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

Dec 21, 2015

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Page 1: Chapter 9 Profit Maximization Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent.

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.

Page 2: Chapter 9 Profit Maximization Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent.

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.

Page 3: Chapter 9 Profit Maximization Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent.

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.

Page 4: Chapter 9 Profit Maximization Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent.

Choosing Price versus Choosing Quantity

Inverse demand function: how much the firm must charge to sell any given quantity of its product

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Page 5: Chapter 9 Profit Maximization Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent.

9-5

Maximizing Profit

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Page 6: Chapter 9 Profit Maximization Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent.

9-6

Profit-Maximizing Quantity and Price

Profit-maximizing priceCopyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

Page 7: Chapter 9 Profit Maximization Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent.

Profit-Maximizing Sales Quantity

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Page 8: Chapter 9 Profit Maximization Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent.

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

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

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.

Page 10: Chapter 9 Profit Maximization Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent.

Marginal Revenue and Price

Output expansion effect

Price reduction effect Output

expansion effect

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Page 11: Chapter 9 Profit Maximization Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent.

9-11

Marginal Revenue and Demand Curves

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Page 12: Chapter 9 Profit Maximization Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent.

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.

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Page 13: Chapter 9 Profit Maximization Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent.

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.

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Page 14: Chapter 9 Profit Maximization Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent.

Profit-Maximizing Sales for Price-Taking Firm - No Sunk Costs

P > ACElse, shut down

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Page 15: Chapter 9 Profit Maximization Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent.

9-15

Supply Function of a Price-Taking Firm

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Page 16: Chapter 9 Profit Maximization Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent.

Supply Curve of a Price-Taking Firm

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Page 17: Chapter 9 Profit Maximization Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent.

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

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Page 18: Chapter 9 Profit Maximization Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent.

9-18

Increase in Marginal Cost

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9-19

Increase in Avoidable Fixed Cost

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Page 20: Chapter 9 Profit Maximization Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent.

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

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Page 21: Chapter 9 Profit Maximization Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent.

SR and LR Responses to a Price Increase

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Page 22: Chapter 9 Profit Maximization Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent.

Producer Surplus

• Producer Surplus = revenue - avoidable cost

• Profit = producer surplus – sunk cost Producer

surplus

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Page 23: Chapter 9 Profit Maximization Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent.

• Producer Surplus = revenue - avoidable cost

• Profit = producer surplus – sunk cost Producer

surplus

Producer Surplus

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Page 24: Chapter 9 Profit Maximization Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent.

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 secondb) Shutting down second product while selling firstc) Shutting down both products

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Page 25: Chapter 9 Profit Maximization Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent.

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.

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Page 26: Chapter 9 Profit Maximization Copyright © 2014 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent.

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.

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