Lecture on Firm Goals and Profit Maximization

Introduction

• In consumer theory, individuals have preferences and aim to achieve highly ranked outcomes.
• Firms, unlike individuals, have varied reasons for existence, including:
  • Passion for a product or service
  • Desire to make the world better
  • Desire to make money
• Ultimately, the primary goal of a firm is to make profits.

Profit Maximization

• Competitive Marketplace:

  • Firms that can achieve profitable outcomes consume those that cannot by obtaining scarce resources more efficiently.
  • Similar to nature, where traits likely to reproduce are selected.

• Profits:

  • Represented by the Greek letter Pi (π).
  • Equation: Profits = Total Revenue - Total Costs

Total Revenue and Total Costs

• Total Revenue:

  • Depends on price charged and quantity sold.
  • Example: Selling 100 calculators at $10 each = $1,000 total revenue.

• Total Costs:

  • Include explicit and implicit costs.
  • Explicit Costs: Money outlay for resources (e.g., cups, lemons, sugar for a lemonade stand).
  • Implicit Costs: Costs of a foregone opportunity (e.g., potential earnings from alternative jobs).
  • Implicit costs significantly influence firm behavior.

Real-Life Example and Economic Profit

• Video Paradise Case:
  • Although accounting profits were positive, implicitly they were losing money due to more profitable alternatives (Dollar Tree).
  • Economic profit considers both explicit and implicit costs.
  • Example: If corn yields $50,000 and soybeans $100,000, economic profit for corn is negative $50,000.

Fixed and Variable Costs

• Variable Costs:

  • Depend on the quantity produced (e.g., more loaves of bread require more bakers and ingredients).

• Fixed Costs:

  • Do not vary with output (e.g., rent for a storefront, baking equipment).

• Total costs include both fixed and variable costs plus implicit costs.

Decision Making and Marginal Costs

• Firms decide on production quantity day-to-day based on cost analysis.

• Marginal Costs:

  • Tend to rise in the short run due to diminishing marginal returns.

• Short Run vs. Long Run:

  • Short run has fixed resources (e.g., number of ovens).
  • In the long run, firms can adjust more resources to optimize production.

Graphical Analysis

• Revenue and Costs Representation:

  • Total revenue is an upward line based on quantity.
  • Fixed costs are horizontal as they do not change with quantity.
  • Marginal costs rise with quantity, leading to exponential total costs.

• Bread Baking Example:

  • Overproduction is costlier; it’s about finding the optimal output where profit is maximized.

Conclusion

• Firms aim to find the quantity where the gap between total revenue and total cost is maximized for profit.

• Increasing production beyond this optimal point reduces profits.

• Key Question: How to determine the quantity that maximizes profits?