ECON 211 ELEMENTS OF ECONOMICS I Session 5– Profit Maximization (Part 2) Lecturer: Dr. (Mrs.) Nkechi S. Owoo, Department of Economics Contact Information: nowoo@ug.edu.gh

Session Overview Session 5 explains how a firm sets its price and output level in the short run under the assumption that the firm’s goal is to maximize its economic profit. There are two approaches to finding a firm’s short-run profit-maximizing level of output. In the total revenue and total cost approach, the firm calculates profit as the difference between total revenue and total cost, and produces the quantity of output where profit is greatest. In the marginal revenue and marginal cost approach, the firm maximizes profit when it sets marginal revenue equal to marginal cost. These two approaches are demonstrated with tables and graphs.

Session Outline The key topics to be covered in the session are as follows: Total Revenue and Total Cost Approach Marginal Revenue and Marginal Cost Approach

Reading List Hall and Lieberman Chapter 7, pp:202- 213

The total revenue- total cost approach Topic One The total revenue- total cost approach

The Profit-Maximizing Output Level How do firms decide on the level of output that will earn the greatest possible profit? Profit Total revenue (TR) minus total cost (TC) at each output level The firm chooses the output level where profit is greatest Loss Total cost (TC) minus total revenue (TR), when TC > TR Given that we are including all costs (implicit and explicit), the profits and losses are economic profits and losses In the table below, the profit-maximizing output for Neds Beds is 5 units per day This is where the difference between total costs and total revenue is greatest, as illustrated on slide 8

Demand and Total Revenue The Demand Curve Facing the Firm

Profit Maximization: TR-TC Maximize Profit = TR-TC -greatest vertical distance between TR and TC curves -TR curve above the TC curve. $3,500 3,000 2,500 2,000 1,500 1,000 500 Output Dollars 1 2 3 4 5 6 7 8 9 10 TC Profit at 7 Units Profit at 5 Units Profit at 3 Units TR DTR from producing 2nd unit DTR from producing 1st unit Total Fixed Cost

The marginal revenue- marginal cost approach Topic One The marginal revenue- marginal cost approach

The Profit-Maximizing Output Level There is another way to determine the profit-maximizing output level, using marginal concepts A firm’s marginal revenue is the change in total revenue from producing one more unit of output . It may be illustrated mathematically as: MR=ΔTR/ΔQ The marginal revenue tells us how much revenue rises per unit increase in output

The Profit-Maximizing Output Level There are two things to note about the marginal revenue When MR is positive, an increase in output causes TR to rise; and when the MR is negative, an increase in output causes TR to fall Each time output increases, MR is smaller than the price the firm charges at the new output level This is because of the downward sloping demand curve facing the firm In order to sell more output, the firm must lower its price

Using MR and MC to Maximize Profits Increase output whenever MR > MC An increase in output will raise profit if MR > MC Decrease output when MR < MC An increase in output will lower profit if MR < MC Profits are maximized when MR= MC [Average costs (ATC, AVC, AFC) Irrelevant to profit maximization] We can illustrate profit maximization using the MR/MC approach with some graphs

Profit Maximization: MR=MC 600 500 400 300 200 100 –100 –200 Output Dollars 1 2 3 4 5 6 7 8 Maximize profit: MR=MC - MC and MR curves intersect. $700 MC 9 10 profit rises profit falls MR

Profit Maximization: MR= MC To maximize profits, the firm should produce the quantity of output closest to the point where MC= MR, or where the two curves intersect However, the MC and MR cross at two different points In this case, the profit-maximizing output level is the one at which the MC curve crosses the MR curve from below The figure on the next slide illustrates this Point A cannot be the profit-maximizing output level because below Q1, MC> MR so profits fall as output increases towards Q1. Profits increase beyond Q1 as MC< MR Point B is the profit-maximizing output level because once we arrive at Q*, further increases in output will reduce profits

Profit Maximization: MR=MC Two Points of Intersection Dollars Output Profit-maximizing output level -MC curve crosses MR curve from below MC A B MR Q1 Q*

Dealing with Losses So far, we have dealt with the pleasant case of firms earning profits and how they can select their profit-maximizing output level But what about a firm that cannot earn profits at any output level? What should it do? The answer depends on the time horizon Short run or long run

Dealing with Losses The short run and the Shutdown rule In the short run, the firm should continue to produce if total revenue exceeds total variable costs; otherwise, it should shut down i.e. stop producing temporarily It is not always the case that a loss-making firm should shut down in the short run It depends on whether it is covering its variable costs or not

Dealing with Losses A firm that is making losses will minimize its losses by producing where the vertical distance between TR and TC is smallest In the figure below, the firm should keep producing because TR > TVC This implies that by staying open, the firm can earn more than enough revenue to cover its operating costs Therefore, this firm would be making an operating profit i.e. (TR> TC), which can help to cover fixed costs

Dealing with Losses Loss Minimization (a) TC Dollars Loss at Q* Output Loss at Q* TR>TVC Loss <TFC TVC TFC Q* TR TFC

Dealing with Losses Figure 4 Loss Minimization (b) Dollars Output MC Q* MR

Dealing with Losses On the other hand, if TR< TVC, a firm is suffering an operating loss and should certainly shut down Continuing to produce only adds to the firms loss, increasing the total loss beyond fixed costs See the next slide

Dealing with Losses Figure 5 Shut Down TC Dollars Output Loss at Q* , TVC>TR Shut down, produce nothing, Loss=TFC in the short run TVC TFC Q* TR TFC

Dealing with Losses This suggests the following guideline, also called the shutdown rule: If Q* is the output level at which MR= MC, in the short run: If TR>TVC - keep producing If TR < TVC - shut down If TR = TVC - indifferent between shutting down and producing

The Long Run: The Exit Decision The shut down rule applies only in the short run A firm may also decide to stop producing in the long run, or exit the market Exit A permanent cessation of production when a firm leaves an industry A firm should exit the industry in the long run when - at its best possible output level - it has any loss at all

References Economics: Principles and Applications: Hall R.E. and Lieberman M. (2008), Thomson/ South Western (4th Edition)