Profit-Maximization

Short run and long run

 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.
Firms seek to maximize profits.
 The Competitive Firm
The competitive firm takes all output prices
p1,,pn and all input prices w1,,wm as given
constants.
 =TR-TC
TR=PQ
MR=TR/Q
Profit is maximised where MR=MC
(Q)=P(Q)Q-C(Q)=R(Q)-C(Q)
MR=MC is found by differentiating the profit function with
respect to Q. (necessary condition).
The sufficient condition is to find the second derivative of the
profit function which should be less than 0 for maximum
profit.
 Economic Profit
The economic profit generated by the
production plan (x1,,xm,y1,,yn) is

p1y1 pnyn w1x1 wmxm .

 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 firms stream of periodic
economic profits is 0, 1, 2, and r is
the rate of interest.
Then the present-value of the firms
economic profit stream is
1 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 x2 .
Its short-run production function is
~
y f ( x1 , x2 ).
The firms fixed cost is ~
FC w 2x 2
and its profit function is
~ .
py w1x1 w 2x 2
 Short-Run Iso-Profit Lines
An isoprofit line shows all combinations of input goods that
give a consumer a constant level of profit. As profit varies, we
get a family of isoprofit lines each with slope w1 and
p
w2 ~x 2
vertical intercept of p which measures profits plus
fixed costs of the firm.
A $ iso-profit line contains all the production plans that
provide a profit level $ .
A $ iso-profit lines equation is
py w1 x1 w2 ~
x2 .
 Short-Run Iso-Profit Lines
A $ iso-profit line contains all the production
plans that yield a profit level of $ .
The equation of a $ iso-profit line is

I.e. ~
py w1x1 w 2x2 .
w1 ~
w 2x 2
y x1 .
p p
 Short-Run Iso-Profit Lines
y

w1
Slopes
p

x1
 Short-Run Profit-Maximization
The firms problem is to locate the production
plan that attains the highest possible iso-profit
line, given the firms constraint on choices of
production plans.
Q: What is this constraint?
A: The production function.
Short-Run Profit-Maximization
y



w1
y* Slopes
p

x*1 x1
 At the short-run profit-maximizing plan, the
slopes of the short-run production function
and the maximal iso-profit line are equal.
This occurs at: w1
MP1 at ( x1* , ~
x2 , y * )
p
p MP1 w1
The firm chooses the input and output combination that lies on
the highest iso-profit line
 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 MP w then profit increases with x1.
1 1

If p MP1 w1 then profit decreases with x1.

Short-Run Profit-Maximization; A
Cobb-Douglas Example
Suppose the short-run production
function is y x11 / 3 ~
x21 / 3 .
The marginal product of the variable
input 1 is y 1 2 / 3 ~1 / 3
MP1 x1 x2 .
x1 3

The profit-maximizing condition is

p * 2 / 3 ~1 / 3
MRP1 p MP1 ( x1 ) x2 w1 .
3
Short-Run Profit-Maximization; A
Cobb-Douglas Example
Solving p * 2 / 3 ~1 / 3
( x1 ) x 2 w1 for x1 gives
3

3w1
( x1* ) 2 / 3 ~ 1/ 3
.
px 2

That is,
p~
x 21 / 3
(x )*
1
2/3

3w1

~ 1/ 3 3 / 2 3/ 2
so px2 p ~1/ 2
x1
*
x2 .
3w1 3w1
Short-Run Profit-Maximization; A
Cobb-Douglas Example
3/ 2
p
x1*
3w
is the firms
~
x 21 / 2
1
short-run demand
for input 1 when the level of input 2 is
~ units. (input demand
fixed at x 2
function)
Short-Run Profit-Maximization; A
Cobb-Douglas Example
3/ 2
p is the firms
~
x
*
1
x 21 / 2
3w1 short-run demand
for input 1 when the level of input 2 is
~ units.
fixed at x 2
The firms short-run output level (supply)is thus
1/ 2
~ p ~1 / 2
y ( x ) x2
* * 1/ 3
1
1/ 3
x2 .
3w1
 Comparative Statics of Short-Run
Profit-Maximization
What happens to the short-run profit-
maximizing production plan as the output
price p changes?
Comparative Statics of Short-Run
Profit-Maximization
The equation of a short-run iso-profit line
is
w1 w2 ~x 2
y x1
p p
so an increase in p causes
-- a reduction in the slope, and
-- a reduction in the vertical intercept.
Comparative Statics of Short-Run
Profit-Maximization
The Cobb-Douglas example: When
1/3~ 1/3
y x1 x 2 then the firms 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 x2 .
3w 1
x*1 increases as p increases.
y* increases as p increases.
 Comparative Statics of Short-Run
Profit-Maximization
What happens to the short-run profit-
maximizing production plan as the variable
input price w1 changes?
Comparative Statics of Short-Run
Profit-Maximization
The Cobb-Douglas example: When
1/3~ 1/3
y x1 x 2 then the firms 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 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.
 Long-Run Profit-Maximization
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.
 Long-Run Profit-Maximization
In the long run, all factors are variable The
equation of a long-run iso-profit line is
w1 w2 x 2
y x1
p p

so an increase in x2 causes
-- no change to the slope, and
-- an increase in the vertical intercept.
Long-Run Profit-Maximization
y

y f ( x1 , x2 )

x1
 Long-Run Profit-Maximization
y

y f ( x1 , 3x2 )
y f ( x1 , 2x2 )

y f ( x1 , x2 )

x1
Larger levels of input 2 increase the
productivity of input 1.
 Long-Run Profit-Maximization
y

y f ( x1 , 3x2 )
y f ( x1 , 2x2 )

y f ( x1 , x2 )
The marginal product
of input 2 is
diminishing.
x1
Larger levels of input 2 increase the
productivity of input 1.
 Long-Run Profit-Maximization
y

y f ( x1 , 3x2 )
y f ( x1 , 2x2 )

y f ( x1 , x2 )
The marginal product
of input 2 is
diminishing.
x1
Larger levels of input 2 increase the
productivity of input 1.
 Long-Run Profit-Maximization
y
p MP1 w1 0 for each short-run
production plan.
y f ( x1 , 3x2 )
y f ( x1 , 2x2 )
y* ( 3x2 )
y* ( 2x2 )
y f ( x1 , x2 )

y* ( x2 )

x*1 ( x2 ) x*1 ( 3x2 ) x1

x*1 ( 2x2 )
 Long-Run Profit-Maximization
y
p MP1 w1 0 for each short-run
production plan.
y f ( x1 , 3x2 )
y f ( x1 , 2x2 )
y* ( 3x2 )
y* ( 2x2 )
y f ( x1 , x2 )
The marginal product
y* ( x2 ) of input 2 is
diminishing so ...
x*1 ( x2 ) x*1 ( 3x2 ) x1
x*1 ( 2x2 )
 Long-Run Profit-Maximization
y
p MP1 w1 0 for each short-run
production plan.
y f ( x1 , 3x2 )
y f ( x1 , 2x2 )
y* ( 3x2 )
y* ( 2x2 )
y f ( x1 , x2 )
the marginal profit
y* ( x2 ) of input 2 is
diminishing.
x*1 ( x2 ) x*1 ( 3x2 ) x1
x*1 ( 2x2 )
 Long-Run Profit-Maximization
Profit will increase as x2 increases so long as
the marginal profit of input 2
p MP2 w 2 0.
The profit-maximizing level of input 2
therefore satisfies
p MP2 w 2 0.
 Long-Run Profit-Maximization
Profit will increase as x2 increases so long as
the marginal profit of input 2
p MP2 w 2 0.
The profit-maximizing level of input 2
therefore satisfies
p MP2 w 2 0.
And p MP1 w1 0 is satisfied in any
short-run, so ...
 Long-Run Profit-Maximization
The input levels of the long-run profit-
maximizing plan satisfy

p MP1 w1 0 and p MP2 w 2 0.

That is, marginal revenue equals marginal cost

for all inputs.
 Long-Run Profit-Maximization
The Cobb-Douglas example: When
1/3~ 1/3
y x1 x 2 then the firms 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 x2 .
3w 1
Short-run profit is therefore
Long-Run Profit-Maximization
py * w1 x1* w2 ~
x2
1/ 2 3/ 2
p ~ p ~
p x 2 w1
1/ 2
x 21 / 2 w2 ~
x2
3w1 3w1
Long-Run Profit-Maximization

py * w1 x1* w2 ~
x2
1/ 2 3/ 2
p ~ p ~
p x 2 w1
1/ 2
x 21 / 2 w2 ~
x2
3w1 3w1
1/ 2 1/ 2
p ~ p p
p x 2 w1
1/ 2
w2 ~
x2
3w1 3w1 3w1
Long-Run Profit-Maximization
py * w1 x1* w2 ~
x2
1/ 2 3/ 2
p ~ p ~
p x 21 / 2 w1 x 21 / 2 w2 ~
x2
3w1 3w1
1/ 2 1/ 2
p ~ p p
p x 2 w1
1/ 2
w2 ~
x2
3w1 3w1 3w1
1/ 2
2p p ~
x 21 / 2 w2 ~
x2
3 3w1
 Long-Run Profit-Maximization
py * w1 x1* w2 ~
x2
1/ 2 3/ 2
p ~ p ~
p x 2 w1
1/ 2
x 21 / 2 w2 ~
x2
3w1 3w1
1/ 2 1/ 2
p ~ p p
p x 21 / 2 w1 w2 ~
x2
3w1 3w1 3w1
1/ 2
2p p ~
x 21 / 2 w2 ~
x2
3 3w1
1/ 2
4p 3
~
x 21 / 2 w2 ~
x2 .
27 w1
 Long-Run Profit-Maximization
1/ 2
4p 3
~
x 21 / 2 w2 ~
x2 .
27 w1
What is the long-run profit-maximizing
level of input 2? Solve
1/ 2
1 4 p ~ 1 / 2
3
0 ~ x2 w2
x2 2 27 w1
to get 3
~ p
x2 x *
2 2
.
27 w1 w2
 Long-Run Profit-Maximization
What is the long-run profit-maximizing
input 1 level? Substitute
3/ 2
* p
3
p ~ 1/ 2
x*2 into x1 x 2
27w 1w 2
2 3w 1

to get
 Long-Run Profit-Maximization
What is the long-run profit-maximizing
input 1 level? Substitute
3/ 2
* p
3
p ~ 1/ 2
x*2 into x1 x 2
27w 1w 2
2 3w 1

to get
3 / 2 1/ 2
* p p 3 p 3
x1 .
3w 1 27w1w 22 27w12w 2
 Long-Run Profit-Maximization
What is the long-run profit-maximizing
output level? Substitute
1/ 2
p 3
* p ~ 1/ 2
x*2 into y x 2
27w 1w 2
2 3w 1
to get
 Long-Run Profit-Maximization
What is the long-run profit-maximizing
output level? Substitute
1/ 2
p 3 p
* ~ 1/ 2
x*2 into y x 2
27w 1w 2
2 3w 1
to get
1/ 2 1/ 2
* p p 3 p2
y .
3w 1 27w 1w 22 9 w 1w 2
 Long-Run Profit-Maximization
So given the prices p, w1 and w2, and
the production function y x1 / 3 x1 / 3
1 2

the long-run profit-maximizing production

plan is
p 3
p 3
p 2

( x1 , x2 , y )
* * *
2
, 2
, .
27 w1 w2 27 w1 w2 9w1 w2
 Returns-to-Scale and Profit-
Maximization
If a competitive firms technology exhibits
decreasing returns-to-scale then the firm has
a single long-run profit-maximizing production
plan.
 Returns-to Scale and Profit-
y
Maximization

y f(x)
y*

Decreasing
returns-to-scale

x* x
 Returns-to-Scale and Profit-
Maximization
If a competitive firms technology exhibits
exhibits increasing returns-to-scale then the
firm does not have a profit-maximizing plan.
 Returns-to Scale and Profit-
y
Maximization

y f(x)

y Increasing
returns-to-scale
x x x
 Returns-to-Scale and Profit-
Maximization
So an increasing returns-to-scale technology is
inconsistent with firms being perfectly
competitive.
 Returns-to-Scale and Profit-
Maximization
What if the competitive firms technology
exhibits constant returns-to-scale?
 Returns-to Scale and Profit-
y
Maximization

y f(x)

y
Constant
y returns-to-scale
x x x
 Returns-to Scale and Profit-
Maximization
So if 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.
 Returns-to Scale and Profit-
Maximization
Therefore, when a firms 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.
 Returns-to Scale and Profit-
y
Maximization

y f(x)

=0
y
Constant
y returns-to-scale
x x x