Producers and Profit Maximization
In economic theory, people play two main roles in the market. As we have just seen, they are consumers. The other main role is producers. For producers, the economic problem is to maximize profits. The key decisions are which outputs to produce, how much of each output to produce, and which inputs to use to produce the outputs. We will take these decisions one at at time.
How Much Output?
Let us return to Josh's lawn mowing business, and focus on the decision of how many lawns to mow each day. To make things simple, suppose he already has leased a lawnmower and a pickup truck. Also, to avoid confusing the output decision with Josh's labor-leisure choice, ...view middle of the document...
When we start at 12 hours of work, the next two hours produce two more lawns mowed, which gives Josh $36 in additional revenue compared with $22 in marginal cost. However, when the employees work a total of 14 hours (7 hours apiece), the next two-hour increment produces only one more lawn mowed, which means only $18 in revenue. This is less than the cost of two additional hours, which is $22. So, he should stop after 14 hours.
Another way of putting this is that a firm should increase its output as long as the marginal cost of producing additional output is less than the price of output. In short, we stop increasing output when price equals marginal cost.
Suppose that two partners are just starting a business in the field of email management solutions for corporations. They are in the process of discussing the strategy for their new venture. One partner is a computer wizard, named Cool. The other partner is a marketing and sales expert, named Slick.
A difficult decision that the partnership faces is whether it should try to make money by developing a product or by selling consulting services. Cool thinks that the company should focus on product development. "We'll get a lot more leverage out of my computer skills if we can sell a product," Cool says.
"I don't agree," Slick replies. "Products are really hard to sell. It means I'll be wasting a lot of time giving presentations to companies that are not ready to make up their minds. I say we should start out doing consulting. It's much easier to get a decision on a consulting contract."
Cool and Slick continue to argue. Cool does not like consulting, because it uses up a lot of his time and has limited revenue potential. Slick likes consulting because the cost of sale is lower. How can this issue be resolved?
The firm's goal is to maximize profits. To do so, Cool and Slick are going to have to make some estimates about the the technology and about prices.
The technology issue concerns what they can produce with their inputs, which consist of technical effort and sales effort. The price issue concerns what the prices are for a product and for consulting services.
Slick and Cool each have 2000 hours a year that they can spend working. Slick says, "For every 400 hours I put into selling consulting services, I can generate 6 consulting contracts. Each contract is worth $8000. So I can generate 30 contracts in a year, for a total of $240,000 a year in revenue."
"That's great," Cool replies. "But each contract takes 10 hours of my time, and I don't have 3000 hours. So the most we can do in consulting is 2000 hours, or $160,000 worth. What if you put all of your time into product sales?"
"Well," Slick says, "that means you put all of your time into product development, so we have a really cool product. In that case, I could sell maybe 1000 licenses for $150 each, or a total of $150,000. We're better off with consulting."
"Not so fast," says Cool. "What if we compromise? I...