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How Firms Make Decisions:
Profit Maximization
Slides by: John & Pamela Hall
ECONOMICS 3e / HALL & LIEBERMAN
HOW FIRMS MAKE DECISIONS
© 2005 South-Western/Thomson Learning
The Goal Of Profit Maximization
• To analyze decision making at the firm, let’s start with a
very 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
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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)
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Understanding Profit: Two
Definitions of Profit
• Difference between economic profit and
accounting profit is an important one
– When they are confused, some serious (and
costly) mistakes can result
• 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?
• 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
• 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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Figure 1: The Demand Curve
Facing The Firm
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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?
• 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
• 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
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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
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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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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
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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 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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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
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Figure 2: Profit Maximization
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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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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
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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
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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
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Figure 3: Two Points of Intersection
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Dealing With Losses: The Short Run
and the Shutdown Rule
• You might think that a loss-making firm should always shut down its
operation in the short run
– However, it makes sense for some unprofitable firms to continue operating
• The question is
– Should this firm produce at Q* and suffer a loss?
• 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)
– 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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Dealing With Losses: The ShortRun and the Shutdown Rule
• Guideline—called the shutdown rule—for a lossmaking firm
– Let Q* be output level at which MR = MC
– Then in the short-run
• If TR > Q* firm should keep producing
• If TR < Q* firm should shut down
• If TR = Q* firm should be indifferent between shutting down and
producing
• The shutdown rule is a powerful predictor of firms’
decisions to stay open or cease production in
short-run
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Figure 4: Loss Minimization
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Figure 5: Shut Down
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The Long Run: The Exit Decision
• 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 long- run
– When—at its best possible output level—it has
any loss at all
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Using The Theory: Getting It Wrong—
The Failure of Franklin National Bank
• In the mid-1970’s, Franklin National Bank—one of
the largest banks in the United States—went
bankrupt
• In mid-1974, John Sadlik, Franklin’s CFO, asked
his staff to compute average cost to bank of a
dollar in loanable funds
– Determined to be 7¢
– At the time, all banks—including Franklin—were
charging interest rates of 9 to 9.5% to their best
customers
– Ordered his loan officers to approve any loan that could
be made to a reputable borrower at 8% interest
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Using The Theory: Getting It Wrong—
The Failure of Franklin National Bank
• Where did Franklin get the additional funds it was
lending out?
– Were borrowed not at 7%, the average cost of funds,
but at 9 to 11%, the cost of borrowing in the federal
funds market
• Not surprisingly, these loans—which never should
have been made—caused Franklin’s profits to
decrease
– Within a year the bank had lost hundreds of millions of
dollars
– This, together with other management errors, caused
bank to fail
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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
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