Overview: Maximizing Profit

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The business firm is the productive unit in an exchange economy. In order to survive, a firm must deal with three constraints: the demand for its product, the production function, and the supply of its inputs. When the firm successfully deals with these constraints, it makes a profit.

These readings examine the assumption that firms maximize profits, pointing out some of the ambiguities of this assumption. They then explore how the rules of maximization apply to the firm. There are two ways in which the maximization principle can be used: to determine the proper levels of inputs or to determine the proper level of output. The first leads to the rule that marginal resource cost should equal marginal revenue product and the second to the rule that marginal cost should equal marginal revenue. The readings show that these two rules are equivalent and simply represented different ways of using the information from the three constraints that a firm faces.

Much of this material is quite technical but it forms the core of traditional microeconomics. The unit closes with a section arguing that ignoring the insights that these readings develops has led to bad economic policy.

After you complete this unit, you should be able to:

  • Explain why economic profit is often impossible to measure.
  • Explain the principal-agent problem.
  • Defined fixed costs, marginal revenue product.
  • Compute marginal revenue product when given marginal revenue and marginal product.
  • When given data on output, marginal revenue, and marginal cost, determine which level of output maximizes profit.
  • When given data on levels of input, marginal revenue product, and marginal resource cost, determine the level of input that maximizes profit.
  • Show how the two ways to maximize profits (by looking at optimal output and optimal input) uses the information from the three constraints a firm faces (the production function, the demand curve, and the supply curve of resources).
Copyright Robert Schenk