Download Chapter 7 - How Firms Make Decisions

Learning without thinking is useless
Thinking without learning is dangerous
Confucius (551-479 BC)
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Economics: Principles
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Econ 101:
Microeconomics
Chapter 7:
How Firms Make Decisions:
Profit Maximization
The Goal Of Profit Maximization
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To analyze decision making at the firm, let’s start with a
very basic question
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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?
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Managers who deviate from profit-maximizing for too long
are typically replaced either by
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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 profitmaximization
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Understanding Profit:
Two Definitions of Profit
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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
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Accounting profit = Total revenue – Accounting costs
A broader conception of costs (opportunity
costs) leads to a second definition of profit
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Economic profit = Total revenue – All costs of
production
Or Total revenue – (Explicit costs + Implicit costs)
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Understanding Profit:
Two Definitions of Profit
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Difference between economic profit and
accounting profit is an important one
• When they are confused, some serious (and
costly) mistakes can result
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Proper measure of profit for
understanding and predicting firm
behavior is economic profit
• Unlike accounting profit, economic profit
recognizes all the opportunity costs of
production—both explicit and implicit costs
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Why Are There Profits?
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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
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The Firm’s Constraints:
The Demand Constraint
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Demand curve facing firm is a profit constraint
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Curve that indicates for different prices, quantity of
output customers will purchase from a particular firm
Can flip demand relationship around
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Once firm has selected an output level, it has also
determined the maximum price it can charge
Leads to an alternative definition
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Shows maximum price firm can charge to sell any
given amount of output
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The Demand Curve Facing The Firm
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Total Revenue
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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
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The Cost Constraint
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Every firm struggles to reduce costs, but there
is a limit to how low costs can go
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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
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It must pay the cost of the “least cost method” of
production
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Two Approaches to Profit
Maximization
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TR and TC approach
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MR and MC approach
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Total Revenue (TR) and
Total Cost (TC) Approach
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At any given output level, we know
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How much revenue the firm will earn
Its cost of production
Loss
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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
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Selects output level where profit is greatest
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The TR and TC
Approach Using Graphs
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To maximize profit, firm should
• Produce quantity of output where vertical
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distance between TR and TC curves is
greatest and
TR curve lies above TC curve
Figure 2a
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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
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8
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10
Output
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Marginal Revenue (MR) and
Marginal Cost (MC) 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
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Marginal Revenue (MR) and
Marginal Cost (MC) Approach
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Important things to notice about marginal revenue
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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
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Revenue gain
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From selling additional output at the new price
Revenue loss
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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
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Using MR and MC
to Maximize Profits
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Marginal revenue and marginal cost can be
used to find the profit-maximizing output level
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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
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Economics: Principles
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The MR and MC Approach
Using Graphs
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Figure 2b also illustrates the MR and MC
approach to maximizing profits
Can summarize MC and MR approach
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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
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This rule is very useful—allows us to look at a
diagram of MC and MR curves and
immediately identify profit-maximizing output
level
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Figure 2b: Profit Maximization
Dollars
600
MC
500
400
300
200
100
0
–100
1
–200
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profit rises
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5
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7
profit falls
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Output
MR
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Exception
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Important exception to this rule
• Sometimes MC and MR curves cross at two
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different points
In this case, profit-maximizing output level is
the one at which MC curve crosses MR curve
from below
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Figure 3: Two Points of Intersection
Dollars
MC
A
B
MR
Q1
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Economics: Principles
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Output
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What About Average Costs?
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Different types of average cost (ATC, AVC, and AFC) are
irrelevant to earning the greatest possible level of profit
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Common error—sometimes made even by business
managers—is to use average cost in place of marginal cost
in making decisions
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Problems with this approach
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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
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Dealing With Losses: The Short Run
and the Shutdown Rule
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You might think that a loss-making firm should always shut
down its operation in the short run
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However, it makes sense for some unprofitable firms to continue
operating
The question is
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Should this firm produce at Q* and suffer a loss?
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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)
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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
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Economics: Principles
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Dealing With Losses: The Short-Run
and the Shutdown Rule
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Guideline for shutdown rule—for a loss-making firm:
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Let Q* be output level at which MR = MC
Then in the short-run
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firm should keep producing:
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firm should shut down:
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If TR < TVC or p < AVC at Q*
firm should be indifferent between shutting down and
producing:
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If TR >TVC or p > AVC at Q*
If TR = TVC or p = AVC at Q*
The shutdown rule is a powerful predictor of firms’ decisions to
stay open or cease production in short-run
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Economics: Principles
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Figure 4: Loss Minimization
Dollars
TFC
Q*
Hall & Leiberman;
Economics: Principles
Output
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Figure 5: Shut Down
Dollars
TC
TVC
Loss at Q*
TFC
TR
TFC
Q*
Hall & Leiberman;
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Output
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The Long Run: The Exit Decision
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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 longrun
• When—at its best possible output level—it
has any loss at all
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Economics: Principles
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Using The Theory:
Economics in Action
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Between November 2000 and May 2001 the state of
California went through an electricity crisis.
Supply of power were limited, and wholesale price of
electricity ran constantly at more than 10 times its
normal level.
Economists used data on electricity generating costs
to estimate marginal cost curves for producers.
Economist accused the power generators of
deliberately withholding electricity from the market in
order to drive up prices.
Power companies were caught red-handed: tape
recordings revealed they purposely shut down plants
in order to drive up prices.
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Economics: Principles
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Learning without thinking is useless
Thinking without learning is dangerous
Confucius (551-479 BC)
Hall & Leiberman;
Economics: Principles
29