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CHAPTER How Firms Make Decisions: Profit Maximization PowerPoint Slides Slides prepared prepared by: by: PowerPoint Andreea CHIRITESCU CHIRITESCU Andreea Eastern Illinois Illinois University University Eastern © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 1 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2 Understanding Profit • Accounting 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 3 Understanding Profit © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 4 Understanding Profit © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 5 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 6 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) © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 7 Figure 1 The Demand Curve Facing the Firm The table presents information about Ned’s Beds. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 8 Figure 1 The Demand Curve Facing the Firm Price per Bed $600 450 Demand Curve Facing Ned’s Beds 200 1 2 3 4 5 6 7 8 9 10 Number of Bed Frames per Day 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. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 9 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 10 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 11 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 12 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 13 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 14 Table 1 More Data for Ned’s Beds © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 15 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 16 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 17 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 18 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 19 Figure 2 Profit Maximization (a) Dollars $3,500 Profit at 7 units 3,000 Profit at 5 units 2,500 2,000 TC Profit at 3 units TR 1,500 1,000 ΔTR from producing 2nd unit 500 Total Fixed Cost ΔTR from producing 1st unit 1 2 3 4 5 6 7 8 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. 9 10 Output © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 20 Figure 2 Profit Maximization (b) Dollars $700 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 600 500 400 300 200 100 0 -100 1 2 3 Profit rises 4 5 6 7 Profit falls 8 9 10 Output MR -200 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 21 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 22 Figure 3 Two Points of Intersection Dollars MC A B MR Q1 Q* Output Sometimes the MR and MC curves intersect twice. The profit-maximizing level of output is always found where MC crosses MR from below. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 23 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 24 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 25 Figure 4 Loss Minimization Dollars TC Loss at Q* TVC TR TFC TFC Output Q* Dollars MC Q* MR 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. Output © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 26 Figure 5 Shut Down Dollars TC TVC Loss at Q* TFC TR TFC Q* Output 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. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 27 Dealing with Losses • Exit – 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 28 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) © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 29 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 30 Getting It Right: Continental Airlines • Continental Airlines – Flying jets filled to just 50% of capacity – Expanding flights on many routes – Higher profits – MC = $2,000 per flight © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 31