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    BIE201 Handout04

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    andersonmapfirakupa
    This document discusses the concepts of profit maximization, revenue, costs, and optimal output level for a firm. It defines profit as revenue minus total costs. Total costs include fixed and variable costs. The profit maximization rule states that a firm should produce the quantity where marginal revenue equals marginal cost, as this is the point that maximizes profit. An example is provided to demonstrate finding the optimal output level that satisfies the profit maximization rule.

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    BIE201 Handout04

    Uploaded by

    andersonmapfirakupa
    24 views9 pages
    This document discusses the concepts of profit maximization, revenue, costs, and optimal output level for a firm. It defines profit as revenue minus total costs. Total costs include fixed and variable costs. The profit maximization rule states that a firm should produce the quantity where marginal revenue equals marginal cost, as this is the point that maximizes profit. An example is provided to demonstrate finding the optimal output level that satisfies the profit maximization rule.

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    This document discusses the concepts of profit maximization, revenue, costs, and optimal output level for a firm. It defines profit as revenue minus total costs. Total costs include fixed and variable costs. The profit maximization rule states that a firm should produce the quantity where marginal revenue equals marginal cost, as this is the point that maximizes profit. An example is provided to demonstrate finding the optimal output level that satisfies the profit maximization rule.

    Copyright:

    © All Rights Reserved
    Download as PDF, TXT or read online from Scribd
    Download as pdf or txt
    24 views9 pages

    BIE201 Handout04

    Uploaded by

    andersonmapfirakupa
    This document discusses the concepts of profit maximization, revenue, costs, and optimal output level for a firm. It defines profit as revenue minus total costs. Total costs include fixed and variable costs. The profit maximization rule states that a firm should produce the quantity where marginal revenue equals marginal cost, as this is the point that maximizes profit. An example is provided to demonstrate finding the optimal output level that satisfies the profit maximization rule.

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    of 9

    Perfect competition and Monopoly

    Concept of Profit Maximization


    •Defining profit
    •Revenue, Cost and Profit
    •Fixed and Variable Costs
    •Marginal cost and Marginal Revenue
    •Profit maximization rule
    •Profit maximization: Example
    Defining Profit
    Profit maximization is often assumed because it predicts
    business behavior reasonably well and avoids unnecessary
    analytical complications
    We therefore assume the firm wants to maximize profit
    Π): amount by which firm’s revenues exceed its costs
    Profit (Π
    Π) = Revenues (TR) – Total Costs (TC)
    o Profit (Π
    Revenue (TR) → amount the firm receives for the sale of its
    output
    o This depends on consumer preferences and type of market
    interaction
    Average Revenue (AR): revenue per unit sold
    Total Costs (TC) → depend on firm’s technology
    Both TR and TC depend on output (q) the firm produces
    The firm chooses an output level such that Π is maximized
    Revenue, Cost and Profit
    TC, TR, and Π (graphically)
    TR, TC, Π
    TR(Q)

    TC(Q)

    Profit (Q)

    Q
    The profit function hits zero exactly where TC equals (intersects) TR
    The profit curve reaches its maximum where there is the largest gap
    between TC and TR
    Fixed and Variable Costs
    Assume a firm’s cost function is: TC(q) = 2000 + 10q2
    Fixed costs: Costs of production that do not vary with
    production (Quantity)
    Fixed costs = 2000
    Variable costs: Costs that vary with quantity (anything with
    the term q in the cost function.
    Variable cost = 10q2
    The slope of each curve has a marginal interpretation:
    Slope of TC → marginal cost (MC)
    Slope of TR → marginal revenue (MR)
    Slope of Π → marginal profit
    Marginal Cost and Marginal Revenue
    Marginal cost: additional cost of producing one extra unit
    Formal definition: the derivative of cost with respect to
    quantity (∂TC/∂q)
    Marginal cost = ∂TC/∂q = 20q
    Marginal revenue: the additional revenue the firm receives
    for one extra unit of production
    Formal definition: derivative of the total revenue (TR)
    function with respect to quantity (∂TR/∂q)
    TR is computed as: price x quantity (p*q):
    Example: Let p = 30 – 5q be the demand equation
    TR = pq = 30q - 5q2
    Marginal Revenue = ∂TR/∂q = 30 – 10q
    NOTE: The exact form of MR depends on the market structure
    Profit maximization Rule
    Assume that a firm produces q units at total cost of TC(q)
    As defined above, the firm’s profits equal its total revenues
    minus its total costs
    Π(Q) = TR(q) – TC(q)
    where TR(q) are the total revenues the firm receives from
    selling the output, q and TC(q) is the cost
    Firm has to solve the following maximization problem:
    Maxq Π(q) = Pq – TC(q)
    Since the profit function is just comprised of the revenue and
    cost functions, its derivative is the MR minus the MC.
    Profit is maximized at output level where marginal profit is 0
    Taking the first derivative of the profit function with respect to
    q and setting it equal to zero gives the quantity q that
    maximizes profit, assuming of course that the firm has already
    taken steps to minimize costs.
    Profit maximization Rule
    Differentiating profit function and equating to zero gives:
    ∂ π ( q ) ∂ TR ( q ) ∂ TC ( q )
    = − =0
    ∂q ∂q ∂q
    Point at which profits are maximized is: ∂π (q) or:
    =0
    ∂ TR ( q ) ∂ TC ( q ) ∂q
    =
    ∂q ∂q
    The additional revenue gained by producing and selling one
    additional unit MR should be equal to the extra cost incurred
    to produce and sell an extra unit (MC)
    Firm maximizes profit by producing where MR = MC.
    If MR > MC: then increasing production will raise firm revenue by
    more than the raise in firm’s cost ⇒ increase production
    If MR < MC: then increasing production will raise firm’s cost by
    more that the raise in firm’s revenue ⇒ decrease production
    So in equilibrium the MR of selling and extra unit should be equal
    to the MC of producing that unit.
    Profit maximization: Example
    Example:
    Assume that a firm has the following functions:
    TR = 9q and TC = 3q2
    The firm’s profit function is therefore: TR – TC = 9q – 3q2
    Differentiate with respect to q:
    Marginal profit = 9 – 6q
    Setting it equal to zero to solve for optimal q:
    9 – 6q = 0 → q* = 9/6 = 1.5 units
    Intuition
    If firm produces a q less than q*, MR would exceed MC
    The firm could increase profit by producing more units
    If firm produces a q more than q*, MC would exceed MR
    The firm could increase profit by producing less units
    As long as either of these is true, the firm is not maximizing profit.
    Profit maximization: Example
    Profit level
    Finally, it is possible to substitute the optimal quantity back
    into the profit function to solve for the firm’s profit level
    Π(q* ) = 9 (1.5) – 3(1.5)2 = $6.75
    This is the amount of profit the firm makes if it chooses its
    output level optimally

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