Ch06 Cmba 401

Slides by John F. Hall

Animations by Anthony ZambelliINTRODUCTION TO ECONOMICS 2e / LIEBERMAN & HALLCHAPTER 6 / HOW FIRMS MAKE DECISIONS: PROFIT MAXIMIZATION©2005, South-Western/Thomson Learning

Chapter 6

How Firms Make Decisions:

Profit Maximization

Lieberman & Hall; Introduction to Economics, 2005 2

The Goal Of Profit Maximization To analyze decision making at the firm, let’s start with a very

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


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)


Why Are There Profits?

Economists view profit as a payment for two necessary contributions

Risk-taking Someone—the owner—had to be willing to take

the initiative to set up the business• This individual assumed the risk that business might

fail and the initial investment be lost

Innovation• In almost any business you will find that some sort of

innovation was needed to get things started


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


Figure 1: The Demand Curve Facing The Firm


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


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


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


The Marginal Revenue and Marginal Cost Approach

Marginal revenueChange in total revenue from

producing one more unit of output•MR = ΔTR / ΔQ

Tells us how much revenue rises per unit increase in output


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


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


Figure 2(a): Profit Maximization

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

1,000

500

Output

Dollars

1 210 3 4 5 6 7 8 9 10

Profit at 7 Units


Figure 2(b): Profit Maximization

profit rises profit falls

MC

MR

0

600

500

400

300

200

100

–100

–200

Output

Dollars

1 2 3 4 5 6 7 8


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


An Important Proviso

Important exception to this ruleSometimes 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


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


Dealing With Losses: The Short Run and the Shutdown Rule

You might think that a loss-making firm should always shut down its operation in the short run However, it makes sense for some unprofitable firms to continue operating

The question is Should this firm produce at Q* and suffer a loss?

• The answer is yes—if the firm would lose even more if it stopped producing and shut down its operation

If, by staying open, a firm can earn more than enough revenue to cover its operating costs, then it is making an operating profit (TR > TVC) Should not shut down because operating profit can be used to help pay fixed

costs But if the firm cannot even cover its operating costs when it stays open, it

should shut down


Dealing With Losses: The Short-Run and the Shutdown Rule

Guideline—called the shutdown rule—for a loss-making firm Let Q* be output level at which MR = MC Then in the short-run

• If TR > Q* firm should keep producing• If TR < Q* firm should shut down• If TR = Q* firm should be indifferent between shutting down and

producing

The shutdown rule is a powerful predictor of firms’ decisions to stay open or cease production in short-run


Figure 4(a): Loss Minimization

Q*

Dollars

Output

TFC


Figure 4(b): Loss Minimization

MC

MR Q*

Dollars

Output


Figure 5: Shut Down

Q*

TC

TR

TVC

TFC

TFC

Loss at Q*

Dollars

Output


The Long Run: The Exit Decision

We only use term shut down when referring to short-run

If a firm stops production in the long-run it is termed an exit

A firm should exit the industry in long- run When—at its best possible output level—it has

any loss at all


Using The Theory: Getting It Wrong—The Failure of Franklin National Bank

In the mid-1970’s, Franklin National Bank—one of the largest banks in the United States—went bankrupt

In mid-1974, John Sadlik, Franklin’s CFO, asked his staff to compute average cost to bank of a dollar in loanable funds Determined to be 7¢ At the time, all banks—including Franklin—were charging

interest rates of 9 to 9.5% to their best customers Ordered his loan officers to approve any loan that could

be made to a reputable borrower at 8% interest


Using The Theory: Getting It Wrong—The Failure of Franklin National Bank

Where did Franklin get the additional funds it was lending out? Were borrowed not at 7%, the average cost of funds, but

at 9 to 11%, the cost of borrowing in the federal funds market

Not surprisingly, these loans—which never should have been made—caused Franklin’s profits to decrease Within a year the bank had lost hundreds of millions of

dollars This, together with other management errors, caused

bank to fail


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

Ch06 Cmba 401

Business

level of output firm

profit maximization

mr level of output

definitions of profit

unit of output mr

units profit

unit profit

output dollars