Profit Maximization
ECON 600
Lecture 3: Profit Maximization
I.
The Concept of Profit Maximization
Profit is defined as total revenue minus total cost.
Π = TR – TC
(We use Π to stand for profit because we use P for something else: price.)
Total revenue simply means the total amount of money that the firm receives from sales of its product or other sources.
Total cost means the cost of all factors of production. But – and this is crucial – we have to think in terms of opportunity cost, not just explicit monetary payments. If the owner of the business also works there, we must include the value of his time. If the firm owns machines or land, we must include the payments those factors could have earned if the firm had chosen to rent them out instead of using them.
If only explicit monetary costs are considered, we get accounting profit. But to find economic profit, we need to take into account the opportunity cost, implicit or explicit of all resources employed.
The main constraints faced by the firm are:
•
•
•
II.
technology, as summarized in the cost curves of the last lecture; the prices of factors of production, also taken into account by the cost curves; and the demand for its product.
Demand Curve Facing the Firm
The firm’s demand curve tells how much consumers will buy at each price from a particular firm. (This is distinguished from other kinds of demand curve, such as the market demand curve, which shows how much consumers will buy at each price from all firms put together.)
The shape of the firm’s demand curve is related to the degree of competition in the market. Loosely speaking, more competition causes the firm’s demand curve to be more elastic (flatter), because consumers can respond to price increases by shifting their purchases to other firms. Less competition, on the other hand, implies a more inelastic
(steeper) demand curve. Perfect competition and monopoly turn out to be the extreme ends of the spectrum:
•
•
a perfectly
Lecture 3: Profit Maximization
I.
The Concept of Profit Maximization
Profit is defined as total revenue minus total cost.
Π = TR – TC
(We use Π to stand for profit because we use P for something else: price.)
Total revenue simply means the total amount of money that the firm receives from sales of its product or other sources.
Total cost means the cost of all factors of production. But – and this is crucial – we have to think in terms of opportunity cost, not just explicit monetary payments. If the owner of the business also works there, we must include the value of his time. If the firm owns machines or land, we must include the payments those factors could have earned if the firm had chosen to rent them out instead of using them.
If only explicit monetary costs are considered, we get accounting profit. But to find economic profit, we need to take into account the opportunity cost, implicit or explicit of all resources employed.
The main constraints faced by the firm are:
•
•
•
II.
technology, as summarized in the cost curves of the last lecture; the prices of factors of production, also taken into account by the cost curves; and the demand for its product.
Demand Curve Facing the Firm
The firm’s demand curve tells how much consumers will buy at each price from a particular firm. (This is distinguished from other kinds of demand curve, such as the market demand curve, which shows how much consumers will buy at each price from all firms put together.)
The shape of the firm’s demand curve is related to the degree of competition in the market. Loosely speaking, more competition causes the firm’s demand curve to be more elastic (flatter), because consumers can respond to price increases by shifting their purchases to other firms. Less competition, on the other hand, implies a more inelastic
(steeper) demand curve. Perfect competition and monopoly turn out to be the extreme ends of the spectrum:
•
•
a perfectly