Question

Refer to our analysis of the optimal investment decision of the firm in chapter 11. Specifically, we learned in class that firms will aim to maximise profits in each period by producing up to the point where MC(I) = MB(1). When this condition is met, the firms optimal investment decision is guided by

MB(I) = MPK +1-8 1+r → MPK-8=r, if MB = 1
That is one unit of additional investment in the current period implies an additional MPK of future production plus the remaining capital stock in period two (1-5).
Now suppose instead we assume that any capital firms have remaining at the end of future period can be sold at price Pk.
A) State the Optimal decision rule of the firm under the above scenario and explain how this change affects the optimal investment rule of the firm
B) Suppose that we interpret Pk as the firms stock price. If P rises what effect does this have on the firm's investment schedule? Draw a graph to show the effect
C) What does your answer in B above imply about the relationship between investment expenditures and stock prices?

Answer 1

Profit maximization occurs at a specific output level where marginal revenue (MR) equals marginal cost (MC) and, for a perfectly competitive firm, this level is also where price (P) equals MC. Discrepancies in output levels for maximum profit as indicated in Table 8.1 can be understood by recognizing that a firm should only expand production as long as MR exceeds MC. The MR=MC rule ensures that a firm produces the socially optimal amount of goods, balancing societal costs and benefits.

Step-by-step explanation:

Profit Maximization and the Relationship Between Marginal Revenue and Marginal Cost

Profit maximization for a firm occurs at a specific level of output where marginal revenue (MR) equals marginal cost (MC), rather than occurring over a range. This is commonly known in economics as the profit-maximization rule. According to Table 8.1, maximum profit seems to occur between 70 and 80 units of output; however, MR=MV actually occurs at 80 units. This discrepancy can be explained as follows: As long as MR is greater than MC, it is beneficial for a firm to increase production since this will increase economic profits. It is only when increasing production leads to MR falling below MC that the firm should cease expansion to avoid reducing profits. Therefore, by producing where MR=MC, the firm ensures it does not produce excessive quantities that would lead to decreased profits.

Moving beyond this point, where MR is less than MC, would mean that the additional costs of producing one more unit (marginal cost) exceeds the additional revenue (marginal revenue) and would lead to economic losses. This is the reason why MR=MC acts as a stop signal for production expansion.

Additionally, for a perfectly competitive firm, price (P) is equal to MR, and the firm's goal is to produce the quantity where P=MC. This results in benefits for society, since it means that the firm is producing the quantity where societal benefits of a good production (as represented by the market price) are equal to the societal costs of production (as represented by the marginal cost).