Chapter Nineteen

Profit-Maximization
Economic Profit
 A firm uses inputs j = 1…,m to make products i = 1,…
n.
 Output levels are y1,…,yn.
 Input levels are x1,…,xm.
 Product prices are p1,…,pn.
 Input prices are w1,…,wm.
The Competitive Firm

 The competitive firm takes all output

prices p1,…,pn and all input prices w1,
…,wm as given constants.
Economic Profit

 The economic profit generated by the

production plan (x1,…,xm,y1,…,yn) is

  p1y1  pnyn  w 1x1  w mxm .

Economic Profit

 Output and input levels are typically flows.

 E.g. x1 might be the number of labor units used per
hour.
 And y3 might be the number of cars produced per
hour.
 Consequently, profit is typically a flow also; e.g. the
number of dollars of profit earned per hour.
Economic Profit
 How do we value a firm?
 Suppose the firm’s stream of periodic economic
profits is  … and r is the rate of interest.
 Then the present-value of the firm’s economic profit
stream is

1 2
PV   0   
1  r (1  r ) 2
Economic Profit

 A competitive firm seeks to maximize its

present-value.
 How?
Economic Profit
 Suppose the firm is in a short-run circumstance in
which x x ~ .
2 2
 Its short-run production function is

~
y  f ( x1 , x 2 ).
Economic Profit
 Suppose the firm is in a short-run circumstance in
which
~
x 2  x2 .
 Its short-run production function is
~ ).
y  f ( x1 , x 2
 The firm’s fixed cost is
and its profit function is ~
FC  w 2x 2

~ .
  py  w 1x1  w 2x 2
Short-Run Iso-Profit Lines

 A $ iso-profit line contains all the

production plans that provide a profit
level $.
 A $ iso-profit line’s equation is

~
  py  w 1x1  w 2x 2 .
Short-Run Iso-Profit Lines

 A $ iso-profit line contains all the

production plans that yield a profit level
of $.
 The equation of a $ iso-profit line is
~
  py  w 1x1  w 2x 2 .
 I.e.

w1 ~
  w 2x 2
y x1  .
p p
Short-Run Iso-Profit Lines ~
w1   w 2x 2
y x1 
p p
has a slope of
w1

p
and a vertical intercept of
~
  w 2x 2
.
p
Short-Run Iso-Profit Lines
y i ng
a s
c e
r fit
I n    
pro    
  

w1
Slopes  
p

x1
Short-Run Profit-
Maximization
 The firm’s problem is to locate the
production plan that attains the highest
possible iso-profit line, given the firm’s
constraint on choices of production plans.
 Q: What is this constraint?
Short-Run Profit-
Maximization
 The firm’s problem is to locate the
production plan that attains the highest
possible iso-profit line, given the firm’s
constraint on choices of production plans.
 Q: What is this constraint?
 A: The production function.
Short-Run Profit-
The short-run production function and
Maximization
y ~
technology set for x 2  x 2 .

~ )
y  f ( x1 , x 2

Technically
inefficient
plans
x1
Short-Run Profit-
Maximization
y
ngs i    
re a
Inc rofit    
p    ~ )
y  f ( x1 , x 2

w1
Slopes  
p

x1
Short-Run Profit- ~ , the short-run
Given p, w1 and x 2  x 2
Maximization
y * ~ *
profit-maximizing plan is ( x1 , x 2 , y ).
   

w1
y* Slopes  
p

x*1 x1
Short-Run Profit- ~ , the short-run
Given p, w1 and x 2  x 2
Maximization
y * ~ *
profit-maximizing plan is ( x1 , x 2 , y ).
And the maximum    
possible profit
is   . w1
y* Slopes  
p

x*1 x1
Short-Run Profit-
At the short-run profit-maximizing plan,
Maximization
y the slopes of the short-run production
function and the maximal    
iso-profit line are
equal.
w 1
y* Slopes  
p

x*1 x1
Short-Run Profit-
At the short-run profit-maximizing plan,
Maximization
y the slopes of the short-run production
function and the maximal    
iso-profit line are
equal.
w 1
y* Slopes  
w1 p
MP1 
p
* ~ *
at ( x , x , y )
1 2

x*1 x1
 Short-Run Profit-
Maximization
MP 
w1
 p  MP1  w1
1
p

p  MP1 is the marginal revenue product of

input 1, the rate at which revenue increases
with the amount used of input 1.
If p  MP1  w1 then profit increases with x 1.
If p  MP1  w1 then profit decreases with x 1.
Short-Run Profit-Maximization; A
Cobb-Douglas Example
Suppose the short-run production
3 ~ 1/ 3
function is y  x1/
1 x2 .
The marginal product of the variable
input 1 is  y 1  2/ 3~ 1/ 3
MP1   x1 x 2 .
 x1 3
The profit-maximizing condition is
p *  2/ 3 ~ 1/ 3
MRP1  p  MP1  ( x1 ) x 2  w1 .
3
Short-Run Profit-Maximization; A
Cobb-Douglas Example
p *  2/ 3 ~ 1/ 3
Solving ( x1 ) x 2  w 1 for x1 gives
3
*  2/ 3 3w 1
( x1 )  .
px ~ 1/ 3
2
Short-Run Profit-Maximization; A
Cobb-Douglas Example
p *  2/ 3 ~ 1/ 3
Solving ( x1 ) x 2  w 1 for x1 gives
3
*  2/ 3 3w 1
( x1 )  .
px ~ 1/ 3
2
That is, ~ 1/ 3
* 2 / 3 px 2
( x1 ) 
3w 1
Short-Run Profit-Maximization; A
Cobb-Douglas Example
p *  2/ 3 ~ 1/ 3
Solving ( x1 ) x 2  w 1 for x1 gives
3
*  2/ 3 3w 1
( x1 )  .
px ~ 1/ 3
2
That is, ~ 1/ 3
* 2 / 3 px 2
( x1 ) 
3w 1
3/ 2 3/ 2
 ~ 1/ 3   p 
*  px 2  ~ 1/ 2
so x1      x2 .
 3w 1   3w 1 
Short-Run Profit-Maximization; A
Cobb-Douglas Example
3/ 2
*  p  ~ 1/ 2
x1    x2
is the firm’s
 3w 1 
short-run demand
for input 1 when the level of input 2 is
~ units.
fixed at x 2
Short-Run Profit-Maximization; A
Cobb-Douglas Example
3/ 2
*  p  ~ 1/ 2
x1    x2
is the firm’s
 3w 1 
short-run demand
for input 1 when the level of input 2 is
~ units.
fixed at x 2
The firm’s short-run output level is thus
1/ 2
* * 1/3 ~ 1/ 3  p  ~ 1/2 .
y  ( x1 ) x 2    x 2
 3w 1 
Comparative Statics of Short-
Run Profit-Maximization
 What happens to the short-run profit-
maximizing production plan as the output
price p changes?
Comparative Statics of Short-
Run Profit-Maximization
The equation of a short-run iso-profit line
is w1   w 2x~
y x1  2
p p
so an increase in p causes
-- a reduction in the slope, and
-- a reduction in the vertical intercept.
Comparative Statics of Short-
Run Profit-Maximization    
y    
  
~ )
y  f ( x1 , x 2
y*
w1
Slopes  
p

x*1 x1
Comparative Statics of Short-
Run Profit-Maximization
y

~ )
y  f ( x1 , x 2
y*

w1
Slopes  
p

x*1 x1
Comparative Statics of Short-
Run Profit-Maximization
 An increase in p, the price of the firm’s output,
causes
 an increase in the firm’s output level (the firm’s
supply curve slopes upward), and
 an increase in the level of the firm’s variable
input (the firm’s demand curve for its variable
input shifts outward).
Comparative Statics of Short-
Run Profit-Maximization
The Cobb-Douglas example: When
1/3 ~ 1/ 3
y  x1 x 2 then the firm’s short-run
demand for its variable input 1 is
3/ 2
*  p  ~ 1/ 2
x1    x2 and its short-run
 3w 1 
1/ 2 supply is
*  p  ~ 1/ 2 .
y   x 2
 3w 1 
Comparative Statics of Short-
Run Profit-Maximization
The Cobb-Douglas example: When
1/3 ~ 1/ 3
y  x1 x 2 then the firm’s short-run
demand for its variable input 1 is
3/ 2
*  p  ~ 1/ 2
x1    x2 and its short-run
 3w 1 
1/ 2 supply is
*  p  ~ 1/ 2
y   x2 .
 3w 1 
x*1 increases as p increases.
Comparative Statics of Short-
Run Profit-Maximization
The Cobb-Douglas example: When
1/3 ~ 1/ 3
y  x1 x 2 then the firm’s short-run
demand for its variable input 1 is
3/ 2
*  p  ~ 1/ 2
x1    x2 and its short-run
 3w 1 
1/ 2 supply is
*  p  ~ 1/ 2
y   x2 .
 3w 1 
x*1 increases as p increases.
y* increases as p increases.
Comparative Statics of Short-
Run Profit-Maximization
 What happens to the short-run profit-
maximizing production plan as the
variable input price w1 changes?
Comparative Statics of Short-
Run Profit-Maximization
The equation of a short-run iso-profit line
is w1 ~
  w 2x 2
y x1 
p p
so an increase in w1 causes
-- an increase in the slope, and
-- no change to the vertical intercept.
Comparative Statics of Short-
Run Profit-Maximization    
y    
  
~ )
y  f ( x1 , x 2
y*
w1
Slopes  
p

x*1 x1
Comparative Statics of Short-
Run Profit-Maximization
y    
   
  
~ )
y  f ( x1 , x 2

w1
Slopes  
y* p

x*1 x1
Comparative Statics of Short-
Run Profit-Maximization

 An increase in w1, the price of the firm’s variable

input, causes
a decrease in the firm’s output level (the firm’s
supply curve shifts inward), and
a decrease in the level of the firm’s variable
input (the firm’s demand curve for its variable
input slopes downward).
Comparative Statics of Short-
Run Profit-Maximization
The Cobb-Douglas example: When
1/3 ~ 1/ 3
y  x1 x 2 then the firm’s short-run
demand for its variable input 1 is
3/ 2
*  p  ~ 1/ 2
x1    x2 and its short-run
 3w 1 
1/ 2 supply is
*  p  ~ 1/ 2 .
y   x 2
 3w 1 
Comparative Statics of Short-
Run Profit-Maximization
The Cobb-Douglas example: When
1/3 ~ 1/ 3
y  x1 x 2 then the firm’s short-run
demand for its variable input 1 is
3/ 2
*  p  ~ 1/ 2
x1    x2 and its short-run
 3w 1 
1/ 2 supply is
*  p  ~ 1/ 2
y   x2 .
 3w 1 
x*1 decreases as w1 increases.
Comparative Statics of Short-
Run Profit-Maximization
The Cobb-Douglas example: When
1/3 ~ 1/ 3
y  x1 x 2 then the firm’s short-run
demand for its variable input 1 is
3/ 2
*  p  ~ 1/ 2
x1    x2 and its short-run
 3w 1 
1/ 2 supply is
*  p  ~ 1/ 2
y   x2 .
 3w 1 
x*1 decreases as w1 increases.
y* decreases as w1 increases.
Long-Run Profit-Maximization
 Now allow the firm to vary both input levels.
 Since no input level is fixed, there are no fixed
costs.
Long-Run Profit-Maximization

 Both x1 and x2 are variable.

 Think of the firm as choosing the
production plan that maximizes profits for
a given value of x2, and then varying x2 to
find the largest possible profit level.
Long-Run Profit-Maximization

The equation of a long-run iso-profit line

is w1   w 2x 2
y x1 
p p
so an increase in x2 causes
-- no change to the slope, and
-- an increase in the vertical intercept.
Long-Run Profit-Maximization
y

y  f ( x1 , x2 )

x1
Long-Run Profit-Maximization
y

y  f ( x1 , 3x2 )
y  f ( x1 , 2x2 )

y  f ( x1 , x2 )

x1
Larger levels of input 2 increase the
productivity of input 1.
Long-Run Profit-Maximization
y

y  f ( x1 , 3x2 )
y  f ( x1 , 2x2 )

y  f ( x1 , x2 )
The marginal product
of input 2 is
diminishing.
x1
Larger levels of input 2 increase the
productivity of input 1.
 Long-Run Profit-Maximization
p  MP1  w 1  0 for each short-run
y
production plan.
y  f ( x1 , 3x2 )
y  f ( x1 , 2x2 )
y* ( 3x 2 )
y* ( 2x 2 )
y  f ( x1 , x2 )
the marginal profit
y* ( x 2 ) of input 2 is
diminishing.
x*1 ( x 2 ) x*1 ( 3x2 ) x1
x*1 ( 2x2 )
Long-Run Profit-Maximization
 Profit will increase as x2 increases so long as the
marginal profit of input 2
p  MP2  w 2  0.
 The profit-maximizing level of input 2 therefore
satisfies

p  MP2  w 2  0.
Long-Run Profit-Maximization
 Profit will increase as x2 increases so long as the
marginal profit of input 2
p  MP2  w 2  0.
 The profit-maximizing level of input 2 therefore
satisfies
p  MP2  w 2  0.
 And is satisfied in any short-run,
so ...
p  MP1  w 1  0
Long-Run Profit-Maximization

 The input levels of the long-run profit-

maximizing plan satisfy
p  MP1  w 1  0 and p  MP2  w 2  0.

 That is, marginal revenue equals marginal

cost for all inputs.
Long-Run Profit-Maximization
The Cobb-Douglas example: When
1/ 3 ~ 1/ 3
y  x1 x 2 then the firm’s short-run
demand for its variable input 1 is
3/ 2
*  p  ~ 1/ 2
x1    x2 and its short-run
 3w 1 
1/ 2 supply is
*  p  ~ 1/ 2
y   x2 .
 3w 1 
Short-run profit is therefore …
 Long-Run Profit-Maximization

~
  py*  w 1x*1  w 2x 2
1/ 2 3/ 2
 p  ~ 1/ 2  p  ~ 1/ 2  w x
~
 p  x2  w1  x 2 2 2
 3w 1   3w 1 
 Long-Run Profit-Maximization

~
  py*  w 1x*1  w 2x 2
1/ 2 3/ 2
 p  ~ 1/ 2  p  ~ 1/ 2  w x
~
 p  x2  w1  x 2 2 2
 3w 1   3w 1 
1/ 2 1/ 2
 p  ~ 1/ 2 p  p  ~
 p  x2  w1    w 2x 2
 3w 1  3w 1  3w 1 
 Long-Run Profit-Maximization
~
  py*  w 1x*1  w 2x 2
1/ 2 3/ 2
 p  ~ 1/ 2  p  ~ 1/ 2  w x
~
 p  x 2  w1   x 2 2 2
 3w 1   3w 1 
1/ 2 1/ 2
 p  ~ 1/ 2 p  p  ~
 p  x 2  w1    w 2x 2
 3w 1  3w 1  3w 1 
1/ 2
2p  p  ~ 1/ 2  w x
~
   x 2 2 2
3  3w 1 
Long-Run Profit-Maximization
~
  py*  w1x*1  w 2x 2
1/ 2 3/ 2
 p  ~ 1/ 2  p  ~ 1/ 2  w x
~
 p  x 2  w1  x 2 2 2
 3w 1   3w 1 
1/ 2 1/ 2
 p  ~ 1/ 2 p  p  ~
 p  x 2  w1    w 2x 2
 3w 1  3w 1  3w 1 
1/ 2
2p  p  ~ 1/ 2  w x
~
   x 2 2 2
3  3w 1 
1/ 2
 4p 3
~ 1/ 2  w x
~ .
   x 2 2 2
 27 w 1
Long-Run Profit-Maximization
1/ 2
 4p 3
~ 1/ 2  w x
~ .
    x 2 2 2
 27 w 1

What is the long-run profit-maximizing

level of input 2? Solve
1/ 2
  1  4p  3
~  1/ 2  w
0  ~    x 2 2
 x 2 2  27w 1 

to get ~  x*  p3
x 2 2 .
27w 1w 2
2
Long-Run Profit-Maximization
What is the long-run profit-maximizing
input 1 level? Substitute
3 3/ 2
x*2 
p *  p  ~ 1/ 2
into x1    x 2
27w 1w 2
2  3w 1 

to get
3 / 2 1/ 2
*  p  p 3  p 3
x1       .
 3w 1   27w 1w 22  27w 12w 2
Long-Run Profit-Maximization
What is the long-run profit-maximizing
output level? Substitute
1/ 2
p 3  p 
* ~ 1/ 2
x*2  into y    x 2
27w 1w 2
2  3w 1 

to get
1/ 2 1/ 2
*  p  p 3  p2
y      .
 3w 1   27w 1w 22  9 w 1w 2
 Long-Run Profit-Maximization
So given the prices p, w1 and w2, and
the production function y  x1/3
1 x2
1/ 3

the long-run profit-maximizing production

plan is
 p 3
p 3
p 2 
( x*1 , x*2 , y* )   , ,  .
2 2 9w w
 27w 1 w 2 27w 1w 2 1 2
Returns-to-Scale and Profit-
Maximization
 If a competitive firm’s technology exhibits
decreasing returns-to-scale then the firm
has a single long-run profit-maximizing
production plan.
Returns-to Scale and Profit-
Maximization
y

y  f(x)
y*

Decreasing
returns-to-scale

x* x
Returns-to-Scale and Profit-
Maximization
 If a competitive firm’s technology exhibits
exhibits increasing returns-to-scale then
the firm does not have a profit-
maximizing plan.
Returns-to Scale and Profit-
Maximization
y

as ing
Inc re y  f(x)
ro fit
p
y”

y’ Increasing
returns-to-scale
x’ x” x
Returns-to-Scale and Profit-
Maximization
 So an increasing returns-to-scale
technology is inconsistent with firms
being perfectly competitive.
Returns-to-Scale and Profit-
Maximization
 What if the competitive firm’s technology
exhibits constant returns-to-scale?
Returns-to Scale and Profit-
Maximization
y
as ing
I nc re
ro fit y  f(x)
p

y”
Constant
y’ returns-to-scale
x’ x” x
Returns-to Scale and Profit-
Maximization
 So if any production plan earns a positive
profit, the firm can double up all inputs
to produce twice the original output and
earn twice the original profit.
Returns-to Scale and Profit-
Maximization
 Therefore, when a firm’s technology
exhibits constant returns-to-scale, earning
a positive economic profit is inconsistent
with firms being perfectly competitive.
 Hence constant returns-to-scale requires
that competitive firms earn economic
profits of zero.
Returns-to Scale and Profit-
Maximization
y

y  f(x)

=0
y”
Constant
y’ returns-to-scale
x’ x” x
Revealed Profitability

 Consider a competitive firm with a

technology that exhibits decreasing
returns-to-scale.
 For a variety of output and input prices
we observe the firm’s choices of
production plans.
 What can we learn from our observations?
Revealed Profitability

 If a production plan (x’,y’) is chosen at prices (w’,p’)

we deduce that the plan (x’,y’) is revealed to be profit-
maximizing for the prices (w’,p’).
 Revealed Profitability
( x  , y ) is chosen at prices ( w  , p ) so
y ( x  , y ) is profit-maximizing at these prices.
w
Slope 
p
y
y
The technology
set is somewhere
in here

x x x
So the firm’s technology set must lie under the
iso-profit line.
Revealed Profitability
( x  , y ) is chosen at prices ( w  , p ) so
y ( x  , y ) maximizes profit at these prices.

w 
Slope 
p
y
The technology set is
also somewhere in
y here.

x x  x
Revealed Profitability
y The firm’s technology set must lie under
both iso-profit lines

y
The technology set
is somewhere
y in this intersection

x x x
Revealed Profitability

 Observing more choices of production

plans by the firm in response to different
prices for its input and its output gives
more information on the location of its
technology set.
Revealed Profitability
y The firm’s technology set must lie under
all the iso-profit lines ( w  , p )
( w  , p )
( w  , p )
y
y y  f(x)

y

x x x x
Revealed Profitability

 What else can be learned from the firm’s

choices of profit-maximizing production
plans?
Revealed Profitability
The firm’s technology set must lie under
y
all the iso-profit lines ( w  , p )
( w  , p )

y ( x  , y ) is chosen at prices
( w  , p ) so
p y  w  x   p y  w  x  .
y ( x  , y ) is chosen at prices
( w  , p ) so
p y  w  x   p y  w  x  .
x  x x
 Revealed Profitability
p y  w  x  p y  w  x and
p y  w x  p y  w  x so
p y  w  x  p y  w  x and
 p y  w  x   p y  w  x .

Adding gives
( p  p ) y  ( w   w  ) x  
( p  p ) y  ( w   w  ) x  .
 Revealed Profitability
(p  p )y  ( w   w  )x  
(p  p ) y  ( w   w  )x 
so
(p  p )( y  y )  ( w   w  )( x  x )
That is,
py  wx
is a necessary implication of profit-
maximization.
Revealed Profitability
py  w x
is a necessary implication of profit-
maximization.
Suppose the input price does not change.
Then w = 0 and profit-maximization
implies py  0; i.e., a competitive
firm’s output supply curve cannot slope
downward.
Revealed Profitability
py  w x
is a necessary implication of profit-
maximization.
Suppose the output price does not change.
Then p = 0 and profit-maximization
implies 0  w x; i.e., a competitive
firm’s input demand curve cannot slope
upward.