Topic 4: Profit (Cont.) : Profit-Maximization Firm's Supply Industry Supply

Topic 4: Profit (cont.
1. Profit-Maximization
2. Firm’s supply
3. Industry supply
Economic Profit
A firm uses inputs j = 1…,m to make
products i = 1,…n.
 Output levels are y1,…,yn.
 Input levels are x1,…,xm.

 Product prices are p1,…,pn.
 Input prices are w1,…,wm.
The Competitive Firm
 Thecompetitive firm takes all output
prices p1,…,pn and all input prices w1,
…,wm as given constants.
 price - taker? (competitive market)
 price - maker? (market power)
Economic Profit/ II = TR – TC (both opportunity cost and FC, VC)
accounting profit = TR – TC (VC and FC)
 The economic profit generated by

the production plan (x1,…,xm,y1,…,yn)
is
  p1y1  pnyn w 1x 1  w m x m .
Economic Profit
 Output and input levels are typically
flows.
 E.g. x1 might be the number of labor
units used per hour.
 And y3 might be the number of cars
produced per hour.
 Consequently, profit is typically a flow
also; e.g. the number of dollars of
profit earned per hour.
Economic Profit
 How do we value a firm?
 Suppose the firm’s stream of
periodic economic profits is
 … and r is the rate of
interest.
 Then the present-value of the firm’s
economic stream
profit 1 is
2 
PV   0  
1  r (1  r ) 2
Economic Profit
A competitive firm seeks to maximize
its present-value.
 How?
Economic Profit
 Suppose the firm is in a short-run
~
circumstance in which x 2  x 2 .
 Its short-run production function is
~
y  f ( x 1 , x 2 ).
Economic Profit
 Suppose the firm is in a short-run
~
circumstance in which x 2  x 2 .
 Its short-run production function is
~
y  f ( x 1 , x 2 ).
~
 The firm’s fixed cost is FC  w 2 x 2
and its profit function is
~ .
  py  w 1x 1  w 2 x 2
Short-Run Iso-Profit Lines
A $ iso-profit line contains all the
production plans that provide a profit
level $.
 A $ iso-profit line’s equation is
~
  py  w 1x 1  w 2 x 2 .
A $ iso-profit line contains all the
production plans that yield a profit
level of $.
 The equation of a $ iso-profit line is
~
  py  w 1x 1  w 2 x 2 .
 I.e.
w1 ~
  w 2x 2
y x1  .
p p
w1 ~
  w 2x 2
y x1 
p p
has a slope of
w1

p
and a vertical intercept of
~
  w 2x 2
.
p
y i ng
a s
c e
r fit
I n    
pro    
  
w1
Slopes  
p
x1
Short-Run Profit-Maximization
 The firm’s problem is to locate the
production plan that attains the
highest possible iso-profit line, given
the firm’s constraint on choices of
production plans.
 Q: What is this constraint?
 The firm’s problem is to locate the
production plan that attains the
highest possible iso-profit line, given
the firm’s constraint on choices of
production plans.
 Q: What is this constraint?
 A: The production function.
y The short-run production function and
x  ~ .
x
technology set for 2 2
~ )
y  f ( x1 , x 2
Technically
inefficient
plans
x1
y g
s i n    
e a
r fit
I nc    
pro    ~ )
y  f ( x1 , x 2
w1
Slopes  
p
x1
y
   
   
  
w1
y* Slopes  
p
x*1 x1
~ , the short-run
Given p, w1 and x 2  x 2 * ~
y *
profit-maximizing plan is ( x1 , x 2 , y ).
   
w1
y* Slopes  
p
x*1 x1
~ , the short-run
Given p, w1 and x 2  x 2 * ~
y *
profit-maximizing plan is ( x1 , x 2 , y ).
And the maximum    
possible profit
is   . w1
y* Slopes  
p
x*1 x1
At the short-run profit-maximizing plan,
y the slopes of the short-run production
function and the maximal    
iso-profit line are
equal.
w 1
y* Slopes  
p
x*1 x1
At the short-run profit-maximizing plan,
y the slopes of the short-run production
function and the maximal    
iso-profit line are
equal.
w 1
y* Slopes  
w1 p
MP1 
p
* ~ *
at ( x , x , y )
1 2
x*1 x1
w1
MP1   p  MP1  w 1
p
p  MP1 is the marginal revenue product of

input 1, the rate at which revenue increases
with the amount used of input 1.
If p  MP1  w 1 then profit increases with x 1.
If p  MP1  w 1 then profit decreases with x 1.
Short-Run Profit-Maximization; A
Cobb-Douglas Example
Suppose the short-run production
3 ~ 1/ 3
function is y  x1/
1 x2 .
The marginal product of the variable
input 1 is  y 1  2 / 3 ~ 1/ 3
MP1   x1 x 2 .
 x1 3
The profit-maximizing condition is
p *  2 / 3 ~ 1/ 3
MRP1  p  MP1  ( x1 ) x2  w1.
3
p *  2 / 3 ~ 1/ 3
Solving ( x1 ) x 2  w 1 for x1 gives
3
*  2/ 3 3w 1
( x1 )  .
px ~ 1/ 3
2
p *  2 / 3 ~ 1/ 3
3
*  2/ 3 3w 1
( x1 )  .
px ~ 1/ 3
2
That is, ~ 1/ 3
* 2 / 3 px 2
( x1 ) 
3w 1
p *  2 / 3 ~ 1/ 3
3
*  2/ 3 3w 1
( x1 )  .
px ~ 1/ 3
2
That is, ~ 1/ 3
* 2 / 3 px 2
( x1 ) 
3w 1
3/ 2 3/ 2
 ~ 1/ 3   p 
*  px 2  ~ 1/ 2
so x1      x2 .
 3w 1   3w 1 
3/ 2
*  p  ~ 1/ 2
x1    x2
is the firm’s
 3w 1 
short-run demand
for input 1 when the level of input 2 is
~ units.
fixed at x 2
3/ 2
*  p  ~ 1/ 2
x1    x2
is the firm’s
 3w 1 
short-run demand
for input 1 when the level of input 2 is
~ units.
fixed at x 2
The firm’s short-run output level is thus
1/ 2
* * 1/ 3 ~ 1/ 3  p  ~ 1/ 2 .
y  ( x1 ) x 2    x 2
 3w 1 
Comparative Statics of Short-Run
Profit-Maximization
 Whathappens to the short-run profit-
maximizing production plan as the
output price p changes?
Profit-Maximization
The equation of a short-run iso-profit line
is w1   w 2x~
y x1  2
p p
so an increase in p causes
-- a reduction in the slope, and
-- a reduction in the vertical intercept.
Profit-Maximization    
y    
  
~ )
y  f ( x1 , x 2
y*
w1
Slopes  
p
x*1 x1
Profit-Maximization
y
~ )
y  f ( x1 , x 2
y*
w1
Slopes  
p
x*1 x1
Profit-Maximization
y
~ )
y  f ( x1 , x 2
y*
w1
Slopes  
p
x*1 x1
Profit-Maximization
 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).
Profit-Maximization
The Cobb-Douglas example: When
1/ 3 ~ 1/ 3
y  x1 x 2 then the firm’s short-run
demand for its variable input 1 is
3/ 2
*  p  ~ 1/ 2
x1    x2 and its short-run
 3w 1 
1/ 2 supply is
*  p  ~ 1/ 2 .
y   x 2
 3w 1 
Profit-Maximization
1/ 3 ~ 1/ 3
3/ 2
*  p  ~ 1/ 2
 3w 1 
1/ 2 supply is
*  p  ~ 1/ 2
y   x2 .
 3w 1 
x*1 increases as p increases.
Profit-Maximization
1/ 3 ~ 1/ 3
3/ 2
*  p  ~ 1/ 2
 3w 1 
1/ 2 supply is
*  p  ~ 1/ 2
y   x2 .
 3w 1 
x*1 increases as p increases.
y* increases as p increases.
Profit-Maximization
 What happens to the short-run profit-
maximizing production plan as the
variable input price w1 changes?
Profit-Maximization
The equation of a short-run iso-profit line
is w1 ~
  w 2x 2
y x1 
p p
so an increase in w1 causes
-- an increase in the slope, and
-- no change to the vertical intercept.
Profit-Maximization    
y    
  
~ )
y  f ( x1 , x 2
y*
w1
Slopes  
p
x*1 x1
Profit-Maximization
y    
   
  
~ )
y  f ( x1 , x 2
y*
w1
Slopes  
p
x*1 x1
Profit-Maximization
y    
   
  
~ )
y  f ( x1 , x 2
w1
Slopes  
y* p
x*1 x1
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).
Profit-Maximization
1/ 3 ~ 1/ 3
3/ 2
*  p  ~ 1/ 2
 3w 1 
1/ 2 supply is
*  p  ~ 1/ 2 .
y   x 2
 3w 1 
Profit-Maximization
1/ 3 ~ 1/ 3
3/ 2
*  p  ~ 1/ 2
 3w 1 
1/ 2 supply is
*  p  ~ 1/ 2
y   x2 .
 3w 1 
x*1 decreases as w1 increases.
Profit-Maximization
1/ 3 ~ 1/ 3
3/ 2
*  p  ~ 1/ 2
 3w 1 
1/ 2 supply is
*  p  ~ 1/ 2
y   x2 .
 3w 1 
x*1 decreases as w1 increases.
y* decreases as w1 increases.
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.
 Think of the firm as choosing the
production plan that maximizes
profits for a given value of x2, and
then varying x2 to find the largest
possible profit level.
The equation of a long-run iso-profit line

is w1   w 2x 2
y x1 
p p
so an increase in x2 causes
-- no change to the slope, and
-- an increase in the vertical intercept.
y
y  f ( x 1 , x 2 )
x1
y
y  f ( x 1 , 3x 2 )
y  f ( x 1 , 2x 2 )
y  f ( x 1 , x 2 )
x1
Larger levels of input 2 increase the
productivity of input 1.
y
y  f ( x 1 , 3x 2 )
y  f ( x 1 , 2x 2 )
y  f ( x 1 , x 2 )
The marginal product
of input 2 is
diminishing.
x1
y
y  f ( x 1 , 3x 2 )
y  f ( x 1 , 2x 2 )
y  f ( x 1 , x 2 )
of input 2 is
diminishing.
x1
p  MP1  w 1  0 for each short-run
y
production plan.
y  f ( x 1 , 3x 2 )
y  f ( x 1 , 2x 2 )
y* ( 3x 2 )
y* ( 2x 2 )
y  f ( x 1 , x 2 )
y* ( x 2 )
x*1 ( x 2 ) x*1 ( 3x 2 ) x1
x*1 ( 2x 2 )
y
production plan.
y  f ( x 1 , 3x 2 )
y  f ( x 1 , 2x 2 )
y* ( 3x 2 )
y* ( 2x 2 )
y  f ( x 1 , x 2 )
y* ( x 2 ) of input 2 is
diminishing so ...
x*1 ( x 2 ) x*1 ( 3x 2 ) x1
x*1 ( 2x 2 )
y
production plan.
y  f ( x 1 , 3x 2 )
y  f ( x 1 , 2x 2 )
y* ( 3x 2 )
y* ( 2x 2 )
y  f ( x 1 , x 2 )
the marginal profit
y* ( x 2 ) of input 2 is
diminishing.
x*1 ( x 2 ) x*1 ( 3x 2 ) x1
x*1 ( 2x 2 )
 Profit
will increase as x2 increases so
long as the marginal profit of input 2
p  MP2  w 2  0.
 Theprofit-maximizing level of input 2
therefore satisfies
p  MP2  w 2  0.
 Profit
will increase as x2 increases so
long as the marginal profit of input 2
p  MP2  w 2  0.
 Theprofit-maximizing level of input 2
therefore satisfies
p  MP2  w 2  0.
 And p  MP1  w 1  0 is satisfied in any
short-run, so ...
 Theinput levels of the long-run
profit-maximizing plan satisfy
p  MP1  w 1  0 and p  MP2  w 2  0.

 That
is, marginal revenue equals
marginal cost for all inputs.

1/ 3 ~ 1/ 3
3/ 2
*  p  ~ 1/ 2
 3w 1 
1/ 2 supply is
*  p  ~ 1/ 2
y   x2 .
 3w 1 
Short-run profit is therefore …
~
  py*  w 1x*1  w 2x 2
1/ 2 3/ 2
 p  ~ 1/ 2  p  ~ 1/ 2  w x
~
 p  x2  w1  x 2 2 2
 3w 1   3w 1 
~
  py*  w 1x*1  w 2x 2
1/ 2 3/ 2
 p  ~ 1/ 2  p  ~ 1/ 2  w x
~
 p  x2  w1  x 2 2 2
 3w 1   3w 1 
1/ 2 1/ 2
 p  ~ 1/ 2 p  p  ~
 p  x2  w1    w 2x 2
 3w 1  3w 1  3w 1 
~
  py*  w 1x*1  w 2x 2
1/ 2 3/ 2
 p  ~ 1/ 2  p  ~ 1/ 2  w x
~
 p  x2  w1  x 2 2 2
 3w 1   3w 1 
1/ 2 1/ 2
 p  ~ 1/ 2 p  p  ~
 p  x2  w1    w 2x 2
 3w 1  3w 1  3w 1 
1/ 2
2p  p  ~ 1/ 2  w x
~
   x 2 2 2
3  3w 1 
~
  py*  w 1x*1  w 2x 2
1/ 2 3/ 2
 p  ~ 1/ 2  p  ~ 1/ 2  w x
~
 p  x2  w1  x 2 2 2
 3w 1   3w 1 
1/ 2 1/ 2
 p  ~ 1/ 2 p  p  ~
 p  x2  w1    w 2x 2
 3w 1  3w 1  3w 1 
1/ 2
2p  p  ~ 1/ 2  w x
~
   x 2 2 2
3  3w 1 
3 1/ 2
 4p  ~ 1/ 2  w x
~ .
   x 2 2 2
 27 w 1
3 1/ 2
 4p  ~ 1/ 2  w x
~ .
    x 2 2 2
 27 w 1
What is the long-run profit-maximizing

level of input 2? Solve
3 1/ 2
 1  4p  ~  1/ 2  w
0  ~    x 2 2
 x 2 2  27 w 1 
to get ~  x*  p3
x 2 2 .
27w 1w 22
input 1 level? Substitute
3 3/ 2
x*2 
p *  p  ~ 1/ 2
into x1    x 2
27w 1w 22  3w 1 
to get
input 1 level? Substitute
3 3/ 2
x*2 
p *  p  ~ 1/ 2
into x1    x 2
27w 1w 22  3w 1 
to get
3 / 2 3 1/ 2 3
*  p  p  p
x1       .
 3w 1   27 w 1w 22  27 w 12 w 2
output level? Substitute
3 1/ 2
p *  p  ~ 1/ 2
x*2  into y    x 2
27w 1w 22  3w 1 
to get
output level? Substitute
3 1/ 2
p  p 
* ~ 1/ 2
x*2  into y    x 2
27w 1w 22  3w 1 
to get
1/ 2 3 1/ 2
*  p  p  p2
y      .
 3w 1   27 w 1w 22  9 w 1w 2
So given the prices p, w1 and w2, and
the production function y  x1/ 3 1/ 3
1 x2
the long-run profit-maximizing production

plan is
 3 3 2 
p p p
( x*1 , x*2 , y* )   , ,  .
2 2 9w w
 27 w 1 w 2 27 w 1w 2 1 2
Returns-to-Scale and Profit-
Maximization (LONG - RUN)
 Ifa competitive firm’s technology
exhibits decreasing returns-to-scale
then the firm has a single long-run
profit-maximizing production plan.
Returns-to Scale and Profit-
Maximization
y
y  f(x)
y*
Decreasing
returns-to-scale
x* x
Maximization
 Ifa competitive firm’s technology
exhibits exhibits increasing returns-
to-scale then the firm does not have
a profit-maximizing plan.
Maximization
y
as ing
Inc re y  f(x)
ro fit
p
y”
y’ Increasing
returns-to-scale
x’ x” x
Maximization
 Soan increasing returns-to-scale
technology is inconsistent with firms
being perfectly competitive.
Maximization
 What if the competitive firm’s
technology exhibits constant
returns-to-scale?
Maximization
y
as ing
I nc re
ro fit y  f(x)
p
y”
Constant
y’ returns-to-scale
x’ x” x
Maximization
 Soif 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.
Maximization
 Therefore, when a firm’s technology
exhibits constant returns-to-scale,
earning a positive economic profit is
inconsistent with firms being
perfectly competitive.
 Hence constant returns-to-scale
requires that competitive firms earn
economic profits of zero.
Maximization
y
y  f(x)
=0
y”
Constant
y’ returns-to-scale
x’ x” x
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?
 The production function is Q = L1/2
and the market price of this product is
100. Find the profit – maximizing of
this firm. Given the wage for the only
one input is 25.
(w = MPxP)
Profit maximizing
 II= TR – TC
 TR = P.Q and TC = VC + FC
 W = MP. P
 MR = MC
(Perfect competition: Q
Monopoly: Q, use demand curve => P
Oligopoly: cartel / Nash/ Cournot/ game
theory)
Monopolistic competition: advertising

Topic 4: Profit (Cont.) : Profit-Maximization Firm's Supply Industry Supply

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Topic 4: Profit (Cont.) : Profit-Maximization Firm's Supply Industry Supply

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Topic 4: Profit (cont.

 Input levels are x1,…,xm.

 The economic profit generated by

p  MP1 is the marginal revenue product of

 Now allow the firm to vary both input

The equation of a long-run iso-profit line

p  MP1  w 1  0 and p  MP2  w 2  0.

The Cobb-Douglas example: When

What is the long-run profit-maximizing

the long-run profit-maximizing production

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