Theory of the firm:
Profit maximization
Chapters 6, 7 & 8
1
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
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
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.
Types of Markets (degrees of competition)
5
One firm
2-12 firms
many firms
Monopoly
Oligopoly
Monopolistic
Competition
many, many firms
Perfect
Competition
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
Economic profit
v.
Accounting profit
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.
2 Types of Costs and 2 Types of Profit
9
 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

Two Types of Profit
10
 Accounting Profit
 Total Revenue – Explicit Costs
 Economic Profit
 Total Revenue – Explicit Costs – Implicit Costs
 Economic Loss
 An economic profit less than zero
The Difference Between Accounting Profit
and Economic Profit
11
The Difference Between Accounting Profit and
Economic Profit
12
 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”
Econ vs. Acct Profits
13
 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)
To Farm or Not To Farm?
14
 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
Example
15
 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.
Example continued
16
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
- inventory
- rent
- wages for worker
economic
- inventory
- rent
- wages for worker
- opp cost of Labor = $50,000
- opp cost of funds = $1,000
Example continued
17
 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?

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?
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?
“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
Functions of Price
21
 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 < ATC => negative profits
 Changes in price may therefore reallocate resources.
Market Forces and Economic Profit
22
 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

Fig. 8.2
The Effect of Economic Profit on Entry
23
Market Forces and Economic Profit
24
 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
Fig. 8.3
The Effect of Economic Losses on Exit
25
26
Production
& the principle of diminishing
marginal returns
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
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.
Law of Diminishing Marginal Returns
29
Q
Point of diminishing
marginal returns
Labor
MPL
Implications for Marginal Costs
30
 Since productivity (MPL) 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
Types of Markets (degrees of competition)
31
One firm
2-12 firms
many firms
Monopoly
Oligopoly
Monopolistic
Competition
many, many firms
Perfect
Competition
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
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

The Demand Curve Facing Perfectly Competitive Firm
34
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
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
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
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
Profit Maximization
39
P
ATC = Total Cost / Q so, TC = ATC x Q
P > ATC means profit > 0
MC
ATC
D = MR
10 = P*
8
Q*
100
Quantity
Suppose Price Falls to Min ATC
40
P
P = ATC means profit = 0
MC
ATC
7 = P*
D = MR
Q*
Quantity
Suppose Price Falls below Min ATC
41
P
P < ATC means profit < 0
MC
ATC
7 = P*
D = MR
Q*
Quantity
Response to Economic Profits
 Markets with excess profits attract resources
Price
$/bu
Corn Industry
S
Price
$/bu
Typical Corn Farm
MC
ATC
Economic
Profit
2
2
P
1.20
D
65
Quantity (M of bushels/year)
130
Quantity (000s of bushels/year)
Shrinking Economic Profits
 Supply increases in the long run
Price
$/bu
Corn Industry
S
S'
Price
$/bu
Typical Corn Farm
MC
ATC
Economic
Profit
2
P
1.50
D
65 95
Quantity (M of bushels/year)
120 130
Quantity (000s of bushels/year)
Market Equilibrium
 Eventually, the market saturates and firms earn zero
economic profits
Price
$/bu
Corn Industry
Price
$/bu
S
S'
Typical Corn Farm
MC
ATC
S"
2
1.50
1
D
65
115
Quantity (M of bushels/year)
P
90 130
Quantity (000s of bushels/year)
Response to economic losses
 Resources leave the market
Price
$/bu
Corn Industry
Price
$/bu
Typical Corn Farm
MC
ATC
S
1.05
0.75
0.75
P
D
60
Quantity (M of bushels/year)
70 90
Quantity (000s of bushels/year)
Market Equilibrium
 Again the market reaches a situation of zero economic profit
Price
$/bu
Price
$/bu
MC
ATC
S'
S
P
1
0.75
D
40 60
Quantity (M of bushels/year)
70 90
Quantity (000s of bushels/year)
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).
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
Competitive markets and efficiency
(and inefficiency)
The Domain of Markets
50
 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
Market Equilibrium and Efficiency
51
 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
Market Equilibrium and Efficiency
52

1.
2.
When a market is not in equilibrium:
P > P* = surplus -- QS > QD
P < P* = shortage -- QD > QS
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.
Adam Smith
53
 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
Invisible Hand
54
 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
Economic surplus (net gains)
55
 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
Total economic surplus in the market for milk
56
Surplus and Efficiency
57
 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
Other Goals
58
 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
Markets and Social Optimum
59
 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
Markets and Social Optimum
60
 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)
The Market for Potatoes Without Taxes
61
The Effect of a $1 Pound Tax on Potatoes
62
The Deadweight Loss Caused by a Tax
63
DWL
64
 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
Taxes, Elasticity, and Efficiency
65
 Deadweight loss is minimized if taxes are imposed
on goods and services that have relatively inelastic
supply or relatively inelastic demand.
Elasticity of Demand and the Deadweight Loss from a Tax
66
Elasticity of supply and the deadweight loss from a tax
67
Do all taxes decrease economic efficiency?
68
 Consider a tax on land
 Land supply is perfectly inelastic
 DWL = $0
 What other goods have high tax rates?
 Booze
 Cigarettes
 Gasoline
Taxes, External Costs, and Efficiency
69
 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)
External costs & taxes that are efficiency-enhancing
70
 Consider a market activity that generates harmful
side-effects on a 3rd 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?

Market Equilibrium
71
P
S = MPC
$20 = P*MKT
D = MSB
Q*MKT
At P*MKT QD = QS = Q*MKT
CS + PS are maximized
Q
Market Equilibrium
72
 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 3rd parties.
Social Equilibrium
73
P
MSC = MPC + 2
S = MPC
$21 = P*SOC
$20 = P*MKT
D = MSB
Q*SOC Q*MKT
Q
Social Efficiency
74
 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?
Social Efficiency
75
 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”
Social Equilibrium
76
P
New MPC = Old MPC + 2
S = MPC
$21 = P*SOC
D = MSB
Q*SOC Q*MKT
Q
Can markets create external benefits?
77
 If markets can create costs on 3rd parties, can they
create benefits?
 Sure.




Education.
Lawn care
House maintenance
Text: beekeeper adjacent to apple orchard
 Will the market solution be efficient?
External
78 Benefits
P
S = MSC
P*MKT
MSB
D = MPB
Q*MKT Q*SOC
Q
External Benefits
79
 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.
Naturalist Questions
80
 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?