Overview: How to Maximize Profit

StartTable of ContentsIndex

Reading Selections:


On The Internet:

Alternatives and Supplements

Who's Who






Though economists are interested in many cases of unintended consequences, those unintended consequences that involve businessmen seeking their own gain have been at the heart of economic analysis since Adam Smith. Smith noted that

"It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interests. We address ourselves, not to their humanity but to their self love, and never talk to them of our necessities but of their advantages."

Since Smith, a great deal of intellectual effort has gone into exploring the question of under what conditions the interests of society will be served by businessmen seeking to make a profit--in fact, this is the core of microeconomics. The reading selections present background material to this exploration by explaining a large number of technical terms that economists use, and also by looking at a few of the simplifying assumptions they generally invoke.

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 explore the assumption that firms maximize profits, pointing out some of the ambiguities of this assumption. It then explores how the rules of maximization apply to the firm. Much of this material is quite technical, but it is at the core of microeconomics. The unit closes with a section that shows how this theory can help critique proposals that sound good, but that are flawed because they ignore the theory developed in this unit.

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

  • Define production function, isoquants, marginal product, price discrimination, monopsonist, and the all-or-nothing demand curve.
  • Define increasing, decreasing, and constant returns to scale.
  • Distinguish between income and substitution effects.
  • Distinguish between an individual buyer's demand curve and the industry demand, and between industry demand and the demand curve facing an individual seller.
  • Compute marginal revenue from the demand curve of the seller when that demand curve is given in the form of a table.
  • Explain why marginal revenue equals price for a seller who is a price taker, and why marginal revenue is less than price for a seller who is a price maker.
  • Explain what the law of diminishing returns is and under what conditions it holds.
  • Explain why the demand curve and the production function can be treated as boundaries.
  • 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.
Copyright Robert Schenk