CDAE 254 - Class 23 Nov 14
Last class:
6. Costs
7. Profit maximization and supply
Quiz 7 (take-home)
Today:
7. Profit maximization and supply
Next class:
7. Profit maximization and supply
8. Perfectly competitive markets
Important dates:
Problem set 6 due Thursday, Nov. 16
(6.1., 6.4., 6.6., 6.9., and 6.10 from the textbook)
Final exam: 3:30 – 6:30pm, Friday, Dec. 15
7. Profit maximization and supply
7.1.
7.2.
7.3.
7.4.
7.5.
7.6.
7.7.
Goals of a firm
Profit maximization
Marginal revenue and demand
Marginal revenue curve
Alternatives to profit maximization
Short-run supply
Applications
7.1. Goals of a firm
-- Maximize profit
-- Maximize TR to increase market shares
-- Maximize the utility of the manager
-- Maximize the expected profit and reduce the risk
…..
7.2. Profit maximization
-- Profit  = TR – TC = Pq – TC
-- A graphical analysis (TR, TC and ) (Fig. 7.1.)
-- A better graph
--  is at the maximum level when the slope of the
profit curve is equal to zero
Slope of the total profit = M = 0
“M = 0” is equivalent to “MR=MC”
i.e., when the slope of the TR curve is equal
to the slope of the TC curve
7.2. Profit maximization
-- Conclusion:  is at the maximum level when
MC=MR
-- Why is this the decision rule?
If MR > MC,  can be increased by increasing q
If MR < MC,  can be increased by decreasing q
If MR = MC,  can not be increased
7.3. Marginal revenue and demand
-- A small firm vs. a large firm:
A small firm (price taker): A firm whose decisions
regarding selling do not affect the market
price of the good.
A large firm: A firm whose decisions regarding
selling do affect the market price of the good.
7.3. Marginal revenue and demand
-- Marginal revenue of a small firm: MR = P
-- Marginal revenue of a large firm:
-- A downward-sloping demand curve: when the
firm wants to sell more, it has to reduce the price.
-- MR < P
e.g., a firm has the demand function of q = 10-P.
When P = 7, q = 3, TR = $21. If the firm wants to
sell 4 units, P = 6 and TR = $24. What is the MR
of this last unit?
7.3. Marginal revenue and demand
-- Example
Demand function q = 10 - P
TR and MR (Table 7.2 and Fig. 7.3)
-- Price elasticity of demand and MR:
-- Price elasticity of demand: eq , P
% change in q

% change in P
-- Range of price elasticity of demand:
< -1 elastic
= -1 unit elastic
> -1 inelastic
7.3. Marginal revenue and demand
-- Price elasticity of demand and TR:
< -1 elastic
= -1 unit elastic
> -1 inelastic
-- Price elasticity of demand and MR:
< -1 elastic
MR > 0
= -1 unit elastic MR = 0
> -1 inelastic
MR < 0
-- Summary:


1

MR  P1 
 e 
q,P 

7.4. Marginal revenue curve
-- Marginal revenue curve: Relationship between
MR and output level (q)
-- MR curve of a small firm (price taking firm):
MR=P
-- MR curve of a large firm with a downward-sloping
demand curve:
-- Table 7.1 and Fig. 7.2
-- Fig. 7.3.
Class exercise
Suppose that the demand function for a company’s
product is estimated as q = 8 - 0.5 P where q is the
quantity and P is the price.
(1) Draw the demand curve
(2) Derive the MR function and draw the MR curve
(3) What is the price elasticity of demand when P=4?
(4) If the company wants to increase its market share,
should it increase or decrease its price (current
price is 4)?
7.5. Alternatives to profit maximization
(1) TR maximization
-- A graphical analysis
-- Comparison of profit maximization and TR
maximization:
Output level:
Total profit:
(2) Markup pricing:
-- P = AC + markup
-- Markup and price elasticity of demand
(e.g, textbooks vs. general books)
7.6. Short-run supply by a price-taking firm
(1) Profit maximizing decision: MC = MR = P
(2) The firm’s supply
(3) Shutdown decision:
STC = SFC + SVC
If TR < SVC , the company should shut down
SAC = SAFC + SAVC
i.e., If the price is less than the short-run
average variable cost (SAVC), the firm will
shut down the production.
(4) The firm’s supply curve: SMC above the SAVC