Download Firms decision making

How Firms Make Decisions:
Profit Maximization
Behzad Azarhoushang
Outline
• The Goal of Profit Maximization
• The Firms’ Constraints
• The Profit-Maximizing Output Level
• Dealing with Losses
The Goal of Profit Maximization
• Decision making process
• Product price
• Working hours
• Budget planning
• Example: Apple iPhone 3G in 2008
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Which suppliers?
Location of assembly?
Advertising budget?
What price?
• Producing 15 million cellphone at $399
The Goal of Profit Maximization
• What is the firm trying to maximize?
• Firm as a single economic decision maker whose goal is to
maximize its owners’ profit (sake of simplicity)
• Principle-agent problems
• Two definitions of profit:
• Accounting profit = Total revenue – Accounting costs
• Economic profit = Total revenue – (explicit costs + implicit costs)
• Profit as payment for two contributions of entrepreneurs:
risk taking and innovation (Google)
The Firms’ Constraints
• Firms faces two constraints: revenue and costs
• Revenue constraints
• Demand curve (1): for different prices, the quantity of
output that customers will choose to purchase from that
firm (individual firm but all buyers)
• Demand curve (2): shows us the maximum price the firm
can charge to sell any given amount of output (one degree
of freedom; price or level of output).
• Firms generally chose the level of output
• Total revenue: total inflow of receipts from selling output
The Firms’ Constraints
• Cost constraint
• Every firm would love to decrease costs as much as possible
but there is limit for doing so
• Given production technology determines the different
combinations of inputs the firm can use to produce its
output.
• Firms must pay prices for each of the inputs that it used
• Together, the firm’s technology and the prices of inputs
determine the cheapest way to produce any given level
of output (looking for cheapest possible way).
The Profit-Maximizing Output
Level
• How does a firm find the level of output that will earn it
the greatest profit?
• Total revenue and cost approach:
• The firm’s profit as the difference between total revenue
(TR) and total costs (TC)
• Highest revenue does not always show the highest profit
• The difference between TC and TR if TC>TR is called Loss
• The Marginal Revenue and Marginal Cost Approach
• MR: change in the firms’ TR divided by change in its output
(Q) or MR = ∆TR/ ∆Q
• MC: change in the firms’ TC divided by change in its output
(Q) or MC = ∆TC/ ∆Q
• MR (MC) tells us how much revenue (costs) rises per unit
increases in output
The Profit-Maximizing Output
Level
• When a firm faces a demand curve, each increase in
output will lead to gain and loss in revenue due to
downward slope of demand curve
• MR will always equal the difference between the gain
and loss in revenue
• Using MR and MC to maximize profit
• An increase in output will always rise profit if MR>MC
• An increase in output will always lower profit if MR<MC
• To find the profit maximizing output level, the firms should
increase output whenever MR>MC, and decrease output
whenever MR<MC
The Profit-Maximizing Output
Level
• Profit Maximization using graphs
• MR for any change in output is equal to the slop of TR curve
along that interval
• MC for any change in output is equal to the slop of TC curve
along that interval
• To maximize profit, the firm should produce the quantity of
output where the vertical distance between TR and TC is
the greatest and TR lies above TC
• To maximize profit, the firm should produce the quantity of
output closest to the point where MR = MC – that is, the
quantity of output at which MR and MC curves intersect
• A proviso: sometimes MC and MR curves cross at 2
different points. In this case, the profit-maximizing
output level is the one at which MC curve crosses MR
curve from below
Dealing with Losses
• What about a firm that cannot earn a positive profit at
any output level? What should it do?
• Depends on time horizon
• The short-run
• Paying for fixed costs
• TC>TR
highest profit will be the one with the least
negative value (loss minimization)
• Q* where the distance between TC and TR curve is smallest
• In marginal approach: MC and MR intersect at Q*
• Should from suffer from losses? Yes, until its costs is less
than TFC
Dealing with Losses
• Shutdown rule
• TVC or firm’s operating costs
• If TR>TVC (operating profit) 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
• In the short-run, the firm should continue to produce if
total revenue exceeds total variable costs; otherwise, it
should shut down.
Dealing with Losses
• The long-run and the exit decision
• The shutdown rule applies only in short-run, a time horizon
too short for the firm to escape its commitment to pay for
fixed inputs
• Exit: a permanent cessation of production when a firm
leaves an industry