1. 1 Theory of the firm: Profit maximization Chapters 6, 7 & 8 Theory of the firm: Profit maximization Chapters 6, 7 & 8

2. Theory of the firm: Outline 2 Types of markets (degrees of competition) Economic profit  Firm entry & exit behavior * Production theory & diminishing marginal returns  Short-run unit cost curves * Perfect competition  Profit maximization  Competitive market efficiency * Market intervention  Efficiency-reducing interventions  Efficiency-enhancing interventions

3. Buyers and Sellers 3 Buyers  “Should I buy another unit?”  Answer: If the marginal benefit exceeds the marginal cost Sellers  “Should I sell another unit?  Answer: If the marginal revenue exceeds the marginal cost of making it

4. Seller’s goal? 4 Maximize profit Decisions:  What to produce (what market)?  How much to produce?  What inputs to use?  What price to charge? Firm behavior depends on the competitive environment they operate in.

5. Types of Markets (degrees of competition) 5 One firm 2-12 firmsmany firmsmany, many firms MonopolyOligopolyMonopolistic Perfect Competition

6. Basic principles 6 There are some basic ideas that apply to all types of firms:  What “profit” means  Production theory & implications for unit costs

7. 7 Economic profit v. Accounting profit

8. Profit Maximization 8 Accounting Profit The difference between the total revenue a firm receives from the sale of its product minus explicit costs (“expenses”). Economic Profit  The difference between the total revenue a firm receives from the sale of its product minus all costs, explicit and implicit.  Note: this includes opportunity cost, and is therefore different than profit in a traditional accounting sense.

9. 9 2 Types of Costs and 2 Types of Profit Explicit Costs (“accounting costs” or “expenses”)  Actual payments made to factors of production and other suppliers Implicit Costs (opportunity costs)  All the opportunity costs of the resources supplied by the firm’s owners  Eg: opportunity cost of owner’s time  Eg: opportunity cost of owner-invested funds

10. 10 Two Types of Profit Accounting Profit  Total Revenue – Explicit Costs Economic Profit  Total Revenue – Explicit Costs – Implicit Costs Economic Loss  An economic profit less than zero

11. 11 The Difference Between Accounting Profit and Economic Profit

12. 12 The Difference Between Accounting Profit and Economic Profit Revenue – Acct Costs = Acct Profit Revenue – Econ Costs = Econ Profit Revenue – Explicit Costs = Acct Profit Revenue – (Explicit + Implicit costs) = Econ Profit Acct Profit – Implicit Costs = Econ Profit If Acct Profit exactly = Implicit Costs => Econ Profit = 0, and the firm is said to be earning a “normal profit”

13. 13 Econ vs. Acct Profits True or False: Economic profits are always less than or equal to accounting profits.  TRUE If some implicit costs exist…  economic cost > accounting cost  economic profit < accounting profit (ie: we are subtracting more costs from the same revenue)

14. 14 To Farm or Not To Farm? Farmer Dave sells corn  his revenues are $22,000/yr  he pays $10,000/yr in explicit costs  he could earn $11,000 at another job he likes equally well (implicit costs) Dave’s economic profit is  $22,000 - $10,000 - $11,000 = $1,000  Dave is earning a positive economic profit  Dave is earning more than a normal profit

15. 15 Example After graduation you face the following job choice: Option 1: IBM in RTP Salary = $50K/year Option 2: your own firm in Wilmington You choose option 2 and withdraw $20,000 from savings to start the business. Assume that you could have earned 5% on that money.

16. 16 Example continued You chose option 2 and have the following info after 1 year: 1st year analysis: Revenue = $50,000 Costs of inventory = $8,000 Labor expenses = $15,000 Rent = $12,000 Cost categories: accounting economic- inventory- rent- wages for worker - opp cost of Labor = $50,000 - opp cost of funds = $1,000

17. 17 Example continued Accounting profit = 50 – 8 – 15 – 12 = 15 Economic profit = 50 – 8 – 15 – 12 – 50 – 1 = -36 Your firm is earning negative economic profit  What does this mean?  Did you make a bad decision?  What will happen when firms in a market are characterized by negative economic profits?

18. What if economic profits are > 0? 18 What does it mean when economic profits are positive?  The firm owner is doing better than their next best alternative  The firm owner is more than covering opportunity costs What will happen in markets where firms are characterized by positive economic profits?

19. What if economic profits are = 0? 19 What does it mean when economic profits are zero?  The firm owner is doing just as well as their next best alternative  The firm owner is exactly covering opportunity costs What will happen in markets where firms are characterized by zero economic profits?

20. “Normal Profit” 20 If market wages for your labor and market interest rates for your funds were accurate reflections of the value of your time and money, how much accounting profit should your firm have earned? What is a “normal profit” for your firm? Normal profit = the (accounting) profit required to exactly cover opportunity costs. Normal profit = the accounting profit required to earn exactly zero economic profit

21. 21 Functions of Price Where price is relative to average total costs of production (ATC) will determine firm profits and serve to allocate firm resources.  P > ATC => positive profits  P negative profits Changes in price may therefore reallocate resources.

22. 22 Market Forces and Economic Profit Positive Economic Profit means the firm (owner) is more than covering opp costs Doing better than the next best alternative Price must be higher than ATC  Firms enter this industry  Supply increases  Price falls  Profits fall

23. 23 Fig. 8.2 The Effect of Economic Profit on Entry

24. 24 Market Forces and Economic Profit Negative Economic Profit means the firm (owner) is not covering opp costs Doing worse than the next best alternative Price must be below ATC  Firms exit this industry  Supply decreases  Price rises  Losses fall Zero profit tendency of competitive markets

25. 25 Fig. 8.3 The Effect of Economic Losses on Exit

26. 26 Production & the principle of diminishing marginal returns

27. Production in the Short Run 27 Factors of Production  An input used in the production of a good or service The “Short Run”  A period of time sufficiently short that at least some of the firm’s factors of production are fixed The “Long Run”  A period of time of sufficient length that all the firm’s factors of production are variable

28. Law of Diminishing Returns 28 Fixed factor of production  An input whose quantity cannot be altered in the short run. E.g. square footage of factory space Variable factor of production  An input whose quantity can be altered in the short run. E.g. labor Law of Diminishing Returns  If one factor is variable and others are fixed: the increased production of the good eventually requires ever larger increases in the variable factor  As additional units of a variable input are added to fixed amounts of other inputs, the marginal product of the variable input will eventually decrease.

29. Law of Diminishing Marginal Returns 29 Q Labor MP L Point of diminishing marginal returns

30. Implications for Marginal Costs 30 Since productivity (MP L ) typically first increases and then decreases (at the point of DMR), what will marginal costs do? When productivity is rising, marginal costs should be falling. When productivity is falling, marginal costs should be rising. Unit costs measures are inversely related to productivity measures

31. Types of Markets (degrees of competition) 31 One firm 2-12 firmsmany firmsmany, many firms MonopolyOligopolyMonopolistic Perfect Competition

32. Perfect Competition 32 Perfectly Competitive Market  Many sellers, selling a standardized product in an environment with readily available information and low-cost entry and exit.  No individual supplier has significant influence on the market price of the product

33. Price taking behavior 33 Given that there are many firms all selling the exact same product, what will the demand curve for the product of one firm in a perfectly competitive market look like? Implications?  PC firms have no influence over the price at which they sell their product  PC firms sell only a fraction of total market output  PC firms can sell as much output as they wish

34. The Demand Curve Facing Perfectly Competitive Firm 34

35. How to choose output to maximize profit? 35 Recall … The Low-Hanging Fruit Principle  Suppliers first use the resources easiest-to-find  So, the price of the output must go up in order to compensate for using harder-to-find resources  i.e. costs tend to rise when producers expand production in the short-run (some inputs are fixed in the short-run)  Supply curves tend to be upward-sloping

36. Choosing Output 36 How much to produce?  The goal is to maximize profit  Profit = TR – TC  A perfectly competitive firm chooses to produce the output level where profit is maximized Cost-benefit principle & quantity decisions  A firm should increase output if marginal benefit (revenue) exceeds the marginal cost

37. Choosing Output 37 Cost-Benefit Principle  Increase output if marginal benefit exceeds the marginal cost For a perfectly competitive firm  Marginal benefit = marginal revenue = price  Only true if demand is perfectly elastic Cost-benefit principle for a price taker  Keep expanding as long as the price of the product is greater than marginal cost  Choose the output where P = MC

38. Profit Maximizing Condition 38 Profit = TR – TC Max Profit with respect to Q d Profit / dQ = (dTR/ dQ) – (dTC/dQ) = 0 therefore maximum profit occurs where MR = MC

39. Profit Maximization 39 P ATC MC Q* Quantity 10 = P* D = MR ATC = Total Cost / Q so, TC = ATC x Q P > ATC means profit > 0 8 100

40. Suppose Price Falls to Min ATC 40 P ATC MC Q* Quantity 7 = P* D = MR P = ATC means profit = 0

41. Suppose Price Falls below Min ATC 41 P ATC MC Q* Quantity 7 = P* D = MR P < ATC means profit < 0

42. Response to Economic Profits Markets with excess profits attract resources P 2 Quantity (000s of bushels/year) Price $/bu MC 130 ATC 1.20 Typical Corn Farm Price $/bu 2 Quantity (M of bushels/year) S D 65 Corn Industry Economic Profit

43. Shrinking Economic Profits Supply increases in the long run P Quantity (000s of bushels/year) Price $/bu MC 130 ATC Typical Corn Farm Price $/bu 2 Quantity (M of bushels/year) S D 65 Corn Industry Economic Profit S' 1.50 95 120

44. Market Equilibrium Eventually, the market saturates and firms earn zero economic profits P Quantity (000s of bushels/year) Price $/bu MC 130 ATC Typical Corn Farm Price $/bu 2 Quantity (M of bushels/year) S D 65 Corn Industry S' 1.50 115 1 S" 90

45. Response to economic losses Resources leave the market 1.05 Quantity (M of bushels/year)Quantity (000s of bushels/year) 70 0.75 P 90 ATC MC S D 60 Price $/bu 0.75 Price $/bu Typical Corn Farm Corn Industry

46. Market Equilibrium Again the market reaches a situation of zero economic profit Quantity (M of bushels/year)Quantity (000s of bushels/year) 70 0.75 P 90 ATC MC S D 60 Price $/bu 1 S' 40

47. Shut Down? 47 Perfectly competitive firms should produce where MR (P) = MC, unless price is very low If total revenue falls below variable cost, the best the firm could do is shut down in the short run i.e. if price is below average variable costs, the firm loses money each time a unit of output is produced. The best thing to do is produce nothing (shut the doors and tell the employees to go home).

48. Perfectly Competitive Firm’s Supply Curve 48 The perfectly competitive firm’s supply curve is its  Marginal cost curve above minimum average variable cost At every point along a market supply curve  Price measures what it would cost producers to expand production by one unit

49. 49 Competitive markets and efficiency (and inefficiency)

50. 50 The Domain of Markets Free & competitive markets promote efficiency  But, markets cannot be expected to solve every problem (e.g., market economies do not guarantee a fair income distribution) Realizing that markets cannot solve every problem has led some critics to falsely conclude  that markets cannot solve any problem

51. 51 Market Equilibrium and Efficiency Pareto efficient (or just efficient)  Is a situation where there is no change possible that will help some people without harming others  Exists when an economy has reached a point where reallocating resources must harm one in order to help another  Occurs at equilibrium of perfectly competitive markets

52. 52 Market Equilibrium and Efficiency When a market is not in equilibrium: 1. P > P* = surplus -- Q S > Q D 2. P Q S In either case, the quantity exchanged is always LESS THAN the true equilibrium quantity. Hence, if a market is not in equilibrium, further benefit-enhancing transactions are always possible.

53. 53 Adam Smith Self-interest moves the economy  Consumers seek to maximize utility from purchases  Firms seek to maximize profit from production  It serves society’s interest  It is due to profit opportunities  With it, the entrepreneur “intends only his own gain,” he is “led by an invisible hand” to promote an end which was no part of his intentions  Prices (and price changes) serve to allocate resources to their highest valued use

54. 54 Invisible Hand Invisible Hand Theory  The actions of independent, self-interested buyers and sellers will often result in the most efficient allocation of resources  i.e. markets are (usually) efficient: the sum of consumer and producer surplus are maximized

55. 55 Economic surplus (net gains) Total economic surplus  The sum of all the individual economic surpluses gained by buyers and sellers participating in the market Consumer Surplus  Economic surplus gained by the buyers of a product  Measured by the difference between their reservation price and the price they pay Producer Surplus  Economic surplus gained by the sellers of a product  Measured by the difference between the price they receive and their reservation price

56. 56 Total economic surplus in the market for milk

57. 57 Surplus and Efficiency Equilibrium price and quantity maximize total economic surplus  Total economic surplus would be lower at any other price and quantity combination  I.E., “waste” or unrealized gain occurs at any other price and quantity combination

58. 58 Other Goals Efficiency is not the only goal  An equitable income distribution is a desirable goal for many Argument that efficiency should be the first goal  Efficiency enables us to achieve all other goals to the fullest possible extent  Efficiency minimizes waste

59. 59 Markets and Social Optimum If free and competitive markets are efficient, then government intervention into those markets may be inefficient. Why then does government mess with markets? Market equilibrium does not necessarily mean the resulting allocation of resources is the best one viewed from society’s perspective. What is smart for one may be dumb for all  For example, some market activities that produce profits for some may produce pollution (externalities) that adversely affects many  We’ll get back to this idea soon… Some markets are inherently inefficient when left alone.  Government intervention can correct such inefficiencies

60. 60 Markets and Social Optimum How can government intervention make markets less efficient? How can government intervention make markets more efficient? Types of government intervention:  Taxation  Price controls  Import quota (and other trade restrictions)

61. 61 The Market for Potatoes Without Taxes

62. 62 The Effect of a $1 Pound Tax on Potatoes

63. 63 The Deadweight Loss Caused by a Tax

64. 64 DWL CS pre-tax = ½ (3)(3,000,000) = $4,500,000 PS pre-tax = ½ (3)(3,000,000) = $4,500,000 CS post-tax = ½ (2.50)(2,500,000) = $3,125,000 PS post-tax = ½ (2.50)(2,500,000) = $3,125,000 Lost PS+CS = $2,750,000 Tax revenue = $1(2,500,000) = $2,500,000 DWL = $250,000

65. 65 Taxes, Elasticity, and Efficiency Deadweight loss is minimized if taxes are imposed on goods and services that have relatively inelastic supply or relatively inelastic demand.

66. 66 Elasticity of Demand and the Deadweight Loss from a Tax

67. 67 Elasticity of supply and the deadweight loss from a tax

68. 68 Do all taxes decrease economic efficiency? Consider a tax on land Land supply is perfectly inelastic DWL = $0 What other goods have high tax rates?  Booze  Cigarettes  Gasoline

69. 69 Taxes, External Costs, and Efficiency Taxing reduces the equilibrium quantity Therefore, taxing activities that people tend to pursue to excess can actually increase total economic surplus (e.g., activities that cause pollution)

70. 70 External costs & taxes that are efficiency-enhancing Consider a market activity that generates harmful side-effects on a 3 rd party … E.g. Pollution from a plant imposes costs on anyone who lives near the plant Does that firm’s supply curve accurately reflect the full costs of production?  No. without regulation, the firm’s supply curve only reflects the marginal costs of production.  The external costs are not included in these costs.  What if they were?

71. 71 Market Equilibrium Q* MKT Q D = MSB P At P* MKT Q D = Q S = Q* MKT CS + PS are maximized S = MPC $20 = P* MKT

72. 72 Market Equilibrium The firm’s supply curve represents “private” or “market-level” marginal costs of production (MPC), and is used by the firm to make pricing and output decisions. If there are external costs (costs realized outside of the market), the FULL costs of production would be represented by a different curve = MSC For example, suppose that each unit of output causes $2 in damage to 3 rd parties.

73. 73 Social Equilibrium Q* SOC Q* MKT Q D = MSB P $20 = P* MKT S = MPC MSC = MPC + 2 $21 = P* SOC

74. 74 Social Efficiency At P* MKT :  MSC > MSB  Q* MKT > Q* SOC the market “overproduces” the good  P* MKT < P* SOC the market “under-prices” the good  Market solution is therefore not efficient from society’s standpoint How can this inefficiency be corrected?

75. 75 Social Efficiency A tax equal to the marginal external cost ($2.00) would serve to increase the firm’s MPC so that it is coincident with the MSC function. In other words, the tax brings the external cost into the market. = “internalizing the externality”

76. 76 Social Equilibrium Q* SOC Q* MKT Q D = MSB P S = MPC New MPC = Old MPC + 2 $21 = P* SOC

77. 77 Can markets create external benefits? If markets can create costs on 3 rd parties, can they create benefits? Sure.  Education.  Lawn care  House maintenance  Text: beekeeper adjacent to apple orchard Will the market solution be efficient?

78. 78 External Benefits Q* MKT Q* SOC Q D = MPB P S = MSC P* MKT MSB

79. 79 External Benefits In the case of external benefits, the market will under-provide the good relative to the socially optimal amount.  I.E. at Q* MKT MSB > MSC How can this inefficiency be corrected?  Recall the solution to negative externality was a tax…  We should subsidize the positive externality generating activity.

80. 80 Naturalist Questions Why are gasoline taxes so high (relative to other goods)? Why aren’t gasoline taxes higher (as in other nations)? Why do communities have zoning laws?