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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
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)
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 revenue
–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
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
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
Figure 2a: Profit Maximization
Dollars
$3,500
TC
3,000
Profit at 7
Units
2,500
Profit at 5
Units
2,000
Profit at 3
Units
1,500
1,000
DTR from producing 2nd unit
500
Total Fixed
Cost
TR
DTR from producing 1st unit
0
1
2
3
4
5
6
7
8
9
10
Output
Figure 2b: Profit Maximization
Dollars
600
MC
500
400
300
200
100
0
–100
–200
1
2
3
profit rises
4
5
6
7
profit falls
8
Output
MR
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
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 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
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
Figure 3: Two Points of Intersection
Dollars
MC
A
B
MR
Q1
Q*
Output
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 vicepresident of operations, had decided to try
marginal approach to profit