Theory of the firm:

Profit maximization

1
 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 Sellers
3

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

Sellers
Should I sell another unit?
Answer: If the marginal revenue exceeds the marginal cost of
making it
 Sellers goal?
4

Maximize profit
Decisions:
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 Perfect

Competition Competition
 Basic principles
6

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 Maximization
8

Accounting Profit
The 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.
 2 Types of Costs and 2 Types of Profit
9

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
firms owners
Eg: opportunity cost of owners time
Eg: opportunity cost of owner-invested funds
 Two Types of Profit
10

Accounting Profit
Total Revenue Explicit Costs

Economic Profit
Total Revenue Explicit Costs Implicit Costs

Economic Loss
An economic profit less than zero
The Difference Between Accounting Profit
and Economic Profit
11
The Difference Between Accounting Profit and
Economic Profit
12

Revenue Acct Costs = Acct Profit

Revenue Econ Costs = Econ Profit

Revenue Explicit Costs = Acct Profit

Revenue (Explicit + Implicit costs) = Econ Profit

Acct Profit Implicit Costs = Econ Profit

If Acct Profit exactly = Implicit Costs => Econ Profit = 0,
and the firm is said to be earning a normal profit
 Econ vs. Acct Profits
13

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)
 To Farm or Not To Farm?
14

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)
Daves 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

 Example
15

After graduation you face the following job choice:

Option 1: IBM in RTP

Salary = $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.
 Example continued
16
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 = $15,000
Rent = $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
 Example continued
17

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
 Functions of Price
21

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.
 Market Forces and Economic Profit
22

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
 Fig. 8.2
The Effect of Economic Profit on Entry
23
 Market Forces and Economic Profit
24

Negative Economic Profit means the firm (owner)

is not covering opp costs
Doing worse than the next best alternative
Price must be below ATC
Firms exit this industry
Supply decreases
Price rises
Losses fall

Zero profit tendency of competitive markets

 Fig. 8.3
The Effect of Economic Losses on Exit
25
 26

Production
& the principle of diminishing
marginal returns
 Production in the Short Run
27

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

The Short Run

A period of time sufficiently short that at least some of
the firms factors of production are fixed
The Long Run
A period of time of sufficient length that all the firms
factors of production are variable
 Law of Diminishing Returns
28

Fixed factor of production

An input whose quantity cannot be altered in the short
run. E.g. square footage of factory space
Variable 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 Point of diminishing
marginal returns

Labor
MPL
 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 Perfect

Competition Competition
 Perfect Competition
32

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 behavior
33

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
34
 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 Output
36

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 maximized
Cost-benefit principle & quantity decisions
A firm should increase output if marginal benefit (revenue)
exceeds the marginal cost
 Choosing Output
37

Cost-Benefit Principle
Increase output if marginal benefit exceeds the marginal
cost
For 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 Condition
38

Profit = TR TC
Max Profit with respect to Q
d Profit / dQ = (dTR/ dQ) (dTC/dQ) = 0
therefore maximum profit occurs where MR = MC
 Profit Maximization
39

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

P > ATC means profit > 0
MC
ATC
10 = P* D = MR

Q* Quantity
100
 Suppose Price Falls to Min ATC
40

P P = ATC means profit = 0

MC
ATC

7 = P* D = MR

Q* Quantity
Suppose Price Falls below Min ATC
41

P P < ATC means profit < 0

MC
ATC

7 = P* D = MR

Q* Quantity
 Response to Economic Profits

Markets with excess profits attract resources

Corn Industry Typical Corn Farm

Price Price
S
$/bu $/bu MC ATC
Economic
Profit

2 2 P

1.20
D

65 130
Quantity (M of bushels/year) Quantity (000s of bushels/year)
 Shrinking Economic Profits

Supply increases in the long run

Corn Industry Typical Corn Farm

Price Price
S
$/bu $/bu MC ATC
S'

Economic
Profit
2
1.50 P

65 95 120 130
Quantity (M of bushels/year) Quantity (000s of bushels/year)
 Market Equilibrium

Eventually, the market saturates and firms earn zero

economic profits
Corn Industry Typical Corn Farm
Price Price
S
$/bu $/bu MC ATC
S'
S"

2
1.50
1 P
D

65 115 90 130
Quantity (M of bushels/year) Quantity (000s of bushels/year)
 Response to economic losses

Resources leave the market

Price Corn Industry Price Typical Corn Farm

$/bu $/bu
MC ATC

1.05
0.75 0.75 P
D
60 70 90
Quantity (M of bushels/year) Quantity (000s of bushels/year)
 Market Equilibrium

Again the market reaches a situation of zero economic profit

Price Price
$/bu $/bu
MC ATC

S'
S

1 P
0.75
D
40 60 70 90
Quantity (M of bushels/year) Quantity (000s of bushels/year)
 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 Firms Supply Curve
48

The perfectly competitive firms 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
 49

Competitive markets and efficiency

(and inefficiency)
 The Domain of Markets
50

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
 Market Equilibrium and Efficiency
51

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
 Market Equilibrium and Efficiency
52

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.
 Adam Smith
53

Self-interest moves the economy

Consumers seek to maximize utility from purchases

Firms seek to maximize profit from production

It serves societys 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
 Invisible Hand
54

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
 Economic surplus (net gains)
55

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
Total economic surplus in the market for milk
56
 Surplus and Efficiency
57

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
 Other Goals
58

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
 Markets and Social Optimum
59

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 societys 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
Well get back to this idea soon
Some markets are inherently inefficient when left alone.
Government intervention can correct such inefficiencies
 Markets and Social Optimum
60

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)

The Market for Potatoes Without Taxes
61
The Effect of a $1 Pound Tax on Potatoes
62
The Deadweight Loss Caused by a Tax
63
 DWL
64

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

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

CS post-tax = (2.50)(2,500,000) = $3,125,000

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

DWL = $250,000
 Taxes, Elasticity, and Efficiency
65

Deadweight loss is minimized if taxes are imposed

on goods and services that have relatively inelastic
supply or relatively inelastic demand.
Elasticity of Demand and the Deadweight Loss from a Tax
66
Elasticity of supply and the deadweight loss from a tax
67
 Do all taxes decrease economic efficiency?
68

Consider a tax on land

Land supply is perfectly inelastic
DWL = $0

What other goods have high tax rates?

Booze
Cigarettes
Gasoline
 Taxes, External Costs, and Efficiency
69

Taxing reduces the equilibrium quantity

Therefore, taxing activities that people tend to
pursue to excess can actually increase total economic
surplus (e.g., activities that cause pollution)
External costs & taxes that are efficiency-enhancing
70

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 firms supply curve accurately reflect the
full costs of production?
No. without regulation, the firms supply curve only
reflects the marginal costs of production.
The external costs are not included in these costs.

What if they were?

 Market Equilibrium
71

S = MPC

$20 = P*MKT

D = MSB

Q*MKT Q

At P*MKT QD = QS = Q*MKT
CS + PS are maximized
 Market Equilibrium
72

The firms 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.
 Social Equilibrium
73

P MSC = MPC + 2

S = MPC

$21 = P*SOC
$20 = P*MKT

D = MSB

Q*SOC Q*MKT Q
 Social Efficiency
74

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

societys standpoint

How can this inefficiency be corrected?

 Social Efficiency
75

A tax equal to the marginal external cost ($2.00)

would serve to increase the firms 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
 Social Equilibrium
76

P New MPC = Old MPC + 2

S = MPC

$21 = P*SOC

D = MSB

Q*SOC Q*MKT Q
 Can markets create external benefits?
77

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?
 External
78 Benefits

S = MSC

P*MKT
MSB
D = MPB

Q*MKT Q*SOC Q
 External Benefits
79

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.
 Naturalist Questions
80

Why are gasoline taxes so high (relative to other

goods)?
Why arent gasoline taxes higher (as in other
nations)?
Why do communities have zoning laws?