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Decision-Making at the firm level The Goal Of Profit Maximization • To analyze decision making at the firm, start with a basic question – 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? – 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 – Many managers are well trained in tools of profit-maximization Understanding Profit: Two Definitions of Profit • 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 – Accounting profit = Total revenue – Accounting costs • A broader conception of costs (opportunity costs) leads to a second definition of profit – Economic profit = Total revenue – All costs of production – Or Total revenue – (Explicit costs + Implicit costs) The Firm’s Constraints: The Demand Constraint • 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 Figure 1: The Demand Curve Facing The Firm 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? • 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 The Cost Constraint • Every firm struggles to reduce costs, but there is a limit to how low costs can go – 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 – It must pay the cost of the “least cost method” of production The 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 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 The Marginal Revenue and Marginal Cost Approach • Important things to notice about marginal revenue – 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 – 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 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 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 Profit Maximization Using Graphs • Both approaches to maximizing profit (using totals or using marginals) can be seen even more clearly with graphs • Marginal revenue curve has an important relationship to total revenue curve • Total revenue (TR) is plotted one the vertical axis, and quantity (Q) on the horizontal axis – Slope along any interval is ΔTR / ΔQ – Which is the definition of marginal revenue • Marginal revenue for any change in output is equal to slope of total revenue curve along that interval 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 2 3 4 5 6 7 8 9 10 Output Figure 2b: Profit Maximization Dollars 600 MC 500 400 300 200 100 0 –100 –200 1 2 3 profit rises 4 5 6 7 profit falls 8 Output MR 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 The MR and MC Approach Using Graphs • Figure 2 also illustrates the MR and MC approach to maximizing profits • Can summarize MC and MR approach – 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 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 What About Average Costs? • Different types of average cost (ATC, AVC, and AFC) are irrelevant to earning the greatest possible level of profit – Common error—sometimes made even by business managers—is to use average cost in place of marginal cost in making decisions • Problems with this approach – 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 – Average cost doesn’t help at all; it only confuses the issue • Average cost should not be used in place of marginal cost as a basis for decisions Figure 3: Two Points of Intersection Dollars MC A B MR Q1 Q* Output Using The Theory: Getting It Right—The Success of Continental Airlines • Continental Airlines was doing something that seemed like a horrible mistake – Yet Continental’s profits—already higher than industry average—continued to grow • A serious mistake was being made by the other airlines, not Continental – Using average cost instead of marginal cost to make decisions • Continental’s management, led by its vicepresident of operations, had decided to try marginal approach to profit