1. How Firms Make Decisions: Profit Maximization
CHAPTER
How Firms Make Decisions:
Profit Maximization
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2. The Goal of Profit Maximization
The firm
A single economic decision maker
Goal: to maximize its owners’ profit
Decisions
What price to charge
How much to produce
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3. Understanding Profit Accounting profit Economic profit Profit
Total revenue minus accounting costs
Economic profit
Total revenue minus all costs of production, explicit and implicit
Profit
Payment for two contributions of entrepreneurs: risk taking and innovation
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4. Understanding Profit
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5. Understanding Profit
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6. Understanding Profit Economic profit
Proper measure of profit: for understanding and predicting the behavior of firms
Recognizes all the opportunity costs of production
Explicit costs and implicit costs
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7. The Firm’s Constraints
Demand curve facing the firm
Tells us, for different prices
The quantity of output that customers will purchase from a particular firm
Shows us the maximum price the firm can charge to sell any given amount of output
One firm; All buyers (potential customers)
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8. 1 The Demand Curve Facing the Firm
The table presents information about Ned’s Beds.
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9. Demand Curve Facing Ned’s Beds1
The Demand Curve Facing the Firm
Price
per Bed
Number of Bed
Frames per Day 1 2 3 4 6 5 7 8 9
200 10
450
$600
Demand Curve Facing Ned’s Beds
The table presents information about Ned’s Beds. Data from the first two columns are plotted in the figure to show the demand curve facing the firm. At any point along that demand curve, the product of price and quantity equals total revenue, which is given in the third column of the table.
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10. The Firm’s Constraints
Total revenue, TR
The total inflow of receipts from selling a given amount of output
Demand and total revenue
Each time the firm chooses a level of output, it also determines its total revenue
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11. The Firm’s Constraints
Total Revenue and Elasticity
Lower price: sell more output
If ED > 1 (elastic demand): total revenue will rise
If ED < 1 (inelastic demand): total revenue will fall
The cost constraint (minimizing costs)
Given production technology
Firm must pay prices for each of the inputs that it uses
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12. The Profit-Maximizing Output Level
Total revenue and total cost approach
Profit is the difference between TC and TR at each output level
The firm chooses the output level where profit is greatest
Loss
Difference between total cost (TC) and total revenue (TR)
When TC > TR
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13. The Profit-Maximizing Output Level
Marginal revenue (MR = ΔTR / ΔQ)
Change in total revenue from producing one more unit of output
Change in the firm’s total revenue (TR) divided by the change in its output (Q)
Tells us how much revenue rises per unit increase in output
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14. The Profit-Maximizing Output Level
When MR is positive
An increase in output causes total revenue to rise
When MR is negative
An increase in output causes total revenue to fall
As output increases
MR is smaller than the price
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15. 1 More Data for Ned’s Beds
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16. The Profit-Maximizing Output Level
Downward-sloping demand curve
Each increase in output causes
A revenue gain: from selling additional output at the new price
A revenue loss: from having to lower the price on all previous units of output
Marginal revenue is less than the price of the last unit of output
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17. The Profit-Maximizing Output Level
An increase in output
Will always raise profit as long as MR>MC
Will always lower profit whenever MR<MC
Marginal revenue and marginal cost approach
Profit-maximizing output level
Increase output whenever MR>MC
Decrease output when MR< MC
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18. The Profit-Maximizing Output Level
Marginal revenue for any change in output
Is equal to the slope of the total revenue curve along that interval
TC and TR approach using graphs
Maximize profit
Produce the quantity of output where the vertical distance between the TR and TC curves is greatest
And the TR curve lies above the TC curve
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19. The Profit-Maximizing Output Level
MC and MR approach using graphs
Maximize profit
Produce the quantity of output closest to the point where MC = MR
MC and MR curves intersect
MC curve crosses the MR curve from below
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20. 2 Profit Maximization (a) Dollars Output 1 2 3 4 6 5 7 8 9 500 10
1,000
$3,500
1,500
2,000
2,500
3,000
Panel (a) shows the firm’s total revenue (TR) and total cost (TC) curves. Profit is the vertical distance between the two curves at any level of output. Profit is maximized when that vertical distance is greatest—at 5 units of output.
Profit at
7 units TR TC
Profit at
5 units
Profit at
3 units
ΔTR from producing 2nd unit
ΔTR from producing 1st unit
Total Fixed Cost
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21. 2 Profit Maximization (b) Dollars Output 1 2 3 4 6 5 7 8 9 400 10 100
100
200
300
500
600
$700
-100
-200
Panel (b) shows the firm’s marginal revenue (MR) and marginal cost (MC) curves. Profit is maximized at the level of output closest to where the MR and MC curves cross—at 5 units of output. MC MR
Profit rises
Profit falls
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22. The Profit-Maximizing Output Level
A Proviso
Sometimes the MC and MR curves cross at two different points
The profit-maximizing output level is the one at which the MC curve crosses the MR curve from below
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23. 3 Two Points of Intersection Dollars Output MC MR A B Q1 Q*
Sometimes the MR and MC curves intersect twice. The profit-maximizing level of output is always found where MC crosses MR from below.
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24. The Profit-Maximizing Output Level
Average costs
Irrelevant to profit maximizing decisions
Marginal approach to profit
A firm maximizes its profit by taking any action that adds more to its revenue than to its cost: MR > MC
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25. Dealing with Losses Shutdown rule in the short run
The firm should continue to produce if TR > TVC (otherwise, it should shut down)
Let Q* be the output level at which MR=MC
If TR > TVC at Q*, the firm should keep producing
If TR < TVC at Q*, the firm should shut down
If TR = TVC at Q*, the firm should be indifferent between shutting down and producing
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26. 4 Loss Minimization Dollars TC Loss at Q* TVC TR TFC TFC Output Q*
The firm shown here cannot earn a positive profit at any level of output. If it produces anything, it will minimize its loss by producing where the vertical distance between TR and TC is smallest. Because TR exceeds TVC at Q*, the firm will produce there in the short run.
TVC TR
TFC
TFC Q*
Dollars
Output MC MR Q*
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27. 5 Shut Down Dollars TC TVC Loss at Q* TFC TR TFC Output Q*
At Q*, this firm’s total variable cost exceeds its total revenue. The best policy is to shut down, produce nothing, and suffer a loss equal to TFC in the short run.
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28. Dealing with Losses Exit In the long run
A permanent cessation of production when a firm leaves an industry
In the long run
A firm should exit the industry when—at its best possible output level—it has any loss at all
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29. Getting It Wrong: The Failure of Franklin National Bank
Mid-1974s, Franklin National Bank’s manager
Average cost of $1 in loans = 7 cents
Offered loans at 8% interest (MR)
Borrowed in federal funds market at 9-11% interest (MC)
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30. Getting It Right: Continental Airlines
1960’s, all other airlines
Offer a flight only if, on average, 65% of the seats could be filled with paying passengers
ATC = $4,000 per flight
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31. Getting It Right: Continental Airlines
Flying jets filled to just 50% of capacity
Expanding flights on many routes
Higher profits
MC = $2,000 per flight
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