Eco205 Chapter 8 – Profit Maximization and Supply 10 January 2013
The Nature of Firms
Why Firms Exist?
Firms exist to reduce down the cost for transportation and reduce time for each individual customer
Contracts within Firms
Workers, who enjoy the negotiating benefits of unions, often arrive at contracts that specify in considerable
detail what hours are to be worked, what work rules are to be followed, and what rate of pay can be expected.
The primary reason that such incentives matter is that information about the actual performance of a firm’s
managers or its employees may be difficult to observe.
Firms’ Goals and Profit Maximization
Economists usually treat the firm as a single decision-making unit. That is, the firm is assumed to have a single
owner-manager who makes all decisions in a rather dictatorial way.
If the manager of a firm is to pursue the goal of profit maximization, they must make the difference between the
firm’s revenue and its total costs as large as possible. In making such calculations, the cost figure should include
allowances for all opportunity costs. With such a definition, economic profits are indeed a residual over and
above all costs. For the owner of the firm, profits constitute an above-competitive return of his or her
investment because allowance for a ‘‘normal’’ rate of return is already considered as a cost.
If managers are profit maximizers, they will make decisions in a marginal way. They will adjust the things that
can be controlled until it is impossible to increase profits further. The manager looks at the incremental (or
marginal) profit from producing one more unit of output or the additional profit from hiring one more
employee. As long as this incremental profit is positive, the manager decides to produce the extra output or hire
the extra worker. When the incremental profit of an activity becomes zero, the manager has pushed the activity
far enough—it would not be profitable to go further.
The Output Decision
A firm sells some level of output, q, and from these sales the firm receives its revenues, R(q). The amount of
revenues received obviously depends on how much output is sold and on what price it is sold for ( ) ( ) ( )
Marginal Revenue / Marginal Cost Rule
In economic jargon, a firm that opted to produce less than q* would find that its marginal revenue (MR) would
be greater than its marginal cost—a sure sign that increasing output will raise profits. Increasing output beyond
q* would cause profits to fall. Beyond q*, the extra revenue from selling one more unit is not as great as the cost
of producing that extra unit, so producing it would cause a drop in profits. Hence, the characteristics of output
level q* are clear—at that output, marginal revenue is precisely equal to marginal cost,
MR = MC
Marginalism in Input Choices
Hiring another worker entails some increase in costs, and a profit-maximizing firm should balance the additional
costs against the extra revenue brought in by selling the output produced by this new worker. Also, additional
machines should be hired only as long as their marginal contributions to profits are positive. As the marginal
productivity of machines begins to decline, the ability of machines to yield additional revenue also declines. The
firm eventually reaches a point at which the marginal contribution of an additional machine to profits is exactly
zero—the extra sales generated precisely match