No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Seven: Production: Man at Work 168 PROFIT MAXIMIZATION Given our assumption of profit maximization, we need to understand how an entrepreneur actually produces to maximize profit. Earlier we defined total profit as the difference between total revenues and total costs: ∏ = TR − TC Higher-level mathematics and economics classes teach how to maximize any function using calculus. However, we will illustrate profit maximization graphically in Figure 7.10 . By plotting a total revenue line (which is just the price of a product multiplied by its quantity) along with a total cost curve, we can see where an entrepreneur will suffer losses or gain profits. We can see that lower levels of output (below Q 1 ) will result in losses for our entrepreneur, as total costs exceed total revenues. In this area of production, the gains from specialization and division of labor have not materialized. In the area between Q 1 and Q 2 , the entrepreneur will accrue those gains and total revenues will exceed total costs such that he or she will achieve a profit. The greatest distance between TR and TC occurs at Q* and is the profit maximizing output level. Further output will result in lower profit, and if output goes beyond Q 2 the entrepreneur will suffer losses as diminishing returns lower production efficiency. Taking this down one level, an entrepreneur would want to produce an additional unit of output as long as the marginal revenue from that unit is greater than the marginal cost. For competitive markets, the marginal revenue is just the price of the product. Profit maximization will occur at Q* where MR=MC as seen in Figure 7.11 . An entrepreneur needs to think on the margin, just like the rest of us! When an entrepreneur is maximizing profit, he or she will choose the best combination of inputs that produce both effectively and efficiently . We say that an entrepreneur or firm is technologically efficient if it is not possible to increase output without increasing inputs. Our entrepreneur in this case is getting everything out of the scarce resources possible. He may produce a given output with a lot of capital equipment and very little (but highly specialized) labor. Or he may choose the opposite. The flip side of the same coin is that he must also be economically efficient . With economic efficiency, a given output is produced with the lowest cost combination of resource inputs. Some entrepreneurs may find it less costly to have more labor and less Technologically efficient: A firm is said to be technologically efficient if it cannot increase output without additional resource inputs. Economically efficient: A firm is said to be economically efficient if it cannot lower costs further without decreasing output. Figure 7.10, Profit Maximization. Since total revenues (TR) are simply the product of price (P) and quantity (Q), TR is a straight line beginning at the origin. With quantities below Q 1 or greater than Q 2 , total costs exceed total revenues: the entrepreneur will suffer losses if he/she produces at that level. Anywhere between Q 1 and Q 2 will result in a profit. The greatest distance between total revenues and total costs occurs at Q* and is the profit- maximizing quantity our entrepreneur should produce. Output $ TR Loss Profit Loss TC TFC Q * Q 1 Q 2