Chapter 7 How Firms Make Decisions: Profit Maximization ECONOMICS: Principles and Applications, 4e HALL & LIEBERMAN, © 2008 Thomson South-Western

2 The Goal Of Profit Maximization The firm –A single economic decision maker –Goal: to maximize its owners’ profit Profit –Sales revenue minus costs of production

3 Two Definitions of Profit Accounting profit –Total revenue minus accounting costs Economic profit –Total revenue minus all costs of production –Recognizes all the opportunity costs of production - both explicit costs and implicit costs

4 The Firm’s Constraints Demand curve facing the firm – A curve that indicates, for different prices, the quantity of output that customers will purchase from a particular firm. –Maximum price the firm can charge to sell any given amount of output Total revenue –The total inflow of receipts from selling a given amount of output

5 Demand and Total Revenue Figure 1 The Demand Curve Facing the Firm

6 Demand and Total Revenue Figure 1 The Demand Curve Facing the Firm Price Per Bed Number of Bed Frames per Day $ Demand Curve Facing Ned’s Beds

7 The Cost Constraint For any level of output the firm might want to produce, it must pay the cost of the “least cost method” of production –Production function –Prices of inputs Total cost – implicit and explicit costs

8 The Profit-Maximizing Output Level 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

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

10 The Profit-Maximizing Output Level Marginal revenue –The change in total revenue from producing one more unit of output MR=ΔTR/ΔQ –how much revenue rises per unit increase in output Increase in output revenue gain - from selling additional output revenue loss - lower the price on all output

11 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 Average costs (ATC, AVC, AFC) –Irrelevant to profit maximization

12 Profit Maximization: MR=MC profit risesprofit falls MC MR –100 –200 Output Dollars $ Figure 2 Profit Maximization Maximize profit: MR=MC - MC and MR curves intersect.

13 Profit Maximization: MR=MC Q1Q1 Q* Dollars Output A MC B MR Figure 3 Two Points of Intersection Profit-maximizing output level -MC curve crosses MR curve from below

14 Dealing with Losses Shutdown rule –In the short run, the firm should continue to produce if total revenue exceeds total variable costs; otherwise, it should shut down MR=MC, Q*; in the short run: –If TR>TVC - keep producing –If TR < TVC - shut down –If TR = TVC - indifferent between shutting down and producing

15 Dealing with Losses Figure 4 Loss Minimization (a) TC TVC TR Dollars Output TFC Loss at Q * TR>TVC Loss <TFC TFC Q*Q*

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

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

18 The Long Run: The Exit Decision 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

19 Getting It Wrong The Failure of Franklin National Bank Mid-1970’s - Franklin National Bank –Went bankrupt Calculated average cost to the bank of a dollar in loanable funds = 7¢ Interest rates = 9 to 9.5% Approved loans to reputable borrowers at 8% The bank - borrowed at 9 to 11%; Profits decreased

20 Getting It Right The Success of Continental Airlines –Mid 1960s - Other airlines Offered a flight if 65% of seats sold Used average cost to make decisions –Continental Airlines Flying jets filled to just 50% capacity Expanded flights on many routes Increase profits Used marginal cost approach to make decisions

21 Public Goods Rivalry –One person’s consumption of a unit of a good or service means that no one else can consume that unit Excludability –The ability to exclude those who do not pay for a good from consuming it Pure private good –Is both rivalrous and excludable

22 Public Goods Pure public good –Nonrival and nonexcludable –Provided by government without charge Marketable public good –Excludable and nonrival –Provided by the market for a price Common Resource –Nonexcludable and rival –Free of charge

23 Private, Public and Mixed Goods Nonexcludable Excludable Marketable Public Goods Software Digital Music and Video Pure Public Good National Defense Legal System Urban parks Common Resources Fish in international waters Earth’s atmosphere Pure Private Good Food Clothing Housing RivalNonrival Figure 5 Pure Private, Pure Public and Mixed Goods

24 Asymmetric information One party to a transaction has relevant information not known by the other party –Adverse selection – quality –Moral hazard - lack of information about someone’s future behavior –Principal–agent problem

25 Market and Government Solutions Market solutions: –Reputation –Behavior –Contingent contract Government solutions: –Regulation