MICROECONOMICS: Topic 5(a)

Profit-Maximizing Supply

Topic 5(a): Profit-maximizing Supply

We continue our analysis of firm behaviour by studying the
profit-maximizing supply decisions of a price-taking firm
The decision problem: Using the cost function TC(q) derived from
the cost-minimization exercise,
exercise determine the profit-maximizing
output supply function for a given planning horizon by maximizing
[TR(q) TC(q)] with respect to q
where TR(q) = output price (p) sales volume (q)
[For a price-making firm, TR(q) = p(q)q where p(q) = maximum
price for which q can be sold]
T
Two decisions
d ii
to make
k in
i a planning
l
i horizon:
h i
(i) If the firm chooses to supply a positive volume at a given market
price, how should the firm decide on that volume?
[given convex costs, equate marginal benefit to marginal cost]
(ii) Should the firm choose to supply a positive volume?
[verify if sales revenues cover total avoidable costs]

Examples of profit maximization of price-taking firm

For a price-taker if TC function is differentiable & strictly convex in
quantity, profit function is differentiable & strictly concave in quantity
For convex costs, define q* > 0 to be the output volume for which:
marginal benefit from selling one more unit of output = output price p
= marginal
i l costt off producing
d i one more unit
it off output
t t (at
( t q*)
*)
If profits at q* greater than profits at q = 0: q* is the optimal q**
while if profits at q* less than profits at q = 0: 0 is the optimal q**
Example 1 output price p = 100, TC(q) = 1000 + 5q2 for all q 0
(i) marginal cost = 10q, (ii) all fixed costs are unavoidable
optimal output: q** = 10, maximized profits = 500
for q = 0
Example 2 output price p = 100, TC(q) = 0
2
1000 + 5q for q > 0
(i) marginal cost = 10q, (ii) all fixed costs are avoidable
optimal output: q** = 0, maximized profits = 0

Arijit Sen
IIM Calcutta | Term 1, 2015

MICROECONOMICS: Topic 5(a)

Profit-Maximizing Supply

For our Brick-maker: Long-run firm supply curve on 1 January

TCLR(q) = {0 for q = 0} and {(160 + (2/5).q2 for q > 0
Firm supply:

qSLR(p) =

Output price

0
0 or 20
(5/4)p

for p < 16
for p = 16
for p > 16

MCLR = (4/5)q
AACLR = 160/q + (2/5)q
16
Output
p
20
= long run firm supply curve

Long-run Firm profits: *(p) =

0
for p 16
(5/8)p2 160
for p > 16
At any p for which there is positive supply, producer surplus at
[p, qS(p)] is defined as area between price line and firm supply curve
- it equals the firms long-run economic profits

Long-run decisions on January 1 given expected output p = 40

The firm will lease 1 acre of land for the year.

It will sign a 1-year contract for monthly supply of 25 kgs of capital
It will sign a 3-mnth contract for monthly supply of 25 hours of labour
p , it will pproduce and sell 50 units of output
p
With the contracted inputs,
per month for each of the months of January, February, and March.
On Jan 1 the firm will recognize that after every 3 months in the
coming year, it can enter into a new labour contract if it so desires.

Note: when the firm hires 25 kgs of K and 25 hours of L per month
marginal product of labour will be: 2.5K(1/4).L(3/4) = 0.5, and
3/4).L
marginal product of capital will be: 22.5K
5K((3/4)
L(1/4) = 0.5.
05
At this optimal input combination, the following conditions hold:
output price marginal product of labour services employed = w
output price marginal product of capital goods employed = k

Arijit Sen
IIM Calcutta | Term 1, 2015

MICROECONOMICS: Topic 5(a)

Profit-Maximizing Supply

Short-run firm supply curve on 1 April (fixed costs unavoidable)

Given K0 = 25: TCSR(q) = 660 + (1/12500).q4 for all q 0
Short-run firm supply function: qSSR(p) = (3125p)1/3
Output price p

MCSR = (1/3125).q
(1/3125) q3
ACSR

minimum ACSR
= 21.60

AACSR

Output
p
= short run firm supply curve

Firm makes s-run losses for p < min ACSR; but by producing on MCSR
it minimizes s-run losses for p between min AACSR (=0) and min ACSR
- in our example, the firm generates positive short-run supply at all
positive prices because there are no short-run avoidable fixed costs

Short-run vs Long-run decisions

(i) On April 1, if the firm sees that the output-price has remained
unchanged at 40 (and is expected to remain at 40),
then it will again contract for 25 hours of monthly labour services
and produce and sell 50 units of output per month for next 3 months.
Note: in thiss case thee firm will
w replicate
ep ca e itss long
o g term
e decisions.
dec s o s.
(ii) On April 1, if the firm sees that the output-price has risen to 135
(and is expected to remain at 135),
then it will contract for 126.5625 hours of monthly labour services
and produce and sell 75 units of output per month for next 3 months.
Note: if output-price was 135 on January 1, the firm would have
pplanned to produce
p
and sell 168.75 units of output
p pper month.
(iii) On April 1, if the firm sees that the output-price has fallen to 5 (and
is expected to remain at 5),
then it will contract for 1.5625 hours of monthly labour services and
produce and sell 25 units of output per month for the next 3 months.
Note: if output-price was 5 on Jan 1, firm would have shut down
for the year.

Arijit Sen
IIM Calcutta | Term 1, 2015

MICROECONOMICS: Topic 5(a)

Profit-Maximizing Supply

Profit maximization by competitive firm with eventually convex costs

In a specific time-horizon, a finite, positive profit maximizing output q**
for a price-taking firm must satisfy three properties:
(i) marginal revenue must equal marginal cost at q**:
MR(q**) = p = MC(q**)
Cost

(ii) MC function must be rising at q**

Avg Cost

Marginal
Cost

(iii) total revenue must cover

total avoidable costs at q**:
TR(q**) > G + VC(q**)
p > average avoidable cost

min AC
min AAC

Avg Avoidable
C t
Cost

m.e.s.

output

If (ii) does not hold, can do better by increasing output

If (iii) does not hold, better off producing nothing for given horizon
If total revenue covers total avoidable costs but not total costs, firm is
minimizing losses by producing its optimal positive output

Properties of Input Demand for a Price-taking Firm

For the relevant time run, once the profit-maximizing output is
determined, the firm can back calculate its input demands
In our example, labour demand in the short run given K = K0:
LSR(q*) = (1/K0)a/b .(q/10)1/b
We can verify that at the short-run optimum (q*, L*):
pMPLSR(q*) = w
- the left-hand side is the value to hiring one more labour hour, and
the right hand side is the cost of doing so
Input demands in the long-run:
KLR(q) = (aw/bk)b/(a+b).(q/10)1/(a+b) = (q/10)2
LLR(q) = (bk/aw)a/(a+b) .(q/10)1/(a+b) = (q/10)2
We can verify that at the long-run optimum (q**, K**, L**):
pMPKLR(q**) = k and pMPLLR(q**) = w

Arijit Sen
IIM Calcutta | Term 1, 2015

MICROECONOMICS: Topic 5(a)

Profit-Maximizing Supply

The long and short of it for a price-taking firm:

Consider a production run where eventually scale economies are
exhausted & costs are convex [otherwise wouldnt be a price taker]
Recognize all your committed input contracts these constitute
yyour unavoidable fixed costs
In addition, you will have avoidable costs, a part of which may be
fixed (G), and a part that is variable (VC)
Construct the TC curve by undertaking cost-minimization exercise
If output price is below the minimum value of the average
avoidable cost (G+VC)/q, shut down for the production run
If not, produce that output where price = MC and MC is rising,
by contracting for the required amounts of variable inputs

Decision Making in a Multi-product Firm

In every planning horizon a multi-product firm has to determine its
profit maximizing output portfolio
Profit-max condition: If the firm is producing two goods X and Y
MC of X at the optimal portfolio (X
(X*,, Y
Y*)) = Output price of X
& MC of Y at the optimal portfolio (X*, Y*) = Output price of Y
If the production processes of X and Y have shared fixed costs,
the firm should not arbitrarily allocate fractions of the fixed cost to
each product-line and then check profitability of that product line
rather the firm should calculate: aggregate profits from operating
both product lines versus profits from operating any single product
line

Arijit Sen
IIM Calcutta | Term 1, 2015