1. ECON 211 ELEMENTS OF ECONOMICS I
Session 5– Profit Maximization (Part 1)
Lecturer: Dr. (Mrs.) Nkechi S. Owoo, Department of Economics
Contact Information:

2. Session Overview
Session 5 explains how a firm sets its price and output level in the short run under the assumption that the firm’s goal is to maximize its economic profit.
There are two approaches to finding a firm’s short-run profit-maximizing level of output.
In the total revenue and total cost approach, the firm calculates profit as the difference between total revenue and total cost, and produces the quantity of output where profit is greatest.
In the marginal revenue and marginal cost approach, the firm maximizes profit when it sets marginal revenue equal to marginal cost. These two approaches are demonstrated with tables and graphs.
The first session deals with the introduction to a number of concepts while the second session deals with the TR/TC and MR/MC approach.

3. Session Outline
The key topics to be covered in the session are as follows:
The Goal of Profit Maximization
Understanding Profit
The Firm’s Constraint
Demand Constraint
Cost Constraint

4. Reading List
Hall and Lieberman
Chapter 7, pp:

5. The GoAL OF Profit maximization
Topic One
The GoAL OF Profit maximization

6. The Goal Of Profit Maximization
In order to analyze firms’ decision-making process, we need to know what the firm is trying to maximize
In this analysis, we assume that firms are single economic decision-makers whose main goal is to maximize profits.
This assumption helps us to understand how firms decide
What prices to charge
How much to produce
Whether to temporarily shut down the firm or keep operating
Whether to enter a new market or exit an existing one

7. Understanding Profit
Profit is defined as the difference between a firms sales revenue and its costs of production
There are two ways of expressing profits:
Accounting profit
Total revenue minus accounting costs
This is mostly used by accountants and takes into account only explicit costs
Economic profit
Total revenue minus all costs of production
Recognizes all the opportunity costs of production - both explicit costs and implicit costs

8. Understanding Profits
Which of the two types of profits is the correct one?
It depends
For tax purposes, the government is interested in profits as measured by accountants
The government is only interested in money earned, and not money that could have been earned had a firm done something else with its time or resources
For the purposes of understanding the behaviour of firms, economic profits is better

9. Why are there Profits?
When we observe households income, we note that there are a variety of payments that accrue
Those who provide firms with land receive rent; the payment for land
Those who provide labour receive a wage or a salary
Those who lend firms money so they can purchase capital equipment receive interest
A firms profits go to its owners
But what do the owners of these firms provide that earns them this payment?

10. Why Are there Profits?
Economists view profits as payment for two contributions of entrepreneurs
Risk-taking
Innovation
Sometimes, in taking the risk of starting a business, the consequences of failure are so severe that the reward for success must be large enough to induce an entrepreneur to establish a business
Profits are also a reward for innovation
Innovation makes a substantial contribution to production and therefore, profit is a reward for those who innovate

11. Topic One
The firms constraints

12. The Firm’s Constraint
If firms were free to earn whatever level of profit they wanted, they would earn virtually infinite profit
This would make owners very happy
However, firms are not free to earn unlimited profits
Firms face constraints on both:
Revenue
Cost

13. The Demand Constraint
The constraint on firms revenue arises from the demand curve
This curve tells us the different quantities that consumers are willing and able to buy at different prices
We are, for the purposes of this session, more interested in the demand curve facing the firm
The demand curve facing the firm refers to the quantity of output that customers will choose to purchase from that firm, at different prices
we are interested in one firm and all buyers who are potential customers of that firm

14. The Demand Constraint
Let us consider a hypothetical firm- Ned’s Beds, a manufacturer of bed frames
The table on the next slide lists the different prices that Ned could charge for each bed frame and the number of these that he can sell at each price
Like other types of demand curves, the demand facing Neds Beds is downward sloping
This indicates that in order to sell more beds, Ned must lower his price
Therefore, once Neds Beds decides on an output level, it has also determined the maximum price it can charge

15. Demand and Total Revenue
The Demand Curve Facing the Firm

16. Demand and Total Revenue
Each time a firm chooses its level of output, it also determines its total revenue
Why?
Because once we know the level of output, we also know the highest price the firm can charge
Total Revenue= Price x Output
Because Ned’s demand curve slopes downwards, he must lower his price each time his output increases, or else he will not be able to sell all he produces
With more units of output but with each selling at a lower price, total revenue could increase or decrease

17. Demand and Total Revenue
Figure 1 The Demand Curve Facing the Firm
Price
Per Bed
Number of Bed
Frames per Day
$600 2
450 5
Demand Curve
Facing Ned’s Beds

18. The Cost Constraint Every firm struggles to reduce costs
But there is a limit on how low costs can go
These impose a second constraint on the firm
Where do these limits come from?
The Production function
This is determined by firms technology
In the long run, the firm can use any method in its production function
In the short run however, some inputs are fixed
The firm must pay the prices of each of the inputs that it uses
Greater output implies greater costs, and greater costs imply lower profits, all else remaining constant

19. The Profit-Maximizing Output Level
In the next session, using information on firms’ demand and cost constraints, we examine how firms arrive at their profit-maximizing level of production

20. References
Economics: Principles and Applications: Hall R.E. and Lieberman M. (2008), Thomson/ South Western (4th Edition)