48 Chapter Highlights
Chapter 20
Profit Maximization
I start out the chapter with a careful definition of profits: you must value
each output and input at its market price, whether or not the good is actually
sold on a market. This is because the market price measures the price at which
you could sell the input, and thus measures the true opportunity cost of using
the factor in this production process rather than in some other use.
I give some commonplace examples of this idea, but more examples won’t
hurt. It’s good to get this idea across carefully now, since it will make it much
easier to discuss the idea of zero long-run profits when it comes up. This idea
is usually a stumbling block for students, and a careful examination about just
what it is that goes into the definition of economic profits helps a lot in getting
the point across.
The material on stock market value is something that is left out of most texts,
but since we have had a careful discussion of asset markets, we can draw the link
between maximizing profits and maximizing stock market value.
The rest of the material in the chapter is fairly standard. The one novel
feature is the revealed profitability approach to firm behavior. This section,
Section 18.10, shows how you can use the fact that the firm is maximizing profits
to derive comparative statics conclusions. If you have treated revealed preference
in consumption carefully, students should have no trouble with this approach.
Profit Maximization
A. Profits defined to be revenues minus costs
1. value each output and input at its market price — even if it is not sold on
a market.
Chapter 20 49
B. Stock market value
1. in world of certainty, stock market value equals present value of stream of
profits
C. Short-run and long-run maximization
1. fixed factors — plant and equipment
D. Short-run profit maximization. Figure 18.1.
1. max pf(x)−wx
E. Long-run profit maximization
1. p∂f/∂x
1=w1,p∂f/∂x
2=w2
F. Profit maximization and returns to scale
1. constant returns to scale implies profits are zero
G. revealed profitability
1. simple, rigorous way to do comparative statics
2. observe two choices, at time tand time s
3. (pt,w
4. if firm is profit maximizing, then must have
5. write these equations as
6. add these two inequalities:
7. rearrange:
8. or
9. implications for changing output and factor prices