The Firm and Profit Maximization

What is a firm?

  • A firm is any entity that sells goods in order to make a profit
    • Assumption: every firm’s objective is to maximize profit
    • Can sell any type of product
    • Can take any form
  • Firms are considered a black box in IO
    • Firms purchase input goods that are used to produce a final product
    • We don’t care about the in-between steps
    • We only care about what inputs are used, how much of the final good is created, and how much it costs to produce

Profit Maximization

Profit maximization is the act of buying and transforming inputs and selling outputs in a way that leads to the highest possible profit. Firms choose quantity, q, that maximizes the following equation:

\[ \Pi(q)=TR(q)-TC(q) \]

  • \(\Pi(q)\) denotes the profit of producing q units
  • \(TR(q)\) denotes the total revenue of producing q units
  • \(TC(q)\) denotes the total cost of producing q units

Common Assumptions

  • Downward sloping demand
  • Non-decreasing marginal cost as \(q → \infty\)
  • Production function and demand function are continuous and differentiable

Note: in this class, we will take these assumptions as given