CHAPTER 2 PROFIT MAXIMIZATION

Economic profit is determined to be the difference between the revue of the firm and the cost
that it incurs. We can write revenue as a function of the level of operations of some n actions,
R(a1,…. An), and costs as a function of these same n activity leves C(a1,.. an)

A basic assumption in economic analysis is that the firm’s behavior is that the firm acts to
maximize its profit. R(a1,…, an) – C(a1,…, an). This is the behavioral assumption that will be
used in the future.

A simple set of application in calculus shows the optimal set of actions a*=(a1*, … a*n)

The intuition behind these conditions is this: if marginal revenue were greater than marginal
cost we should increase the level of activity; if marginal revenue were less than marginal cost,
it would pay to decrease the level of activity.

The firm´s profit maximization problem reduces to the problem of determining the prices that
wishes to charge for its outputs or pay for its inputs. This in an optimal policy, the firm faces
two kind of constraints:

 Technological constraints. These are simply related to the feasibility of the production
plan.
 Market constraints. These are the effect of actions of other agents on the firm.

If the firm will be assumed to take price taking behavior, it will assumed to take prices as given,
as exogenous variables to the profit-maximization problem. Thus, the firm will concerned only
with determining the profit-maximizing levels of inputs and outputs. This firm will be referred
as competitive firm.

2.1. Profit maximization

Consider the problem that the firm is taking a price as given in both: outputs and inputs. Let p
be a vector of prices of inputs and outputs of the firm. The profit maximization problem of the
firm can be started as
For a restricted short run profit production expression like this

If the firm only produces one output:

Where p is now the scalar of prices of outputs, is the vector of factors prices, and the inputs
are measured by the vector x=(x1,… xn). In this case we can define a variant of restricted profit
function, the cost function

Consider the restrictions of short run cost function

Profit-maximization behavior can be characterized by calculus.

In this condition we simply say that the value of the marginal product of each factor must be
equal to its price. Using vector notation like this:

The gradient of f(.): the vector of partial derivatives of f(.) with respect to each of its arguments.

The F.O.C. state says that “marginal value product of each factor must be equal to its price”. In
a graphical way:
A profit maximization firm wants to find a point on the production set with the maximum level
of profits-this is a point where the vertical axis intercepts the associated isoprofit line is
maximal.

In a two-dimensional case we can get the S.O.C. for profit maximization and respect the input
must be nonpositive.

A similar second-order condition holds in the multiple-input case. In this case the SOC for profit
maximization is the matriz of Hessian with second order derivates of the profit maximization; it
must be negative semidefinite at the optimal point.

2.2. Difficulties

For each vector of prices (p,w) there will in general some optimal choice of factors x*. The
function that gives us the optimal choice of inputs as a function of the prices is called the
factor demand function of the firm. Similarly, the function y(p,w)= f(x(p,w)) is called the supply
function of the firm. Sometimes the functions are not well defined or nicely behaved.
  Firstly, it happens that the technology cannot be described by a differentiable
production function. Like Leontief technology function.
 Second, the calculus conditions make sense when variables can vary in a natural
neighborhood of the optimal choice. The solutions are used in a positive amount in the
factors.

These necessary modifications of the conditions to handle the boundary solutions are not
difficult to state. Consider the x to be nonnegative in the profit maximization, the FOC turn
out to be:

2.3. Properties of demand and supply functions

The functions that give the optimal choices of inputs and outputs as a function of the prices
are known as the factor demand and output supply functions. The fact of these functions are
the solutions to maximization problem of a specific form, the profit maximization problem will
imply certain restrictions on the behavior of the demand and supply functions.

Hence, the factor demand functions must satisfy the restriction that:

The term comparative refers to comparing a before and an after situation. The terms statics
refer to the idea that the comparison is made after all adjustments have been “worked out”
that is, we must compare one equilibrium situation to another.

2.4. Comparative statics using the FOC.

Consider the following maximization profit with one output and one input like this:

If f(x) is differentiable, the demand function s(p,w) must satisfy the necessary FOC and SOC.
Notice that theses conditions are an identity in p and w. since x(p,w) is the choice of
maximization of profits so x(p,w) must comply the maximization for all values of p and w. Since
FOC is and identity we can differentiate it with respect w to get:

Assuming that we have a regular maximum so that f´´(x) is not zero, we can divide though to
get

This identity tells facts of how the factor demand x(p,w) responds to changes in w.

 First gives an explicit expression for dx/dw in terms of production function.

 Second, gives information of the sign of the derivative: the factor demand curve slopes
downward as it is negative.

This procedure of differentiating the FOC can be used to examine profit-maximizing behavior
when there are many inputs. Demand must satisfy the FOC:

Differentiation with respect w1 we have:

Differentiation with respect w2 we have:

In a matrix representation

The hessian matrix must strictly negative defined, solving the matrix of the first derivates we
have:

The matrix on the left of this last is known as the substitution matrix since it describes how the
firm substitutes one input for another as the factor prices change.

The substitution matrix must be a symmetric, negative definite matrix. In particular:

 Dxi/dwi<o, for i=1,2, since diagonal entries of a negative definite matrix must be
negative.
 Dxi/dwi = dxi/dwi by the symmetry of the matrix.

2.5. Comparative static using algebra.

Necessary condition of profit maximitation is that:

We will refer to this condition as the weak axiom of profit maximization

By WAMP we fix two observations t and s and we have

Adding these two inequalities gives us:

In other words, the inner product of a vector of price changes with the associated vector of
changes in the net outputs must be nonnegative.

2.6. Recoverability

In this point we will try to construct a technology that generates the observed behavior (pt, yt)
as profit-maximization behavior. If we find such technology for any set of that that satisfy
WAPM, then WAPM must indeed the implications of profit-maximization behavior.

Suppose that the true production set Y is convex and monotonic. Since Y must contain yt for
t=1,…., T it is natual to take inner bound to be the smallest convex, monotonic set contains
y1, …, yt. This set is called onvex, monotonic hull of the points y1,… yt and de noted by: