Profit Maximization

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# Profit Maximization - PowerPoint PPT Presentation

Profit Maximization. What is the goal of the firm? Expand, expand, expand: Amazon. Earnings growth: GE. Produce the highest possible quality: this class. Many other goals: happy customers, happy workers, good reputation, etc.

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## PowerPoint Slideshow about ' Profit Maximization' - sidone

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Presentation Transcript
Profit Maximization
• What is the goal of the firm?
• Expand, expand, expand: Amazon.
• Earnings growth: GE.
• Produce the highest possible quality: this class.
• Many other goals: happy customers, happy workers, good reputation, etc.
• It is to maximize profits: that is, present value of all current and future profits (also known as net present value NPV).
Profit
• Profits=revenue-costs
• Two inputs x1 and x2 with input prices w1 and w2. Inputs can be labor, rent, parts, etc.
• Two outputs y1 and y2 with output prices p1 and p2.
• A competitive firm takes prices as given.
• What is profits?
• Note that inputs and outputs can be internal to the firm.
One input, one output
• There is one output y and one input x where y=f(x).
• The firms problem is the maximize

Max x,y p*y-w*x s.t. y=f(x).

• Two ways:

1. Draw isoprofit lines (where profit is constant). Find which is the highest profit line that can be reached with the production function.

2. Substitute in for y and take FOC and solve.

Past, Present and Future
• What happens if some decisions are already made in the past?
• Remember one can’t change the past.
• Euro-tunnel: spend billions to build it. Does this mean that prices have to be higher for tickets?
• Similar for Airwave Auctions, Iridium and many other cases.
Past costs are sunk.
• y=f(x1,x2), but x2 is already paid for and fixed.
• This problem is the same as our problem with just one variable.
• Try this w/ Cobb-Douglas
• What happens to output when p and w1 change?
In the Long run..
• We can choose both variables. We then need to take FOCs of both.
• Focs are p*f1(x1,x2)=w1 and p*f2(x1,x2)=w2.

(remember f1(x1,x2)= MP1)

• What is output in the C-D case as a function of prices?
Returns to Scale
• If production is decreasing-RS, then solution is simple.
• If production is increasing-RS then “Houston, we have a problem.”
• If production is constant-RS, then
• If profits are negative then firms produce zero.
• If profits are positive then firms can keep producing to increase profits. Result output prices decrease and input prices increase.
• Result: if market is competitive w/ CRS there are zero profits for each firm!!
• Some economists claim any DRS is just CRS with less inputs. Think of CD.