1. Decision-Making at the firm level - The Goal Of Profit Maximization
To analyze decision making at the firm, start with a basic question
What is the firm trying to maximize?
A firm’s owners will usually want the firm to earn as much profit as possible
We will view the firm as a single economic decision maker whose goal is to maximize its owners’ profit
Why?
Managers who deviate from profit-maximizing for too long are typically replaced either by
Current owners or
Other firms who acquire the underperforming firm and then replace management team with their own
Many managers are well trained in tools of profit-maximization

2. Understanding Profit: Two Definitions of Profit
Profit is defined as the firm’s sales revenue minus its costs of production
If we deduct only costs recognized by accountants, we get one definition of profit
Accounting profit = Total revenue – Accounting costs
A broader conception of costs (opportunity costs) leads to a second definition of profit
Economic profit = Total revenue – All costs of production
Or Total revenue – (Explicit costs + Implicit costs)

3. The Firm’s Constraints: The Demand Constraint
Demand curve facing firm is a profit constraint
Curve that indicates for different prices, quantity of output customers will purchase from a particular firm
Can flip demand relationship around
Once firm has selected an output level, it has also determined the maximum price it can charge
Leads to an alternative definition
Shows maximum price firm can charge to sell any given amount of output

4. Figure 1: The Demand Curve Facing The Firm

5. Total Revenue
The total inflow of receipts from selling a given amount of output
Each time the firm chooses a level of output, it also determines its total revenue
Why?
Because once we know the level of output, we also know the highest price the firm can charge
Total revenue—which is the number of units of output times the price per unit—follows automatically

6. The Cost Constraint
Every firm struggles to reduce costs, but there is a limit to how low costs can go
These limits impose a second constraint on the firm
The firm uses its production function, and the prices it must pay for its inputs, to determine the least cost method of producing any given output level
For any level of output the firm might want to produce
It must pay the cost of the “least cost method” of production

7. The Total Revenue And Total Cost Approach
At any given output level, we know
How much revenue the firm will earn
Its cost of production
Loss
A negative profit—when total cost exceeds total revenue
In the total revenue and total cost approach, the firm calculates Profit = TR – TC at each output level
Selects output level where profit is greatest

8. The Marginal Revenue and Marginal Cost Approach
Change in total revenue from producing one more unit of output
MR = ΔTR / ΔQ
Tells us how much revenue rises per unit increase in output

9. The Marginal Revenue and Marginal Cost Approach
Important things to notice about marginal revenue
When MR is positive, an increase in output causes total revenue to rise
Each time output increases, MR is smaller than the price the firm charges at the new output level
When a firm faces a downward sloping demand curve, each increase in output causes
Revenue gain
From selling additional output at the new price
Revenue loss
From having to lower the price on all previous units of output
Marginal revenue is therefore less than the price of the last unit of output

10. Using MR and MC to Maximize Profits
Marginal revenue and marginal cost can be used to find the profit-maximizing output level
Logic behind MC and MR approach
An increase in output will always raise profit as long as marginal revenue is greater than marginal cost (MR > MC)
Converse of this statement is also true
An increase in output will lower profit whenever marginal revenue is less than marginal cost (MR < MC)
Guideline firm should use to find its profit-maximizing level of output
Firm should increase output whenever MR > MC, and decrease output when MR < MC

11. Profit Maximization Using Graphs
Both approaches to maximizing profit (using totals or using marginals) can be seen even more clearly with graphs
Marginal revenue curve has an important relationship to total revenue curve
Total revenue (TR) is plotted one the vertical axis, and quantity (Q) on the horizontal axis
Slope along any interval is ΔTR / ΔQ
Which is the definition of marginal revenue
Marginal revenue for any change in output is equal to slope of total revenue curve along that interval

12. Figure 2a: Profit Maximization
$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

13. Figure 2b: Profit Maximization
600
500
400
300
200
100
–100
–200
Output
Dollars 1 2 3 4 5 6 7 8 MC
profit rises
profit falls MR

14. The TR and TC Approach Using Graphs
To maximize profit, firm should
Produce quantity of output where vertical distance between TR and TC curves is greatest and
TR curve lies above TC curve

15. The MR and MC Approach Using Graphs
Figure 2 also illustrates the MR and MC approach to maximizing profits
Can summarize MC and MR approach
To maximize profits the firm should produce level of output closest to point where MC = MR
Level of output at which the MC and MR curves intersect
This rule is very useful—allows us to look at a diagram of MC and MR curves and immediately identify profit-maximizing output level

16. An Important Proviso Important exception to this rule
Sometimes MC and MR curves cross at two different points
In this case, profit-maximizing output level is the one at which MC curve crosses MR curve from below

17. What About Average Costs?
Different types of average cost (ATC, AVC, and AFC) are irrelevant to earning the greatest possible level of profit
Common error—sometimes made even by business managers—is to use average cost in place of marginal cost in making decisions
Problems with this approach
ATC includes many costs that are fixed in short-run—including cost of all fixed inputs such as factory and equipment and design staff
ATC changes as output increases
Correct approach is to use the marginal cost and to consider increases in output one unit at a time
Average cost doesn’t help at all; it only confuses the issue
Average cost should not be used in place of marginal cost as a basis for decisions

18. Figure 3: Two Points of Intersection
Dollars
Output MC A B MR Q1 Q*

19. Using The Theory: Getting It Right—The Success of Continental Airlines
Continental Airlines was doing something that seemed like a horrible mistake
Yet Continental’s profits—already higher than industry average—continued to grow
A serious mistake was being made by the other airlines, not Continental
Using average cost instead of marginal cost to make decisions
Continental’s management, led by its vice-president of operations, had decided to try marginal approach to profit