2 − 𝑤/ (-!
+ 𝑝 (2 − 𝑤0 (-"
! "

= 𝑦 𝑝, 𝑣, 𝑤

=0 (by FOC of profit

maximisation)

In the same way you can derive

56((,)!,)$) 56((,)!,)$)
= −𝑥* (𝑝, 𝑤* , 𝑤! ) and = −𝑥! (𝑝, 𝑤* , 𝑤! )
5)! 5)$
 Long-run versus short-run profit functions

´ Long-run profit cannot be smaller than

the short-run profit [because of fixed
input in the short-run]

´ Slope of the long-run profit function (w.r.t.

p) is greater than the slope of the short-
run profit function. [LeChartelier principle]
 Long-run Short-run
Profit
profit function profit
function

𝜕𝜋
𝜕𝑝 Short-run
profit
𝜕𝜋'
function
𝜕𝑝

p
p0

56 56(
> LeChatelier principle
5( 5(
 References

1. Varian Ch. 20

(Supplementary)
1. Snyder and Nicholson 11th edition, Chapter 11
2. Nechyba, 3rd edition, Chapter 12