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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 • • • • 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