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Chapter 7
How Firms Make Decisions:
Profit Maximization
ECONOMICS: Principles and Applications, 4e
HALL & LIEBERMAN, © 2008 Thomson South-Western
The Goal Of Profit Maximization
• The firm
– A single economic decision maker
– Goal: to maximize its owners’ profit
• Profit
– Sales revenue minus costs of production
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Two Definitions of Profit
• Accounting profit
– Total revenue minus accounting costs
• Economic profit
– Total revenue minus all costs of
production
– Recognizes all the opportunity costs of
production - both explicit costs and
implicit costs
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The Firm’s Constraints
• Demand curve facing the firm
– A curve that indicates, for different
prices, the quantity of output that
customers will purchase from a particular
firm.
– Maximum price the firm can charge to
sell any given amount of output
• Total revenue
– The total inflow of receipts from selling a
given amount of output
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Demand and Total Revenue
• Figure 1 The Demand Curve Facing the Firm
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Demand and Total Revenue
• Figure 1 The Demand Curve Facing the Firm
Price
Per Bed
$600
450
Demand Curve
Facing Ned’s Beds
2
5
Number of Bed
Frames per Day
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The Cost Constraint
• For any level of output the firm might
want to produce, it must pay the cost of
the “least cost method” of production
– Production function
– Prices of inputs
• Total cost – implicit and explicit costs
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The Profit-Maximizing Output Level
• Profit
– Total revenue (TR) minus total cost (TC)
at each output level
– The firm chooses the output level where
profit is greatest
• Loss
– Total cost (TC) minus total revenue (TR),
when TC > TR
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Profit Maximization: TR-TC
• Figure 2 Profit Maximization
Maximize Profit = TR-TC
-greatest vertical distance between TR and TC curves
-TR curve above the TC curve.
Dollars
$3,500
3,000
Profit at 7
Units
2,500
Profit at 5
Units
2,000
Profit at 3
Units
1,500
1,000
TR
DTR from producing 2nd unit
500
Total Fixed
Cost
TC
DTR from producing 1st unit
0
1
2
3
4
5
6
7
8
9
10
Output
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The Profit-Maximizing Output Level
• Marginal revenue
– The change in total revenue from
producing one more unit of output
MR=ΔTR/ΔQ
– how much revenue rises per unit
increase in output
• Increase in output
• revenue gain - from selling additional output
• revenue loss - lower the price on all output
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Using MR and MC to Maximize Profits
• Increase output whenever MR > MC
– An increase in output will raise profit if
MR > MC
• Decrease output when MR < MC
– An increase in output will lower profit if
MR < MC
• Average costs (ATC, AVC, AFC)
– Irrelevant to profit maximization
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Profit Maximization: MR=MC
• Figure 2 Profit Maximization
Dollars
Maximize profit: MR=MC
- MC and MR curves intersect.
$700
600
MC
500
400
300
200
100
0
–100
–200
1
2
3
profit rises
4
5
6
7
profit falls
8
9
10 Output
MR
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Profit Maximization: MR=MC
• Figure 3 Two Points of Intersection
Dollars
Profit-maximizing output level
-MC curve crosses MR curve from below
MC
A
B
MR
Q1
Q*
Output
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Dealing with Losses
• Shutdown rule
– In the short run, the firm should continue
to produce if total revenue exceeds total
variable costs; otherwise, it should shut
down
• MR=MC, Q*; in the short run:
– If TR>TVC - keep producing
– If TR < TVC - shut down
– If TR = TVC - indifferent between
shutting down and producing
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Dealing with Losses
• Figure 4 Loss Minimization (a)
TC
Dollars
Loss at Q*
TR>TVC
Loss <TFC
TVC
TFC
TR
TFC
Q*
Output
15
Dealing with Losses
• Figure 4 Loss Minimization (b)
Dollars
MC
Q*
MR
Output
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Dealing with Losses
• Figure 5 Shut Down
TC
Dollars
Loss at Q* , TVC>TR
Shut down, produce nothing,
Loss=TFC in the short run
TVC
TFC
TR
TFC
Q*
Output
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The Long Run: The Exit Decision
• Exit
– A permanent cessation of production
when a firm leaves an industry
• A firm should exit the industry in the long
run when - at its best possible output
level - it has any loss at all
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Getting It Wrong
• The Failure of Franklin National Bank
• Mid-1970’s - Franklin National Bank
– Went bankrupt
• Calculated average cost to the bank of a
•
•
•
•
dollar in loanable funds = 7¢
Interest rates = 9 to 9.5%
Approved loans to reputable borrowers at
8%
The bank - borrowed at 9 to 11%;
Profits decreased
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Getting It Right
• The Success of Continental Airlines
– Mid 1960s - Other airlines
• Offered a flight if 65% of seats sold
• Used average cost to make decisions
– Continental Airlines
•
•
•
•
Flying jets filled to just 50% capacity
Expanded flights on many routes
Increase profits
Used marginal cost approach to make
decisions
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Public Goods
• Rivalry
– One person’s consumption of a unit of a
good or service means that no one else
can consume that unit
• Excludability
– The ability to exclude those who do not
pay for a good from consuming it
• Pure private good
– Is both rivalrous and excludable
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Public Goods
• Pure public good
– Nonrival and nonexcludable
– Provided by government without charge
• Marketable public good
– Excludable and nonrival
– Provided by the market for a price
• Common Resource
– Nonexcludable and rival
– Free of charge
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Private, Public and Mixed Goods
• Figure 5 Pure Private, Pure Public and Mixed Goods
Rival
Excludable
Nonrival
Pure Private Good
• Food
• Clothing
• Housing
Marketable Public
Goods
• Software
• Digital Music and
Video
Common Resources
• Fish in international
waters
• Earth’s atmosphere
Pure Public Good
• National Defense
• Legal System
• Urban parks
Nonexcludable
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Asymmetric information
• One party to a transaction has relevant
information not known by the other party
– Adverse selection – quality
– Moral hazard - lack of information about
someone’s future behavior
– Principal–agent problem
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Market and Government Solutions
• Market solutions:
– Reputation
– Behavior
– Contingent contract
• Government solutions:
– Regulation
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