Lecture Notes: Profit Maximizing Rule and Cost Analysis

Introduction to Profit Maximizing Rule

• Concept Complexity: Although the rule seems simple, it is based on complex ideas such as:
  • Implicit Costs
  • Diminishing Marginal Returns
  • Competitive Markets
• Profit Maximization Condition: To maximize profits, a firm must produce until marginal revenue equals marginal cost.

Time Frames in Economics

• Short Run:
  • Fixed costs are unchangeable.
  • Example: A 12-month lease on a storefront locks you into rent payments for that period.
  • Equipment rentals and loans also fall under fixed costs.
  • Decisions are constrained until new decisions can be made.
• Long Run:
  • All costs become variable.
  • Opportunities to renegotiate leases, upgrade or downgrade equipment, and refinance loans.
  • Firms can scale up or down according to profitability.

Bread Baking Business Example

• Revenue: Each loaf sold for $1. Total revenue is easy to calculate per loaf sold.
• Costs:
  • Fixed Costs: $50 per day.
  • Variable Costs: Start at $0.10 per loaf and increase as additional loaves are produced.
  • Example: 75th loaf adds $1 to variable cost.
• Marginal Revenue and Cost:
  • Marginal Revenue: Constant at $1 per loaf.
  • Marginal Cost: Varies with production.

Profit Analysis

• Profit Maximization: Occurs where marginal revenue equals marginal cost.
• Profit Calculations: Largest profit at 75 loaves; still incurs a $1.25 loss per day.
• Decision Making:
  • If total revenue > total variable cost, stay in business in the short run.
  • In the long run, with negative economic profits, shut down is necessary.
  • Economic profit considers opportunity costs and indicates better alternatives.

Summary of Short Run and Long Run Decisions

• Short Run:
  • Continue operations if total revenue covers variable costs.
  • Aim to cover as much of the fixed costs as possible.
  • Decision to shut down if not covering variable costs.
• Long Run:
  • Fixed costs become flexible.
  • Positive profits attract more firms.
  • Negative profits suggest shutting down and pursuing better opportunities.

Market Dynamics and Resource Allocation

• Firm Entry and Exit: Based on comparison of product price to average cost of production.
• Price Influence:
  • High prices attract firms and resources.
  • Low prices drive resources to more profitable uses.
  • Markets set prices, directing resource allocation.

Conclusion

• Understanding of Prices: Firms react to price changes, influencing resource distribution.