Econ 410 Class Notes - Profit Maximization

Econ 410 Class Notes - Profit Maximization - Chapter 10...

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Unformatted text preview: Chapter 10 Profit Maximization Let us take a step back and examine what questions we have answered. From the consumer’s demand function, we are able to determine how much a consumer (or the market as a whole) will demand of a particular good given a specific price. From the firm’s cost-minimization problem, we have determined how a firm will produce a specific amount of output good at the lowest cost. We have yet to answer the fundamental question, “how much output will a firm produce?” or, equivalently, “what price will the firm set, recognizing it can only sell a quantity level as dictated by the market demand function?”. To answer this question, we address a fundamentally important decision facing any firm. Specifi- cally, “what output level should the firm produce in order to maximize profits?”. 1 In order to analyze the incentives firms face in their decision-making, we will ex- amine a simple baseline scenario. Extending the baseline model to incorporate more advanced concepts such as the benefit to research & development can be done within this analytical framework using modified models. 1 While we generally consider profits in monetary terms, this analysis does not require this restriction. For instance, if the “profits” of a particular non-profit firm is the number of vaccina- tions administered in Sub-Saharan Africa, we could modify our “revenue” as defined, below, and identical analysis can be performed. 225 | CHAPTER 10 • PROFIT MAXIMIZATION 10.1 Baseline Monopolistically Competitive Model Definition 10.1 (Monopolistically Competitive Model): The Baseline Monopolistically Competitive Model (BMC Model) is a model of profit-maximization in which 1. Consumers purchase goods according to their demand functions. 2. A firms cost-minimizes by selecting inputs according to its factor demand functions. 3. Firms select quantity (or price) to maximize their profits, where profit, Π , is measured as total revenues - total cost. 4. Firms set the same price for each customer. 5. A firm has some degree of market power, by which it can increase the price of its output good without losing all of its customers. In general, these assumptions are viewed as fairly innocuous. The first assump- tion assumes that consumers are rational. The second assumption assumes that firms operate “on their cost functions”, and do not systematically operate inef- ficiently. The third assumption assumes firms care only about monetary profit, but this assumption can easily be relaxed with no changes to the underlying anal- ysis. The fourth assumption assumes firms cannot, for instance, charge higher prices to higher-valued customers. Again, this assumption can be easily relaxed and is done in models of price discrimination. The final assumption is specific to this model, and assumes that a firm has some degree of monopoly power. This power can be a result of many factors: • Natural Monopolies: In certain scenarios, only a single firm can realisti-...
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This note was uploaded on 02/15/2012 for the course ECON 410 taught by Professor Codrin during the Fall '07 term at UNC.

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Econ 410 Class Notes - Profit Maximization - Chapter 10...

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