Download Chapter 7 - How Firms Make Decisions

The Goal Of Profit Maximization
• What is the firm’s goal?
• A firm’s owners will want the firm to earn
as much profit as possible
• Why?
– Managers who deviate from profit-maximizing
for too long are typically replaced either by
• Current owners or
• Other firms who acquire the underperforming firm
and then replace management team with their
own
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Economics: Principles
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Two Definitions of Profit
• Profit = sales revenue minus costs of
production
• Accounting profit = Total revenue –
Accounting costs
• Economic profit = Total revenue – All costs
of production = Total revenue – (Explicit
costs + Implicit costs)
• This last term is the opportunity cost of
production
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Economics: Principles
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Two Definitions of Profit
• 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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Economics: Principles
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Why Are There Profits?
• Economists view profit as a payment for
• 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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Economics: Principles
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The Firm’s Constraints: Demand
• Demand curve facing firm is a profit constraint
– Curve that indicates for different prices, quantity of
output customers will purchase from a particular firm
• Can flip demand relationship around
– Once firm has selected an output level, it has also
determined the maximum price it can charge
• Leads to an alternative definition
– Shows maximum price firm can charge to sell any
given amount of output
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Economics: Principles
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Figure 1: The Demand Curve
Facing The Firm
Hall & Leiberman;
Economics: Principles
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Total Revenue
• 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?
• Total revenue— PxQ
Hall & Leiberman;
Economics: Principles
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The Cost Constraint
• Every firm wants to reduce costs, but there
is a limit to how low costs can go
• 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
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Economics: Principles
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Total Revenue and Total Cost Approach
• At any given output level, we know
– How much revenue the firm will earn
– Its cost of production
• Loss
– 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
– Selects output level where profit is greatest
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Economics: Principles
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The Marginal Revenue and
Marginal Cost 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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Economics: Principles
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The Marginal Revenue and
Marginal Cost Approach
• What does it mean when MR is positive?
• When a firm faces a downward sloping demand
curve, each increase in output causes
– Revenue gain
• From selling additional output at the new price
– Revenue loss
• 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
Hall & Leiberman;
Economics: Principles
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Using MR and MC to Maximize
Profits
• Marginal revenue and marginal cost can be
used to find the profit-maximizing output level
– Logic behind MC and MR approach
• An increase in output will always raise profit as long as
marginal revenue is _____ than marginal cost (MR __ MC)
– Converse of this statement is also true
• An increase in output will lower profit whenever marginal
revenue is ___ than marginal cost (MR ___ MC)
What should the firm do when MC>MR?
What should the firm do when MC<MR?
Hall & Leiberman;
Economics: Principles
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Profit Maximization Using Graphs
• How is the marginal revenue curve related
to the total revenue curve
• Total revenue (TR) is plotted one the
vertical axis, and quantity (Q) on the
horizontal axis
• So what is the marginal revenue?
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Economics: Principles
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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
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Economics: Principles
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Output
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Figure 2b: Profit Maximization
Dollars
600
MC
500
400
300
200
100
0
–100
–200
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Economics: Principles
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profit rises
4
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profit falls
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Output
MR
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The TR and TC Approach Using
Graphs
• To maximize profit, firm should
– Produce quantity of output where vertical
distance between TR and TC curves is
greatest and
– TR curve lies above TC curve
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Economics: Principles
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The MR and MC Approach Using
Graphs
• Figure 2 also illustrates the MR and MC
approach to maximizing profits
• 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
• 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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Economics: Principles
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An Important Proviso
• Important exception to this rule
– Sometimes MC and MR curves cross at two
different points
– In this case, profit-maximizing output level is
the one at which MC curve crosses MR curve
from below
– Why????
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Economics: Principles
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