1

Theory of the firm:

Profit maximization

Chapters 6, 7 & 8

Theory of the firm:

Profit maximization

Chapters 6, 7 & 8

Theory of the firm: Outline 2

Types of markets (degrees of competition)Economic profit

Firm entry & exit behavior *Production theory & diminishing marginal

returns Short-run unit cost curves *

Perfect competition Profit maximization Competitive market efficiency *

Market intervention Efficiency-reducing interventions Efficiency-enhancing interventions

Buyers and Sellers3

Buyers “Should I buy another unit?” Answer: If the marginal benefit exceeds the marginal

costSellers

“Should I sell another unit? Answer: If the marginal revenue exceeds the

marginal cost of making it

Seller’s goal?4

Maximize profitDecisions:

What to produce (what market)? How much to produce? What inputs to use? What price to charge?

Firm behavior depends on the competitive environment they operate in.

Types of Markets (degrees of competition)

5

One firm 2-12 firms many firms many, many firms

Monopoly Oligopoly Monopolistic PerfectCompetition

Competition

Basic principles6

There are some basic ideas that apply to all types of firms: What “profit” means Production theory & implications for unit costs

7

Economic profit v.

Accounting profit

Profit Maximization8

Accounting ProfitThe difference between the total revenue a firm

receives from the sale of its product minus explicit costs (“expenses”).

Economic Profit The difference between the total revenue a firm

receives from the sale of its product minus all costs, explicit and implicit.

Note: this includes opportunity cost, and is therefore different than profit in a traditional accounting sense.

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2 Types of Costs and 2 Types of Profit

Explicit Costs (“accounting costs” or “expenses”) Actual payments made to factors of production and

other suppliers

Implicit Costs (opportunity costs) All the opportunity costs of the resources supplied by

the firm’s owners Eg: opportunity cost of owner’s time Eg: opportunity cost of owner-invested funds

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Two Types of Profit

Accounting Profit Total Revenue – Explicit Costs

Economic Profit Total Revenue – Explicit Costs – Implicit Costs

Economic Loss An economic profit less than zero

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The Difference Between Accounting Profit and Economic Profit

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The Difference Between Accounting Profit and Economic Profit

Revenue – Acct Costs = Acct ProfitRevenue – Econ Costs = Econ Profit

Revenue – Explicit Costs = Acct ProfitRevenue – (Explicit + Implicit costs) = Econ Profit

Acct Profit – Implicit Costs = Econ ProfitIf Acct Profit exactly = Implicit Costs => Econ Profit

= 0, and the firm is said to be earning a “normal profit”

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Econ vs. Acct Profits

True or False: Economic profits are always less than or equal to accounting profits.

TRUE

If some implicit costs exist… economic cost > accounting cost economic profit < accounting profit (ie: we are subtracting more costs from the same

revenue)

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To Farm or Not To Farm?

Farmer Dave sells corn his revenues are $22,000/yr he pays $10,000/yr in explicit costs he could earn $11,000 at another job he likes

equally well (implicit costs)

Dave’s economic profit is $22,000 - $10,000 - $11,000 = $1,000 Dave is earning a positive economic profit Dave is earning more than a normal profit

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Example

After graduation you face the following job choice:

Option 1: IBM in RTPSalary = $50K/year

Option 2: your own firm in Wilmington

You choose option 2 and withdraw $20,000 from savings to start the business. Assume that you could have earned 5% on that money.

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Example continued

You chose option 2 and have the following info after 1 year:

1st year analysis:Revenue = $50,000 Costs of inventory = $8,000

Labor expenses = $15,000Rent = $12,000

Cost categories:

accounting economic- inventory - inventory- rent - rent- wages for worker - wages for worker

- opp cost of Labor = $50,000- opp cost of funds = $1,000

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Example continued

Accounting profit = 50 – 8 – 15 – 12 = 15

Economic profit = 50 – 8 – 15 – 12 – 50 – 1 = -36

Your firm is earning negative economic profit What does this mean? Did you make a bad decision? What will happen when firms in a market are

characterized by negative economic profits?

What if economic profits are > 0?18

What does it mean when economic profits are positive? The firm owner is doing better than their next best

alternative The firm owner is more than covering opportunity

costs

What will happen in markets where firms are characterized by positive economic profits?

What if economic profits are = 0?19

What does it mean when economic profits are zero? The firm owner is doing just as well as their next best

alternative The firm owner is exactly covering opportunity costs

What will happen in markets where firms are characterized by zero economic profits?

“Normal Profit”20

If market wages for your labor and market interest rates for your funds were accurate reflections of the value of your time and money, how much accounting profit should your firm have earned? What is a “normal profit” for your firm?

Normal profit = the (accounting) profit required to exactly cover opportunity costs.

Normal profit = the accounting profit required to earn exactly zero economic profit

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Functions of Price

Where price is relative to average total costs of production (ATC) will determine firm profits and serve to allocate firm resources. P > ATC => positive profits P < ATC => negative profits

Changes in price may therefore reallocate resources.

22

Market Forces and Economic Profit

Positive Economic Profit means the firm (owner) is more than covering opp costs

Doing better than the next best alternative

Price must be higher than ATC Firms enter this industry

Supply increases Price falls Profits fall

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Fig. 8.2The Effect of Economic Profit on Entry

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Market Forces and Economic Profit

Negative Economic Profit means the firm (owner) is not covering opp costs

Doing worse than the next best alternativePrice must be below ATC

Firms exit this industry Supply decreases Price rises Losses fall

Zero profit tendency of competitive markets

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Fig. 8.3The Effect of Economic Losses on Exit

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Production & the principle of diminishing

marginal returns

Production in the Short Run27

Factors of Production An input used in the production of a good or

serviceThe “Short Run”

A period of time sufficiently short that at least some of the firm’s factors of production are fixed

The “Long Run” A period of time of sufficient length that all the

firm’s factors of production are variable

Law of Diminishing Returns28

Fixed factor of production An input whose quantity cannot be altered in the

short run. E.g. square footage of factory spaceVariable factor of production

An input whose quantity can be altered in the short run. E.g. labor

Law of Diminishing Returns If one factor is variable and others are fixed: the

increased production of the good eventually requires ever larger increases in the variable factor

As additional units of a variable input are added to fixed amounts of other inputs, the marginal product of the variable input will eventually decrease.

Law of Diminishing Marginal Returns

29

Q

Labor

MPL

Point of diminishing marginal returns

Implications for Marginal Costs 30

Since productivity (MPL) typically first increases and then decreases (at the point of DMR), what will marginal costs do?

When productivity is rising, marginal costs should be falling.

When productivity is falling, marginal costs should be rising.

Unit costs measures are inversely related to productivity measures

Types of Markets (degrees of competition)

31

One firm 2-12 firms many firms many, many firms

Monopoly Oligopoly Monopolistic PerfectCompetition

Competition

Perfect Competition32

Perfectly Competitive Market Many sellers, selling a standardized product in

an environment with readily available information and low-cost entry and exit.

No individual supplier has significant influence on the market price of the product

Price taking behavior33

Given that there are many firms all selling the exact same product, what will the demand curve for the product of one firm in a perfectly competitive market look like?

Implications?

PC firms have no influence over the price at which they sell their product

PC firms sell only a fraction of total market output

PC firms can sell as much output as they wish

The Demand Curve Facing Perfectly Competitive Firm

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How to choose output to maximize profit?

35

Recall …The Low-Hanging Fruit Principle

Suppliers first use the resources easiest-to-find So, the price of the output must go up in order to

compensate for using harder-to-find resources i.e. costs tend to rise when producers expand

production in the short-run (some inputs are fixed in the short-run)

Supply curves tend to be upward-sloping

Choosing Output36

How much to produce? The goal is to maximize profit

Profit = TR – TC A perfectly competitive firm chooses to produce the

output level where profit is maximizedCost-benefit principle & quantity decisions

A firm should increase output if marginal benefit (revenue) exceeds the marginal cost

Choosing Output37

Cost-Benefit Principle Increase output if marginal benefit exceeds the

marginal costFor a perfectly competitive firm

Marginal benefit = marginal revenue = price Only true if demand is perfectly elastic

Cost-benefit principle for a price taker Keep expanding as long as the price of the

product is greater than marginal cost Choose the output where P = MC

Profit Maximizing Condition38

Profit = TR – TCMax Profit with respect to Qd Profit / dQ = (dTR/ dQ) – (dTC/dQ) = 0 therefore maximum profit occurs where

MR = MC

Profit Maximization39

P

ATC

MC

Q* Quantity

10 = P* D = MR

ATC = Total Cost / Q so, TC = ATC x Q

P > ATC means profit > 0

8

100

Suppose Price Falls to Min ATC40

P

ATC

MC

Q* Quantity

7 = P* D = MR

P = ATC means profit = 0

Suppose Price Falls below Min ATC41

P

ATC

MC

Q* Quantity

7 = P* D = MR

P < ATC means profit < 0

Response to Economic Profits

Markets with excess profits attract resources

P2

Quantity (000s of bushels/year)

Price $/bu MC

130

ATC

1.20

Typical Corn FarmPrice $/bu

2

Quantity (M of bushels/year)

S

D

65

Corn Industry

Economic Profit

Shrinking Economic Profits

Supply increases in the long run

P

Quantity (000s of bushels/year)

Price $/bu MC

130

ATC

Typical Corn FarmPrice $/bu

2

Quantity (M of bushels/year)

S

D

65

Corn Industry

Economic Profit

S'

1.50

95 120

Market Equilibrium

Eventually, the market saturates and firms earn zero economic profits

P

Quantity (000s of bushels/year)

Price $/bu MC

130

ATC

Typical Corn FarmPrice $/bu

2

Quantity (M of bushels/year)

S

D

65

Corn Industry

S'

1.50

115

1

S"

90

Response to economic losses

Resources leave the market

1.05

Quantity (M of bushels/year)

Quantity (000s of bushels/year)

70

0.75 P

90

ATCMC

S

D

60

Price

$/bu

0.75

Price

$/bu

Typical Corn FarmCorn Industry

Market Equilibrium

Again the market reaches a situation of zero economic profit

Quantity (M of bushels/year)

Quantity (000s of bushels/year)

70

0.75P

90

ATCMC

S

D

60

Price

$/bu

Price

$/bu

1

S'

40

Shut Down?47

Perfectly competitive firms should produce where MR (P) = MC, unless price is very low

If total revenue falls below variable cost, the best the firm could do is shut down in the short run

i.e. if price is below average variable costs, the firm loses money each time a unit of output is produced. The best thing to do is produce nothing (shut the doors and tell the employees to go home).

Perfectly Competitive Firm’s Supply Curve

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The perfectly competitive firm’s supply curve is its Marginal cost curve above minimum average variable

cost

At every point along a market supply curve Price measures what it would cost producers to

expand production by one unit

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Competitive markets and efficiency(and inefficiency)

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The Domain of Markets

Free & competitive markets promote efficiency But, markets cannot be expected to solve every

problem (e.g., market economies do not guarantee a fair income distribution)

Realizing that markets cannot solve every problem has led some critics to falsely conclude that markets cannot solve any problem

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Market Equilibrium and Efficiency

Pareto efficient (or just efficient) Is a situation where there is no change possible that

will help some people without harming others Exists when an economy has reached a point where

reallocating resources must harm one in order to help another

Occurs at equilibrium of perfectly competitive markets

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Market Equilibrium and Efficiency

When a market is not in equilibrium:1. P > P* = surplus -- QS > QD

2. P < P* = shortage -- QD > QS

In either case, the quantity exchanged is always LESS THAN the true equilibrium quantity.

Hence, if a market is not in equilibrium, further benefit-enhancing transactions are always possible.

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Adam Smith

Self-interest moves the economy Consumers seek to maximize utility from purchases

Firms seek to maximize profit from production

It serves society’s interest

It is due to profit opportunities

With it, the entrepreneur “intends only his own gain,” he

is “led by an invisible hand” to promote an end which

was no part of his intentions

Prices (and price changes) serve to allocate resources to

their highest valued use

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Invisible Hand

Invisible Hand Theory The actions of independent, self-interested buyers and

sellers will often result in the most efficient allocation of resources

i.e. markets are (usually) efficient: the sum of consumer and producer surplus are maximized

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Economic surplus (net gains)

Total economic surplus The sum of all the individual economic surpluses gained by

buyers and sellers participating in the market

Consumer Surplus Economic surplus gained by the buyers of a product Measured by the difference between their reservation

price and the price they pay

Producer Surplus Economic surplus gained by the sellers of a product Measured by the difference between the price they

receive and their reservation price

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Total economic surplus in the market for milk

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Surplus and Efficiency

Equilibrium price and quantity maximize total economic surplus Total economic surplus would be lower at any other

price and quantity combination I.E., “waste” or unrealized gain occurs at any other

price and quantity combination

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Other Goals

Efficiency is not the only goal An equitable income distribution is a desirable goal

for many

Argument that efficiency should be the first goal Efficiency enables us to achieve all other goals to the

fullest possible extent Efficiency minimizes waste

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Markets and Social Optimum

If free and competitive markets are efficient, then government intervention into those markets may be inefficient.

Why then does government mess with markets? Market equilibrium does not necessarily mean the

resulting allocation of resources is the best one viewed from society’s perspective.

What is smart for one may be dumb for all For example, some market activities that produce profits for

some may produce pollution (externalities) that adversely affects many

We’ll get back to this idea soon…Some markets are inherently inefficient when left

alone. Government intervention can correct such inefficiencies

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Markets and Social Optimum

How can government intervention make markets less efficient?

How can government intervention make markets more efficient?

Types of government intervention: Taxation Price controls Import quota (and other trade restrictions)

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The Market for Potatoes Without Taxes

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The Effect of a $1 Pound Tax on Potatoes

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The Deadweight Loss Caused by a Tax

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DWL

CS pre-tax = ½ (3)(3,000,000) = $4,500,000PS pre-tax = ½ (3)(3,000,000) = $4,500,000

CS post-tax = ½ (2.50)(2,500,000) = $3,125,000PS post-tax = ½ (2.50)(2,500,000) = $3,125,000Lost PS+CS = $2,750,000Tax revenue = $1(2,500,000) = $2,500,000

DWL = $250,000

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Taxes, Elasticity, and Efficiency

Deadweight loss is minimized if taxes are imposed on goods and services that have relatively inelastic supply or relatively inelastic demand.

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Elasticity of Demand and the Deadweight Loss from a Tax

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Elasticity of supply and the deadweight loss from a tax

68

Do all taxes decrease economic efficiency?

Consider a tax on landLand supply is perfectly inelasticDWL = $0

What other goods have high tax rates? Booze Cigarettes Gasoline

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Taxes, External Costs, and Efficiency

Taxing reduces the equilibrium quantityTherefore, taxing activities that people tend

to pursue to excess can actually increase total economic surplus (e.g., activities that cause pollution)

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External costs & taxes that are efficiency-enhancing

Consider a market activity that generates harmful side-effects on a 3rd party …

E.g. Pollution from a plant imposes costs on anyone who lives near the plant

Does that firm’s supply curve accurately reflect the full costs of production? No. without regulation, the firm’s supply curve

only reflects the marginal costs of production. The external costs are not included in these costs. What if they were?

71Market Equilibrium

Q*MKT Q

D = MSB

P

At P*MKT QD = QS = Q*MKT

CS + PS are maximized

S = MPC

$20 = P*MKT

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Market Equilibrium

The firm’s supply curve represents “private” or “market-level” marginal costs of production (MPC), and is used by the firm to make pricing and output decisions.

If there are external costs (costs realized outside of the market), the FULL costs of production would be represented by a different curve = MSC

For example, suppose that each unit of output causes $2 in damage to 3rd parties.

73Social Equilibrium

Q*SOC Q*MKT Q

D = MSB

P

$20 = P*MKT

S = MPC

MSC = MPC + 2

$21 = P*SOC

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Social Efficiency

At P*MKT: MSC > MSB Q*MKT > Q*SOC the market “overproduces” the

good P*MKT < P*SOC the market “under-prices” the

good Market solution is therefore not efficient from

society’s standpoint

How can this inefficiency be corrected?

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Social Efficiency

A tax equal to the marginal external cost ($2.00) would serve to increase the firm’s MPC so that it is coincident with the MSC function.

In other words, the tax brings the external cost into the market.= “internalizing the externality”

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Social Equilibrium

Q*SOC Q*MKT Q

D = MSB

P

S = MPC

New MPC = Old MPC + 2

$21 = P*SOC

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Can markets create external benefits?

If markets can create costs on 3rd parties, can they create benefits?

Sure. Education. Lawn care House maintenance Text: beekeeper adjacent to apple orchard

Will the market solution be efficient?

78External Benefits

Q*MKT Q*SOC Q

D = MPB

P

S = MSC

P*MKT

MSB

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External Benefits

In the case of external benefits, the market will under-provide the good relative to the socially optimal amount. I.E. at Q*MKT MSB > MSC

How can this inefficiency be corrected? Recall the solution to negative externality was a

tax… We should subsidize the positive externality

generating activity.

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Naturalist Questions

Why are gasoline taxes so high (relative to other goods)?

Why aren’t gasoline taxes higher (as in other nations)?

Why do communities have zoning laws?