Chapter 13

PROFIT MAXIMIZATION
AND SUPPLY
MICROECONOMIC THEORY
BASIC PRINCIPLES AND EXTENSIONS
EIGHTH EDITION

WALTER NICHOLSON
Copyright 2002 by South-Western, a division of Thomson Learning. All rights reserved.

The Nature of Firms

A firm is an association of individuals
who have organized themselves for the
purpose of turning inputs into outputs
Different individuals will provide different
types of inputs
the nature of the contractual relationship
between the providers of inputs to a firm
may be quite complicated

Contractual Relationships
Some contracts between providers of
inputs may be explicit
may specify hours, work details, or
compensation

Other arrangements will be more

implicit in nature
decision-making authority or sharing of
tasks

Modeling Firms Behavior

Most economists treat the firm as a
single decision-making unit
the decisions are made by a single
dictatorial manager who rationally pursues
some goal
profit-maximization

Profit Maximization
A profit-maximizing firm chooses both
its inputs and its outputs with the sole
goal of achieving maximum economic
profits
seeks to maximize the difference between
total revenue and total economic costs

Output Choice
Total revenue for a firm is given by
TR(q) = P(q)q

In the production of q, certain economic

costs are incurred [TC(q)]
Economic profits () are the difference
between total revenue and total costs
= TR(q) TC(q) = P(q)q TC(q)

Output Choice
The necessary condition for choosing
the level of q that maximizes profits can
be found by setting the derivative of the
function with respect to q equal to zero
d
dTR dTC
' (q )

0
dq
dq
dq
dTR dTC

dq
dq

Output Choice
To maximize economic profits, the firm
should choose the output for which
marginal revenue is equal to marginal
cost
MR

dTR dTC

MC
dq
dq

Second-Order Conditions
MR = MC is only a necessary condition
for profit maximization
For sufficiency, it is also required that
d 2
d' (q )

0
2
dq q q *
dq q q *

marginal profit must be decreasing at

the optimal level of q

Profit Maximization
revenues & costs

Profits are maximized when the slope of

the revenue function is equal to the slope
of the cost function
TC

TR

But the second-order

condition prevents us
from mistaking q0 as
a maximum

q0

q*

output

Marginal Revenue
If a firm can sell all it wishes without
having any effect on market price,
marginal revenue will be equal to price
If a firm faces a downward-sloping
demand curve, more output can only be
sold if the firm reduces the goods price
marginal revenue MR(q )

dTR d [P (q ) q ]
dP

P q
dq
dq
dq

Marginal Revenue
If a firm faces a downward-sloping
demand curve, marginal revenue will be
a function of output
If price falls as a firm increases output,
marginal revenue will be less than price

Marginal Revenue
Suppose that the demand curve for a sub
sandwich is
q = 100 10P

Solving for price, we get

P = -q/10 + 10

This means that total revenue is

TR = Pq = -q2/10 + 10q

Marginal revenue will be given by

MR = dTR/dq = -q/5 + 10

Profit Maximization
To determine the profit-maximizing
output, we must know the firms costs
If subs can be produced at a constant
average and marginal cost of $4, then
MR = MC
-q/5 + 10 = 4
q = 30

Marginal Revenue and

Elasticity
The concept of marginal revenue is
directly related to the elasticity of
demand facing the firm
The price elasticity of demand is equal
to the percentage change in quantity
that results from a one percent change
in price
eq,P

dq / q dq P

dP / P dP q

Marginal Revenue and

Elasticity
This means that

q dP
q dP
1

P 1
MR P
P 1

dq
P dq
eq,P

if the demand curve slopes downward,

eq,P < 0 and MR < P
if the demand is elastic, eq,P < -1 and
marginal revenue will be positive
if the demand is infinitely elastic, eq,P = - and
marginal revenue will equal price

Marginal Revenue and

Elasticity
eq,P < -1

MR > 0

eq,P = -1

MR = 0

eq,P > -1

MR < 0

The Inverse Elasticity Rule

Because MR = MC when the firm
maximizes profit, we can see that

1
MC P 1

eq,P

P MC
1

P
eq,P

The gap between price and marginal

cost will fall as the demand curve facing
the firm becomes more elastic

The Inverse Elasticity Rule

P MC
1

P
eq,P

If eq,P > -1, MC < 0

This means that firms will choose to
operate only at points on the demand
curve where demand is elastic

Average Revenue Curve

If we assume that the firm must sell all
its output at one price, we can think of
the demand curve facing the firm as its
average revenue curve
shows the revenue per unit yielded by
alternative output choices

Marginal Revenue Curve

The marginal revenue curve shows the
extra revenue provided by the last unit
sold
In the case of a downward-sloping
demand curve, the marginal revenue
curve will lie below the demand curve

Marginal Revenue Curve

price

As output increases from 0 to q1, total

revenue increases so MR > 0
As output increases beyond q1, total
revenue decreases so MR < 0

P1
D (average revenue)

output

q1
MR

Marginal Revenue Curve

When the demand curve shifts, its
associated marginal revenue curve
shifts as well
a marginal revenue curve cannot be
calculated without referring to a specific
demand curve

Short-Run Supply by a
Price-Taking Firm
price

SMC

SATC

P* = MR

SAVC

Maximum profit
occurs where
P = SMC
q*

output

Short-Run Supply by a
Price-Taking Firm
price

SMC

SATC

P* = MR

SAVC

Since P > SATC,

profit > 0

q*

output

Short-Run Supply by a
Price-Taking Firm
price

SMC

P**
SATC

P* = MR

SAVC

If the price rises

to P**, the firm
will produce q**
and > 0
q*

q**

output

Short-Run Supply by a
Price-Taking Firm
SMC

price

If the price falls to

P***, the firm will
produce q***
SATC

P* = MR

SAVC

profit maximization
requires that P =
SMC and that SMC
is upward-sloping

P***

q***

q*

output

<0

Short-Run Supply by a
Price-Taking Firm
The positively-sloped portion of the shortrun marginal cost curve is the short-run
supply curve for a price-taking firm
it shows how much the firm will produce at
every possible market price
firms will only operate in the short run as
long as total revenue covers variable cost
the firm will produce no output if P < SAVC

Short-Run Supply by a
Price-Taking Firm
Thus, the price-taking firms short-run
supply curve is the positively-sloped
portion of the firms short-run marginal
cost curve above the point of minimum
average variable cost
for prices below this level, the firms profitmaximizing decision is to shut down and
produce no output

Short-Run Supply by a
Price-Taking Firm
price

SMC

SATC
SAVC

The firms short-run supply

curve is that portion of the
SMC curve that is above
minimum SAVC
output

Short-Run Supply
Suppose that the firms short-run total cost
curve is
STC = 4v + wq2/400

If w = v = $4, then the cost curve becomes

STC = 16 + q2/100

This implies that short-run marginal cost is

STC/q = 2q/100 = q/50

Short-Run Supply
Profit maximization requires that price is
equal to marginal cost
P = SMC = q/50

This means that the supply curve (with q

as a function of P) is
q = 50P

Short-Run Supply
To find the firms shut-down price, we
need to solve for SAVC
SVC = q2/100
SAVC = SVC/q = q/100

SAVC is minimized when q = 0

the firm will only shut down when the price
falls to 0

Short-Run Supply
Short-run average costs are given by
SATC = STC/q = 16/q + q/100

SATC is minimized when

SATC/q = -16/q2 + 1/100 = 0
q = 40
SATC = SMC = $0.80

For any price below $0.80, the firm will

incur a loss

Profit Maximization and

Input Demand
A firms output is determined by the
amount of inputs it chooses to employ
the relationship between inputs and
outputs is summarized by the production
function

A firms economic profit can also be

expressed as a function of inputs
(K,L) = Pq TC(q) = Pf(K,L) (vK + wL)

Profit Maximization and

Input Demand

The first-order conditions for a maximum

are
/K = P[f/K] v = 0
/L = P[f/L] w = 0

A profit-maximizing firm should hire any

input up to the point at which its marginal
contribution to revenues is equal to the
marginal cost of hiring the input

Profit Maximization and

Input Demand
These first-order conditions for profit
maximization also imply cost
minimization
they imply that RTS = w/v

Profit Maximization and

Input Demand
To ensure a true maximum, secondorder conditions require that
KK < 0
LL < 0
KK LL - KL2 > 0
Capital and labor must exhibit sufficiently
diminishing marginal productivities so that
marginal costs rise as output expands

Profit Maximization and

Input Demand
The first-order conditions can generally
be solved for the optimal input
combination
K* = K*(P,v,w)
L* = L*(P,v,w)

These input choices can be substituted

into the production function to get q*
q* = f(K,L) = f [K*(P,v,w),L*(P,v,w)] = q*(P,v,w)

Supply Function
The supply function for a profitmaximizing firm that takes both output
price (P) and input prices (v,w) as fixed
is written as
quantity supplied = q*(P,v,w)
this indicates the dependence of output
choices on these prices

Supply Function
The supply function provides a
convenient reminder of two key points
the firms output decision is fundamentally
a decision about hiring inputs
changes in input costs will alter the hiring
of inputs and hence affect output choices
as well

Producer Surplus in the

Short Run

A profit-maximizing firm that decides to

produce a positive output in the short run
must find that decision to be more favorable
than a decision to produce nothing
This improvement in welfare is termed
(short-run) producer surplus
what the firm gains by being able to participate
in market transactions

Producer Surplus in the

Short Run
If the firm was prevented from making
such transactions, output would be zero
and profits would equal -SFC
Production of the profit-maximizing output
would yield profits of *
The firm gains *+ SFC
this is producer surplus

Producer Surplus in the

Short Run
SMC

price

If the market price

is P*, the firm will
produce q*

P*

Producer surplus is the

shaded area below P*
and above SMC
q*

output

Producer Surplus in the

Short Run
In mathematical terms, producer surplus
is given by
q*

q q *

producer surplus [P * MC(q )]dq (P * q TC ) q 0

0

producer surplus P * q * TC(q *) [P * 0 TC(0)]

producer surplus * SFC

Producer Surplus in the

Short Run
Because SFC is constant, changes in
producer surplus as a result of changes
in market price are reflected as
changes in short-run profits
these can be measured by the changes in
the area below market price above the
short-run supply curve

Producer Surplus in the

Long Run
By definition, long-run producer surplus is
zero
fixed costs do not exist in the long run
equilibrium profits under perfect competition
with free entry are zero

In long-run analysis, attention is focused

on the prices of the firms inputs and how
they relate to what they would be in the
absence of market transactions

Revenue Maximization
When firms are uncertain about the
demand curve they face or when they
have no reliable notion of the marginal
costs of their output, the decision to
maximize revenues may be a reasonable
rule of thumb for ensuring their long-term
survival

Revenue Maximization
A revenue-maximizing firm would choose
to produce that level of output for which
marginal revenue is zero
Because we know that MR = P[1+(1/eq,P)],
MR=0 implies that eq,P = -1
demand will be unit elastic at q*

Revenue Maximization
If the firm wishes to
maximize revenues, it
will produce q*

price

P*

output

q*
MR

Revenue Maximization
SMC

price

If the firm wishes to

maximize profits, it will
produce q**

P*

q**

output

q*
MR

Revenue Maximization
SMC

price

Increasing output
beyond q** increases
revenue but lowers
economic profit

P*

q**

output

q*
MR

Constrained Revenue
Maximization
A firm that chooses to maximize
revenue is paying no attention to its
costs
it is possible that maximizing revenues
could result in negative profits for the firm

It may be more realistic to assume that

these firms must meet some minimal
level of profitability

Revenue Maximization
Suppose that a firm faces the following
demand curve
q = 100 - 10P

Total revenues (as a function of q) is

TR = Pq = 10q - q2/10

Marginal revenue is
MR = dTR/dq = 10 - q/5

Revenue Maximization
Total revenues are maximized when MR
=0
this means that q = 50

If output is 50, total revenues are $250

If we assume that AC = MC = $4, total
costs are $200 and profits equal $50

Constrained Revenue
Maximization
Suppose that the firms owners require
a profit of at least $80
Then the firm might seek to maximize
revenue subject to the constraint that
= TR - TC = 10q - q2/10 - 4q = 80

Constrained Revenue
Maximization
Rearranging the constraint, we get
q2 - 60q +800 = 0

or

(q - 40)(q - 20)=0

The solution q = 40 yields higher

revenues than any other output level
between 20 and 40
all of these options yield at least $80 profit

The Principal-Agent Problem

In many cases, firm managers do not
actually own the firm but instead act as
agents for the owners
An agent is a person who makes
economic decisions for another party

The Principal-Agent Problem

Assume that we can show a graph of the
owners (or managers) preferences in
terms of profits and various benefits
(such as fancy offices or use of the
corporate jet)
The owners budget constraint will have a
slope of -1
each $1 of benefits reduces profit by $1

The Principal-Agent Problem

If the manager is also the owner
of the firm, he will maximize his
utility at profits of * and benefits
of B*

Profits

U1
Owners constraint
B*

Benefits

The Principal-Agent Problem

The owner-manager maximizes
profit because any other ownermanager will also want B* in
benefits

Profits

B* represents a true cost

of doing business

U1
Owners constraint
B*

Benefits

The Principal-Agent Problem

Suppose that the manager is not the
sole owner of the firm
suppose there are two other owners who
play no role in operating the firm

$1 in benefits only costs the manager

$0.33 in profits
the other $0.67 is effectively paid by the
other owners in terms of reduced profits

The Principal-Agent Problem

The new budget constraint continues to
include the point B*, *
the manager could still make the same
decision that a sole owner could)

For benefits greater than B*, the slope

of the budget constraint is only -1/3

The Principal-Agent Problem

Given the managers budget
constraint, he will maximize utility
at benefits of B**

Profits

Agents constraint
*
**

U2

Profits for the firm

will be ***

U1

***

Owners constraint
B*

B**

Benefits

The Principal-Agent Problem

The firms owners are harmed by
having to rely on an agency relationship
with the firms manager
The smaller the fraction of the firm that
is owned by the manager, the greater
the distortions that will be induced by
this relationship

The Principal-Agent Problem

The firms owners will not be happy about
accepting lower profits on their
investments
they may refuse to invest in the firm if they
know the manager will behave in this manner

The manager could work out some

contractual arrangement to induce the
would-be owners to invest

The Principal-Agent Problem

One possible contract would be for the
manager to agree to finance all of the
benefits out of his share of the profits
results in lower utility for the manager
would be difficult to enforce

They may instead try to give managers

an incentive to economize on benefits
and to pursue higher profits

Important Points to Note:

In order to maximize profits, the firm should
choose to produce that output level for
which the marginal revenue is equal to the
marginal cost
If a firm is a price taker, its output decisions
do not affect the price of its output
marginal revenue is equal to price

Important Points to Note:

If the firm faces a downward-sloping
demand for its output, it can only sell more
at a lower price
marginal revenue will be less than price and
may be negative

Marginal revenue and the price elasticity of

demand are related by the following
MR P

1
1
eq,P

Important Points to Note:

The supply curve for a price-taking, profitmaximizing firm is given by the positively
sloped portion of its marginal cost curve
above the point of minimum average
variable cost
if price falls below minimum AVC, the firms
profit-maximizing choice is to shut down and
produce nothing

Important Points to Note:

The firms profit-maximization problem can
also be approached as a problem in optimal
input choice
this yields the same results as does an
approach based on output choices

In the short run, firms obtain producer

surplus in the form of short-run profits and
coverage of fixed costs that would not be
earned if the firm produced zero output

Important Points to Note:

In situations of imperfect knowledge, firms
may opt to maximize revenues
this means that the firm expands output until
marginal revenue is zero
sometimes these decisions may be
constrained by minimum profit requirements

Because managers act as agents for a

firms owners, they may not always make
decisions that are consistent with profit
maximization