PRODUCER’S THEORIES (3)
1. PRODUCTION
2. COST MINIMIZATION AND PROFIT
MAXIMIZATION
3. AGGREGATION
By Dyah Margani Utami
PROFIT MAXIMIZATION
GENERAL RULES (1)
Profit maximizing choose both inputs and outputs to maximize the difference between total
revenue and total cost
The firm will adjust variables under its control until it cannot increase profit further. Thus, the firm
looks at each additional unit of input and output with respect to its effect on profit
R and p are functions of and ; Also, C is a function of and
To maximize
or MR=MC
Profit maximizing:
maximizing quantity (q) subject to a cost constraint (C)
minimizing cost (C) subject to a quantity constraint (q)
Find that maximizes and
By Dyah Margani Utami
PROFIT MAXIMIZATION
GENERAL RULES (2)
for profit maximization is: At the optimal quantity ∗
∗
Marginal profit must be declining
Economic profit must be concave function of at ∗
At q*, the slope of C equals the slope of R MC = MR
and is at a maximum.
But MC = MR at two points; one is at maximum and
the other is at minimum .
Must check the SOC at ∗ . At the other MC = MR, the
second derivative of ∗ is > 0!
By Dyah Margani Utami
PROFIT MAXIMIZATION
MARGINAL REVENUE
[ . ]
for a perfectly elastic D curve,
, so ,
MR < p for a downward sloping D curve, which happens when more output can be sold only if the
price is reduced for all units sold.
If
If (downward sloping demand curve) MR < p
By Dyah Margani Utami
PROFIT MAXIMIZATION
ELASTICITY
[ . ]
, (from a firm’s demand curve perspective); therefore,.
+
,
with a negatively sloped demand curve, , is negative and is greater than . Furthermore,
if: ,
,
if: , (demand is elastic),
, (demand is unit elastic),
, (demand is inelastic),
By Dyah Margani Utami
PROFIT MAXIMIZATION
PROFIT MAXIMIZATION BY PRICE-TAKING FIRM (IN THE SHORT RUN) (1)
If:
FOC:
SOC:
because p' = 0 for price-taker.
True only if SMC'(q) > 0
By Dyah Margani Utami
PROFIT MAXIMIZATION
PROFIT MAXIMIZATION BY PRICE-TAKING FIRM (IN THE SHORT RUN) (2)
Because SMC shows how much the firm will
produce at each price, it is the firm’s short-run
supply curve. Set SMC=p and solve for q to get
short-run supply function.
The firm will move up and down the curve so
SMR = SMC, maximizing .
At prices below the firm will produce zero
output because it cannot cover SAVC. The firm
will minimize losses by shutting down
completely and only losing SAFC. If it continues
to operate, it will lose all of SAFC and part of
SAVC.
At prices above the firm earns an economic At prices between p 0 and p 2, the firm will
profit. minimize losses (max ) by continuing to
Thus, the short-run supply curve is SMC above operate to cover all SAVC and part of SAFC. It
the minimum level of SAVC curve. SMC must be loses all SAFC if it shuts down, but only part of
positively sloped also (SOC) SAFC if it operates.
By Dyah Margani Utami
PROFIT MAXIMIZATION
PROPERTIES OF PROFIT FUNCTION
1. Homogeneous of degree 1 – Inflation does not change quantities of inputs used and output
produced, but profit will increase at the rate of inflation.
2. Nondecreasing in output price, p – If the firm does not change input use and output
produced, profit will rise as p increases. If the firm changes input use or output in response
to the increase in p, it must be doing so to make even more profit. Therefore, if p increases,
profit remains the same or increases; it cannot decrease for a profit-maximizing firm.
3. Nonincreasing in input prices – Similar to above discussion. When profit is maximized, a firm
cannot reallocate input use without reducing profit. If v increases and the firm cannot
reallocated resources to achieve higher profit or it would have allocated inputs differently
before.
4. Convex in output prices – Average profits obtainable from two different output prices will
be at least as high as profit obtained from the average of two output prices. ,v,w)
By Dyah Margani Utami
