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20 Profit Maximization

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47 views14 pages

20 Profit Maximization

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powtie7
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CHAPTER 20

Profit Maximization
Economic Profit
A firm uses inputs j = 1, . . . , m to make products i = 1, . . . , n.
Output levels are y1, . . . , yn.
Inputs and outputs are flow variables:
Input levels are x1, . . . , xm. For example, x1 might be the number of labor units used per hour.
Product prices are p1, . . . , pn. And y3 might be the number of cars produced per hour.

Input prices are w1, . . . , wm.

The competitive firm takes all output prices p1, . . . , pn and all input prices w1, . . . , wm
as given constants.
The economic profit generated by the production plan

How do we value a firm? Suppose the firm’s stream of periodic economic profits is π π
π . . . and r is the rate of interest.
Then the present value of the firm’s economic profit stream is
Economic Profit
A competitive firm seeks to maximize its present value.
Suppose the firm is in a short-run circumstance in which input 2 is constant:
Its short-run production function is
The firm’s fixed cost is and its profit function is

Typically, input 1 is thought of


as labor and input 2 is capital.
Short-Run Isoprofit Lines
An isoprofit line contains all the production plans that yield a profit level of $π.
The equation of an isoprofit line is

𝑤1
This line has a slope of and an
𝑝
𝜋+𝑤2 𝑥෤2
intercept of .
𝑝
Short-Run Profit Maximization (Graphical representation)
The firm’s problem is to locate the production plan that attains the highest possible isoprofit
line, given the firm’s constraint on choices of production plans.
What is this constraint? The production function
Short-Run Profit Maximization (Graphical representation)

Marginal product of
Marginal revenue from x1 is
x1 is equal to relative
equal to the cost of x1
cost of x1

If 𝑝 × 𝑀𝑃1 > 𝑤1 then profit increases with x1. → USE MORE x1


If 𝑝 × 𝑀𝑃1 < 𝑤1 then profit decreases with x1. → USE LESS x1
Short-Run Profit Maximization (Formulation and Solution)
Optimization: max 𝜋 = 𝑝𝑦 − 𝑤1 𝑥1 − 𝑤2 𝑥෤2
𝑥1
s.t. 𝑦 = 𝑓(𝑥1 , 𝑥෤2 )

max 𝜋 = 𝑝𝑓(𝑥1 , 𝑥෤2 ) − 𝑤1 𝑥1 − 𝑤2 𝑥෤2 Solution by substitution


𝑥1

𝜕𝑓(𝑥1 ,𝑥෤2 ) 𝜕𝑦 𝜕𝑓(𝑥1 , 𝑥෤2 )


FOC for 𝑥1 : 𝑝 = 𝑤1 𝑝𝑀𝑃1 = 𝑤1 = = 𝑀𝑃1
𝜕𝑥1 𝜕𝑥1 𝜕𝑥1

This is the firm’s short-run demand for input 1 when the level of input 2 is fixed at 𝑥෤2 .
Short-Run Profit Maximization: A Cobb-Douglas Example
The short-run production function:

Optimization: max 𝜋 = 𝑝𝑦 − 𝑤1 𝑥1 − 𝑤2 𝑥෤2


𝑥1
s.t. 𝑦 = 𝑓(𝑥1 , 𝑥෤2 )

FOC:

This is the firm’s short-run demand for input 1 when the level of input 2 is fixed at 𝑥෤2 .

The firm’s short-run output level is thus,


Comparative Statics of Short-Run Profit Maximization
What happens if the output price p changes?

The equation of a short-run isoprofit line is


An increase in p, the price of the firm’s output, causes
• an increase in the firm’s output level (the firm’s supply curve slopes upward), and
• an increase in the level of the firm’s variable input (the firm’s demand curve for its
variable input shifts outward).

The Cobb-Douglas example:


The firm’s short-run demand x1 is
The firm’s short-run supply is
𝜕𝑦 𝜕𝑥1
> 0, >0
𝜕𝑝 𝜕𝑝
Comparative Statics of Short-Run Profit Maximization
An increase in w1, the price of the firm’s variable input, causes
• a decrease in the firm’s output level (the firm’s supply curve shifts inward), and
• a decrease in the level of the firm’s variable input (the firm’s demand curve for its
variable input slopes downward).
𝑥1∗ decreases as 𝑤1 increases. 𝑦 ∗ decreases as 𝑤1 increases.

The Cobb-Douglas example: When


the firm’s short-run demand for its variable input 1 is

and its short-run supply is

𝜕𝑦 𝜕𝑥1
< 0, <0
𝜕𝑤1 𝜕𝑤1
Long-Run Profit Maximization
Now allow the firm to vary both input levels.
Since no input level is fixed, there are no fixed costs.
Both x1 and x2 are variable.
Optimization: max 𝜋 = 𝑝𝑦 − 𝑤1 𝑥1 − 𝑤2 𝑥2
𝑥1 ,𝑥2
s.t. 𝑦 = 𝑓(𝑥1 , 𝑥2 )

𝜕𝑦 𝜕𝑦
FOC: 𝑀𝑃1 = −−→ 𝑝 ∗ 𝑀𝑃1 = 𝑤1 𝑀𝑃2 = −−→ 𝑝 ∗ 𝑀𝑃2 = 𝑤2
𝜕𝑥1 𝜕𝑥2

In the long run, marginal revenue equals marginal cost for all inputs:

Think of the firm as choosing the production plan that An increase in x2 causes
maximizes profits for a given value of x2, and then varying x2
• no change to the slope, and
to find the largest possible profit level. Isoprofit line:
• an increase in the vertical intercept.
Returns to Scale and Profit Maximization
If a firm’s technology exhibits DECREASING If a competitive firm’s technology exhibits
RETURNS TO SCALE then the firm has a single long- INCREASING RETURNS TO SCALE then the firm
run profit-maximizing production plan. does not have a profit-maximizing plan.

An increasing returns-to-scale technology is


inconsistent with firms being perfectly competitive.
Returns to Scale and Profit Maximization
What if the competitive firm’s technology
exhibits constant returns to scale (CRS)?
• So if any production plan earns a positive
profit, the firm can double up all inputs to
produce twice the original output and earn
twice the original profit.

Earning a positive economic profit under CRS is


inconsistent with firms being perfectly
competitive.
Hence, CRS requires that competitive firms earn
economic profits of zero.
Revealed Profitability
Consider a competitive firm with a technology that exhibits decreasing returns to scale.
For a variety of output and input prices we observe the firm’s choices of production plans.
What can we learn from our observations?

If a production plan (x′, y′) is chosen at


prices (w′, p′), we deduce that the plan
(x′, y′) is revealed to be profit
maximizing for the prices (w′, p′).

Observing -production plans in


response to different prices gives
information on the location of its
technology set.

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