1. The Firm and Profit Maximization Overheads

2. Neoclassical firm - A neoclassical firm is an organization that controls the transformation of inputs (resources it owns or purchases) into outputs (valued products that it sells), and earns the difference between what it receives in revenue, and what it spends on inputs

3. We define the production function as f represents the relationship between outputs and inputs x j is the quantity used of the jth input (x 1, x 2, x 3,... x n ) is the input bundle n is the number of inputs used by the firm y represents output

4. Returns (Profit) The profit from a production plan is the revenue obtained from the plan minus the cost of inputs used to implement it

5. Objectives of the firm We typically assume that a firm exists in order to make money A firm that wants to make money is called a for-profit firm, or a profit maximizing firm

6. The firm maximizes the returns from the technologies it controls taking into account: Given the profit max assumption The demand for final consumption goods Opportunities for buying and selling factors / products The actions of other firms in the market

7. The profit max problem

8. What is profit? Profit is revenue minus costs or

9. Explicit and implicit costs Explicit costs 1.purchase of expendable inputs including labor time 2.purchase of capital services (usually rent or lease) Implicit costs 1.value of produced expendables (feed for a cattle producer) 2.value of services provided by owned capital including financial capital and charges such as implicit rent, depreciation, compensation for operator labor, etc.

10. Accounting profit Accounting cost Accounting profit + depreciation on plant & equipmentexplicit costs total revenue - accounting cost

11. Economic profit Economic cost Economic profit + all implicit costsexplicit costs total revenue - economic cost

12. Why do we use economic profit? To reflect total costs and revenues for a decision To account for all resources used in production

13. Why do profits exist? All factors of production receive a payment Expendables receive their market price Labor receives wages Land receives rent Capital receives interest Firm owners receive profits

14. What are profits? Profits are the returns to Innovation Risk production delivery new products

15. The Profit Maximizing Output Level Profit = Revenue - Cost = R - C

16. Demand The individual demand curve facing a firm tells us, for different prices, the quantity of output that customers will choose to purchase from the firm The demand curve facing the firm show us the maximum price the firm can charge to sell any given amount of output

17. Example Inverse Demands p = 320 - 20y p = $1.85

18. Total Revenue Revenue is the total income that comes from the sale of the output (goods and services) of a given firm or production process

19. YPriceFCVCCTRProfit 0.00 3201200.00 120.00 0-120.00 1.00 30012064.00 184.00 300116.00 2.00 280120130.00 250.00 560310.00 3.00 260120204.00 324.00 780456.00 4.00 240120292.00 412.00 960548.00 5.00 220120400.00 520.00 1100580.00

20. YPriceFCVCCTRProfit 0.00 3201200.00 120.00 0-120.00 1.00 30012064.00 184.00 300116.00 2.00 280120130.00 250.00 560310.00 3.00 260120204.00 324.00 780456.00 4.00 240120292.00 412.00 960548.00 5.00 220120400.00 520.00 1100580.00 6.00 200120534.00 654.00 1200546.00 7.00 180120700.00 820.00 1260440.00 8.00 160120904.00 1024.00 1280256.00 9.00 1401201152.00 1272.00 1260-12.00 10.00 1201201450.00 1570.00 1200-370.00 11.00 1001201804.00 1924.00 1100-824.00 12.00 801202220.00 2340.00 960-1380.00 14.00 401203262.00 3382.00 560-2822.00 16.00 01204624.00 4744.00 0-4744.00

21. Total cost

22. Maximizing profit Choose the level of output where the difference between TR and TC is the greatest

23. YPriceFCVCCTRProfit 0.00 3201200.00 120.00 0 -120.00 1.00 30012064.00 184.00 300116.00 2.00 280120130.00 250.00 560310.00 3.00 260120204.00 324.00 780456.00 4.00 240120292.00 412.00 960548.00 5.00 220120400.00 520.00 1100580.00 6.00 200120534.00 654.00 1200546.00 7.00 180120700.00 820.00 1260440.00 8.00 160120904.00 1024.00 1280256.00 9.00 1401201152.00 1272.00 1260-12.00 10.00 1201201450.00 1570.00 1200-370.00 11.00 1001201804.00 1924.00 1100-824.00 12.00 801202220.00 2340.00 960-1380.00

24. YPriceFCVCCTRProfit 0.00 3201200.00 120.00 0-120.00 1.00 30012064.00 184.00 300116.00 2.00 280120130.00 250.00 560310.00 3.00 260120204.00 324.00 780456.00 4.00 240120292.00 412.00 960548.00 5.00 220120400.00 520.00 1100580.00 6.00 200120534.00 654.00 1200546.00 7.00 180120700.00 820.00 1260440.00 8.00 160120904.00 1024.00 1280256.00 9.00 1401201152.00 1272.00 1260-12.00 10.00 1201201450.00 1570.00 1200-370.00 11.00 1001201804.00 1924.00 1100-824.00 12.00 801202220.00 2340.00 960-1380.00 14.00 401203262.00 3382.00 560-2822.00 16.00 01204624.00 4744.00 0-4744.00

25. Marginal cost (MC) Marginal cost is the increment, or addition, to cost that results from producing one more unit of output

26. yPriceFCVCCAFCAVCATCMCTRMRProfit 0.00 3201200.00 120.00 0-120.00 64.00 300.00 1.00 30012064.00 184.00 120.00 64.00 184.00 300116.00 66.00 260.00 2.00 280120130.00 250.00 60.00 65.00 125.00 560310.00 74.00 220.00 3.00 260120204.00 324.00 40.00 68.00 108.00 780456.00 88.00 180.00 4.00 240120292.00 412.00 30.00 73.00 103.00 960548.00 108.00 140.00 5.00 220120400.00 520.00 24.00 80.00 104.00 1100580.00 134.00 100.00 6.00 200120534.00 654.00 20.00 89.00 109.00 1200546.00 166.00 60.00 7.00 180120700.00 820.00 17.14 100.00 117.14 1260440.00 204.00 20.00 8.00 160120904.00 1024.00 15.00 113.00 128.00 1280256.00 248.00 -20.00 9.00 1401201152.00 1272.0013.33 128.00 141.33 1260-12.00 298.00 -60.00 10.00 1201201450.00 1570.00 12.00 145.00 157.00 1200-370.00

27. yPriceFCVCCAFCAVCATCMC 3 260120204.00 324.0 40.00 68.00 108.00 88.00 4 240120292.00 412.0 30.00 73.00 103.00 108.00 5 220120400.00 520.0 24.00 80.00 104.00

28. Marginal Revenue (MR) Marginal revenue is the increment, or addition, to revenue that results from producing one more unit of output Marginal revenue is the change in total revenue from producing one more unit of output

29. yPriceFCVCCAFCAVCATCMCTRMRProfit 0 3201200.00 120.0 0-120.0 64.00 300.0 1 30012064.00 184.0 120.00 64.00 184.00 300116.0 66.00 260.0 2 280120130.00 250.0 60.00 65.00 125.00 560310.0 74.00 220.0 3 260120204.0 324.0 40.0 68.0 108.0 780 456.0 88.00 180.0 4 240120292.0 412.0 30.0 73.0 103.0 960 548.0 108.00 140.0 5 220120400.00 520.0 24.00 80.00 104.00 1100580.0 134.00 100.0 6 200120534.00 654.0 20.00 89.00 109.00 1200546.0 166.00 60.0 7 180120700.00 820.0 17.14 100.00 117.14 1260440.0 204.00 20.0 8 160120904.00 1024.0 15.00 113.00 128.00 1280256.0

30. yPriceTRMRProfit 3.00 260780456.0 180.0 4.00 240960548.0 140.0 5.00 2201100580.0 100.0 6.00 2001200546.0

31. yPriceTRMRProfit 3.00260780456.0 180.0 4.00240960548.0 140.0 5.002201100580.0 100.0 6.00 2001200546.0 Another example Increase output from 4 to 5 units

32. A note on marginal revenue and price Marginal revenue is always less than price The firm must lower price in order to sell more units WHY?

33. p q q0q0 1234 p0p0 5 Revenue Marginal Revenue Marginal Revenue = p 0

34. The lower price applies to all units and so the revenue per unit will be less than the price p0p0 q0q0 p1p1 q1q1 B A p q Demand MR = A - B

35. Profit Max Using MR and MC An increase in output will always increase profit if MR > MC An increase in output will always decrease profit if MR < MC

36. The rule is then Increase output whenever MR > MC Decrease output if MR < MC

37. yPrice CMCTRMRProfit 3.00 260324.00780456.00 88.00 180.00 4.00 240412.00960548.00 108.00 140.00 5.00 220520.001100580.00 134.00 100.00 6.00 200654.001200546.00 Example Should we increase output from 3 to 4? Should we increase output from 4 to 5? Should we increase output from 5 to 6? Yes No !

38. Profit Maximization Using Graphs Profit is positive if TR > TC 0 200 400 600 800 1000 1200 1400 1600 1800 2000 024681012141618 Output $ TR C

39. Profit Maximization Using MR and MC Profit on a given unit is positive if MR > MC 0 50 100 150 200 250 300 350 400 024681012141618 Output $ MC Demand MR

40. Two intersections of MC and MR 0 50 100 150 200 250 300 02468101214161820 Output $ MC Demand MR

41. The optimal output level occurs where MC intersects MR from below 0 50 100 150 200 250 300 02468101214161820 Output $ MC Demand MR

42. Why average costs are irrelevant in the short-run The short-run decision is whether to produce one more unit or not Only marginal cost and marginal revenue are relevant for this decision

43. Marginal Decision Making and Short-run Decisions The marginal approach to profit states that a firm should take any action that adds more to its revenue than to its cost

44. Examples where marginal decision making is relevant advertising cost efficiency consultant adding a salesperson sprucing up sales area adding a two-year warranty to product

45. The shutdown rule Do we keep producing if we are losing money? It depends on what we mean by a loss It depends on whether we are in the short-run or in the long run It depends on which costs are fixed, which are variable, and which are sunk

46. Case 1 - TC > TR at all Q TR > TVC where MR = MC

47. TC > TR at all Q TR > TVC where MR = MC 0 25 50 75 100 125 150 175 200 012345678910 Output - y Cost VC CTR Marginal Cost & Revenue Curves 0 5 10 15 20 25 30 35 40 012345678910 Output - y Cost MC MR Total Cost & Revenue Curves

48. In the short-run fixed costs must be paid independent of the level of output At 6 units of output, total revenue more than covers total variable costs, leaving a residual to help cover fixed costs So the firm should produce 6 units in the short run

49. The shutdown rule In the short-run, the firm should continue to produce if total revenue exceeds total variable costs; otherwise, it should shut down

50. Case 2 - TC > TR at all Q TR < TVC where MR = MC

51. TR < TC at all Q TR < TVC where MR = MC Total Revenue and Cost Curves 0 10 20 30 40 50 60 70 80 90 01234567 Output - y Cost TVC C TR Marginal Revenue and Cost Curves 0 4 8 12 16 20 24 28 32 01234567 Output - y Cost MC MR

52. The shutdown rule In the short-run, the firm should continue to produce if total revenue exceeds total variable costs; otherwise, it should shut down

53. Shutdown in the long-run In the long-run the firm should exit the industry if it has any size loss

54. Shutdown and fixed costs that are not sunk In the short-run, if some of the fixed costs are not sunk, the firm may be better off to not operate when TR > TVC, if it can recover most of its sunk costs that are fixed costs, by shutting down

55. Suppose at 6 units of output, TFC =$50, TVC = $60 and TC = $110 But suppose that only $10 of the fixed costs are sunk, so that by shutting down the firm can recover $40.00 of fixed cost Suppose at 6 units of output, that total revenue is equal to $95. By operating the firm can make $35 over variable costs The firms net loss is then just $15.00 The firm's net loss by shutting down is only $10.00 The firm is better off by shutting down This will help cover the the fixed costs of $50 (95 - 60) (35 - 50 or 95 - 110)

56. Asset FixedVariableTotalSales DisposalTotalProfit/ Cost CostCost RevenueRevenueRevenueLoss Operate506011095095-15 Shut-down5005004040-10

57. The End