Theory of the firm: Profit maximization Chapters 6, 7 & 8

1. Theory of the firm: Profit maximization Chapters 6, 7 & 8

2. Theory of the firm: Outline • 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

3. Buyers and Sellers • 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

4. Seller’s goal? • 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.

5. Types of Markets (degrees of competition) One firm 2-12 firms many firms many, many firms Monopoly Oligopoly Monopolistic Perfect Competition Competition

6. Basic principles • 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

8. Profit Maximization • 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.

9. 2 Types of Costs and 2 Types of Profit • 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 firm’s owners • Eg: opportunity cost of owner’s time • Eg: opportunity cost of owner-invested funds

10. Two Types of Profit • Accounting Profit • Total Revenue – Explicit Costs • Economic Profit • Total Revenue – Explicit Costs – Implicit Costs • Economic Loss • An economic profit less than zero

11. The Difference Between Accounting Profit and Economic Profit

12. The Difference Between Accounting Profit and Economic Profit • 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”

13. Econ vs. Acct Profits • 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)

14. To Farm or Not To Farm? • 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) • Dave’s 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

15. Example • 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.

16. Example continued 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

17. Example continued • 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?

18. What if economic profits are > 0? • 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?

19. What if economic profits are = 0? • 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?

20. “Normal Profit” • 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

21. Functions of Price • 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.

22. Market Forces and Economic Profit • 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

23. Fig. 8.2The Effect of Economic Profit on Entry

24. Market Forces and Economic Profit • 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

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

26. Production & the principle of diminishing marginal returns

27. Production in the Short Run • 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 firm’s factors of production are fixed • The “Long Run” • A period of time of sufficient length that all the firm’s factors of production are variable

28. Law of Diminishing Returns • 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.

29. Law of Diminishing Marginal Returns Q Point of diminishing marginal returns Labor MPL

30. Implications for Marginal Costs • 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

31. Types of Markets (degrees of competition) One firm 2-12 firms many firms many, many firms Monopoly Oligopoly Monopolistic Perfect Competition Competition

32. Perfect Competition • 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

33. Price taking behavior • 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

34. The Demand Curve Facing Perfectly Competitive Firm

35. How to choose output to maximize profit? • 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

36. Choosing Output • 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

37. Choosing Output • 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

38. Profit Maximizing Condition • Profit = TR – TC • Max Profit with respect to Q • d Profit / dQ = (dTR/ dQ) – (dTC/dQ) = 0 • therefore maximum profit occurs where MR = MC

39. Profit Maximization P ATC = Total Cost / Q so, TC = ATC x Q P > ATC means profit > 0 MC ATC 10 = P* D = MR 8 Q* Quantity 100

40. Suppose Price Falls to Min ATC P P = ATC means profit = 0 MC ATC 7 = P* D = MR Q* Quantity

41. Suppose Price Falls below Min ATC P P < ATC means profit < 0 MC ATC 7 = P* D = MR Q* Quantity

42. Response to Economic Profits Typical Corn Farm Corn Industry • Markets with excess profits attract resources Price $/bu Price $/bu S MC ATC Economic Profit P 2 2 1.20 D 130 65 Quantity (M of bushels/year) Quantity (000s of bushels/year)

43. Shrinking Economic Profits • Supply increases in the long run Typical Corn Farm Corn Industry Price $/bu Price $/bu S MC ATC S' Economic Profit 2 P 1.50 D 120 130 65 95 Quantity (M of bushels/year) Quantity (000s of bushels/year)

44. Market Equilibrium • Eventually, the market saturates and firms earn zero economic profits Typical Corn Farm Corn Industry Price $/bu Price $/bu S MC ATC S' S" 2 1.50 1 P D 90 130 65 115 Quantity (M of bushels/year) Quantity (000s of bushels/year)

45. Response to economic losses • Resources leave the market Price $/bu Price $/bu MC Typical Corn Farm Corn Industry ATC S 1.05 P 0.75 0.75 D 60 70 90 Quantity (M of bushels/year) Quantity (000s of bushels/year)

46. Market Equilibrium • Again the market reaches a situation of zero economic profit Price $/bu Price $/bu MC ATC S' S P 1 0.75 D 70 90 40 60 Quantity (M of bushels/year) Quantity (000s of bushels/year)

47. Shut Down? • 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).

48. Perfectly Competitive Firm’s Supply Curve • The perfectly competitive firm’s 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)

50. The Domain of Markets • 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