Chapter 6

Optimal Level of Output and Long

Run Price

6.1 Golden Rule of Profit Maximization

The cost structure of a firm is reflected in its costs functions: total cost TC; average
cost AC; and marginal cost MC. Total cost, the sum of total variable and total fixed
costs, is generally expressed as a function of the level of output Q. While a firm’s
production function is often a bivariate or multivariate function relating its output to
various inputs, the cost functions are usually univariate functions relating different
costs to only one variable, output. It is therefore much easier to specify and estimate
various cost functions for a firm than specify and estimate its production function.1
A typical firm may faces three types of optimization (maximization or minimization)
problems. A firm may decide its level of output Q 0 and focus on minimizing the costs
of producing it, i.e. minimizing its operating cost. This is an example of a constraint
optimization. Here the constraint is the exogenously determined level of output. In
the second class of optimization problems, a firm may decide its total expenditure
on various inputs—or its operating cost—and try to determine its profit maximizing
level of output. This is another constraint optimization problem. Here the constraint
is the exogenously determined total cost TC0 . As we will see, if the total cost function
of a firm is known then these two types of constraint optimizations are rather trivial
problems.
The third type of optimization problem arises when a firm attempts to maximize
its profit (or minimize its loss) without any constraint on output or cost. This is an
example of unconstrained optimization. In this case the main objective of a firm with
cost function TC(Q) is to find the level of output Q ≤ that maximizes its profit π . Q ≤
is the firm’s optimal or equilibrium level of output.
We began by exploring the unconstrained optimization. An unconstrained profit-
maximizing firm expands its output as long as its marginal cost MC is less than its
marginal revenue MR. The optimal level of output is achieved when firm’s marginal
cost becomes equal to its marginal revenue, that is MC = MR. Denoting the firm’s

1 A detailed discussion of production functions and related topics is presented in Chap. 10.

S. Vali, Principles of Mathematical Economics, 123

Mathematics Textbooks for Science and Engineering 3,
DOI: 10.2991/978-94-6239-036-2_6, © Atlantis Press and the authors 2014
124 6 Optimal Level of Output and Long Run Price

total revenue function as TR(Q), the profit function of the firm could be written as

π(Q) = TR(Q) − TC(Q) (6.1)

The firm reaches its profit maximizing level of output when the first order condition
dπ
(FOC) for a maximum, = 0, is satisfied. By setting the derivative of (6.1) with
dQ
respect to Q equal to zero we have

dπ dT R dT C
π → (Q) = = − = T R → (Q) − T C → (Q) = 0
dQ dQ dQ

T R → (Q) − T C → (Q) = 0 −◦ T R → (Q) = T C → (Q) (6.2)

Given that TR→ (Q) and TC→ (Q) are marginal revenue and marginal cost, the FOC
in (6.2) is a mathematical reiteration of the ‘golden rule’ of profit maximization, the
condition MC = MR.
The second order condition (SOC) for maximization requires that the second
derivative of the profit function evaluated at the level of output Q ≤ , a solution to
(6.2), be negative, that is

d 2 π 
π →→ (Q ≤ ) =  = T R →→ (Q ≤ ) − T C →→ (Q ≤ ) < 0 or
d Q 2 Q≤

T R →→ (Q ≤ ) < T C →→ (Q ≤ ) (6.3)

The Economic implication of (6.3) is that the firm maximizes its profit at the level
of output where the rate of change of marginal cost is greater than the rate of change
of marginal revenue. To better understand this condition let us consider two cases.
If the firm operates in a competitive market then its marginal revenue equals the
price, P, determined in the market, and the FOC can be expressed as

dπ
= P − T C → (Q) = 0 or P = MC
dQ

The SOC requirement for maximum profit is

d 2π d
2
= [P − T C → (Q)] = 0 − T C →→ (Q ≤ ) < 0 or T C →→ (Q ≤ ) > 0
dQ dQ

This means that the maximum occurs at the intersection of the price line with the
upward sloping segment of the marginal cost curve. This situation is depicted in
Fig. 6.1.
In Fig. 6.1 the price line intersects the MC curve at points A and B, corresponding
to levels of output Q 1 and Q 2 , at which price is equal to MC. Point A is on the
6.1 Golden Rule of Profit Maximization 125

Fig. 6.1 A Competitive firm’s

marginal revenue and mar-
ginal cost curves

dMC
downward sloping portion of MC curve where = TC→→ (Q ≤ ) < 0. This is the
dQ
SOC for a minimum (at Q 1 profit is actually minimized). Point B is on the upward
sloping segment of MC, where

dMC
= T C →→ (Q ≤ ) > 0
dQ

At Q 2 the SOC for a maximum is satisfied and profit is maximized.

If the market in which this firm operates is not competitive then the graph of
the firm’s marginal revenue function should be a downward sloping curve.2 This
scenario is represented by Fig. 6.2. In Fig. 6.2 point A corresponds to the level of
output leading to a minimum profit. The firm’s profit is maximized at the output
level corresponding to point B, lying on the upward swing of MC curve.

Fig. 6.2 A noncompetitive

firm’s marginal revenue and
marginal cost curves

2 I am ignoring the possibility of an upward sloping marginal revenue curve here.

126 6 Optimal Level of Output and Long Run Price

The total cost function TC plays a major role in study of firms’ behavior in the mar-
ket. Often quadratic, and most often cubic, cost functions are used in mathematical
modeling of firms’ cost structure and study of their operations in both competitive and
non-competitive markets. We first discuss the application of quadratic cost functions
and then proceed to a more detailed presentation of the cubic cost functions.

6.1.1 Firms with Quadratic Cost Functions in a Competitive

Market

Examples
Assume the variable cost function of a perfectly competitive firm is given by

V C = V C(Q) = 0.5Q 2 − 25Q

Assume the firm’s fixed cost FC is 100. If the price of a unit of output is $20 in the
market, what is the firm’s profit maximizing level of output? What is the maximum
profit?
The firm’s total cost, total revenue, and profit functions are:

T C = T C(Q) = V C(Q) + FC = 0.5Q 2 − 25Q + 100

T R = T R(Q) = P ≤ Q = 20Q
π(Q) = T R(Q) − T C(Q) = 20Q − 0.5Q 2 + 25Q − 100
= −0.5Q 2 + 45Q − 100

The stationary value of the profit function is

dπ
= π → (Q) = −Q + 45 = 0 −◦ Q ≤ = 45
dQ

Since π →→ (Q ≤ ) = −1 < 0 the SOC for a maximum is satisfied. At 45 units of output

the firm’s profit is

π(45) = −0.5(45)2 + 45(45) − 100 = 912.5

Are these figures “economically” legitimate? Let explore.

In the above example we used the specified cost functions and market price and
applied the first and second order conditions for profit maximization and determined
that our firm makes the maximum profit of $912.5 at the level of 45 units of output.
From a ‘mathematical’ perspective, the specified functions and the results look
fine. But from an ‘economic’ perspective they have major flaws. These functions are
in violation of a number of economic ‘ordinances’. The most critical violation is that
6.1 Golden Rule of Profit Maximization 127

at the “optimal” level of output the variable cost is actually negative,



V C(45) = (0.5Q 2 − 25Q) = 0.5(45)2 − 25(45) = −112.5
Q=45

This firm produces 45 units of output with variable costs of −112.5!!

This numerical example was introduced to highlight possible pitfalls of mechani-
cal applications of mathematics in economics, particularly in optimization problems.
With an eye on requirements which will be explored in the next section, we can offer
a different formulation of the problem with the total cost function expressed as

T C(Q) = 5Q 2 − 30Q + 400

and the market price set at P = $100 per units. With these revisions, the firm’s profit
function is

π(Q) = T R − T C = 100Q − 5Q 2 + 30Q − 400 = 130Q − 5Q 2 − 400

FOC for a maximum is

dπ
= π → (Q) = 130 − 10Q = 0 −◦ Q ≤ = 13
dQ

And the SOC for a maximum π →→ (Q ≤ ) = −10 < 0 is satisfied. With the optimal
output at 13 units, the variable and total costs are $455 and $855, respectively, and
the firm’s maximum profit is $445.
Figure 6.3 is graphic representation of profit maximizing output and maximum
profit. As the top graph shows, the profit maximizing level of output is reached when
MR = P = MC at Q = 13 units. At this level of output the average total cost or unit
cost is $65.77 and profit per unit is 100 − 65.77 = 34.23, leading to a total profit
of 13 ≤ 34.77 = $445. The bottom graph confirms that profit reaches it maximum
value at Q = 13 units.

6.1.2 Economically Legitimate Quadratic Cost Functions

The graph of a quadratic function of the form y = ax 2 + bx + c is a parabola. If a

is positive the vertex of the parabola is its lowest point, or the function’s minimum
(Fig. 6.4). If a is negative the vertex of the parabola is its highest point or the function’s
maximum (Fig. 6.5).
The FOC for an extreme point of a quadratic function is

dy
= 2ax + b = 0
dx