chapter 9 Profit Maximization Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

9-2 Learning Objectives Describe the relationship between a firm’s marginal revenue and its price. Explain how firms should determine their profit- maximizing sales quantities. Identify the profit-maximizing sales quantity for a price-taking firm, and derive its supply function. Explain why price-taking firms usually respond to price changes more over the long run than they do over the short-run. Define producer surplus and describe its measurement. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

9-3 Overview Firm managers usually set their prices (or sales quantities) to maximize profits To find those optimal prices (or quantities) we will use marginal revenue and marginal cost In competitive markets firms take the market price for their product as given, and decide on profit-maximizing sales quantities Producer surplus is a measure of profits that focuses on avoidable costs Profit maximization techniques also work for multiproduct price-taking firms Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Choosing Price versus Choosing Quantity Inverse demand function: how much the firm must charge to sell any given quantity of its product Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 9-4

9-5 Maximizing Profit Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

9-6 Profit-Maximizing Quantity and Price Profit-maximizing price Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Profit-Maximizing Sales Quantity Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 9-7

9-8 Marginal Revenue, Marginal Cost, and Profit Maximization Marginal revenue: additional revenue produced by the ΔQ marginal units sold, on a per unit basis. Inframarginal units: units firm sells other than the ΔQ marginal units Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

9-9 Marginal Revenue Increase in sales quantity, from Q – ΔQ to Q changes revenue in two ways Output expansion effect: sell ΔQ additional units, each at price of P(Q) Price reduction effect: increased sales quantity requires a reduction in price from P(Q – ΔQ) to P(Q) Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Marginal Revenue and Price Output expansion effect Price reduction effect Output expansion effect Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 9-10

9-11 Marginal Revenue and Demand Curves Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

9-12 Finding Profit-Maximizing Sales Quantity using Marginal Revenue and Marginal Cost Step 1: Quantity rule. Identify positive sales quantities where MR = MC. If it is satisfied by more than one positive sale then determine with produces the highest profit. Step 2: Shut-down rule. Check whether the most profitable positive sale quantity results in greater profit than shutting down. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

9-13 Finding Profit-Maximizing Sales Quantity for Price-Taking Firms Step 1: Quantity rule. For a price-taking firm, P = MR for all quantities. Identify positive sales quantities where P = MC. If it is satisfied by more than one positive sale then determine with produces the highest profit. Step 2: Shut-down rule. Check whether the most profitable positive sale quantity results in greater profit than shutting down. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Profit-Maximizing Sales for Price- Taking Firm - No Sunk Costs P > AC Else, shut down Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 9-14

9-15 Supply Function of a Price-Taking Firm Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Supply Curve of a Price-Taking Firm Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 9-16

Law of Supply When market price increases, the profit- maximizing sales quantity for a price- taking firm never decreases In the graph, when the market price rises, revenue rises more quantity Ǭ than at any smaller quantity Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 9-17

9-18 Increase in Marginal Cost Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

9-19 Increase in Avoidable Fixed Cost Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

9-20 Short-Run Versus Long-Run Supply Firm’s marginal and average costs may differ in the long and short run because some inputs are fixed rather than variable in the short run Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

SR and LR Responses to a Price Increase Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 9-21

Producer Surplus Producer Surplus = revenue - avoidable cost Profit = producer surplus – sunk cost Producer surplus Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 9-22

Producer Surplus = revenue - avoidable cost Profit = producer surplus – sunk cost Producer surplus Producer Surplus Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education. 9-23

9-24 Supply by Multiproduct Price- Taking Firms Finding profit-maximizing sales quantities and prices for two products Quantity rule: find most profitable pair of positive sales quantities at which price equals marginal cost for both products Shut-down rule: compares the profit from those quantities with: a)Shutting down first product while selling second b)Shutting down second product while selling first c)Shutting down both products Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

9-25 Review The relationship between a firm’s price and sales quantity is described by the demand curve for its product. The quantity rule + the shut-down rule identify the firm’s profit-maximizing sales quantity The law of supply tells us that a competitive firm’s supply never decreases when the market price increases. A firm’s producer surplus equals its revenue less its avoidable costs. Therefore, the firm’s profit equals its producer surplus less its sunk costs. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

9-26 Looking Forward Next we will switch our focus to how consumers and firms make intertemporal decisions. The tools we have learned will still be useful, but we will need to learn a few more concepts, the interest rate and the present discounted value among them. Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.