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Economics:
Principles and Applications, 2e
by Robert E. Hall &
Marc Lieberman
Chapter 7:
How Firms Make Decisions:
Profit Maximization
The Goal of Profit
Maximization
We will view the firm as a
single economic decision
maker whose goal is to
maximize its owner’s profit.
Understanding Profit
•Two Definitions of Profit
•Why Are There Profits?
Understanding Profit
Accounting Profit
Total revenue minus
accounting costs.
Understanding Profit
Economic Profit
Total revenue minus all costs
of production, explicit and
implicit.
The Firm’s Constraints
•The Demand Constraint
•The Cost Constraint
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.
The Firm’s Constraints
Total Revenue
The total inflow of receipts
from selling a given amount of
output.
The Nature of the
Firm
•Types of Business Firms
•Why Employees?
•The Limits to the Firm
The Profit-Maximizing
Output Level
•The Total Revenue and Total Cost
Approach
•The Marginal Revenue and Marginal
Cost Approach
•Profit Maximization Using Graphs
•What About Average Costs?
The Profit-Maximizing
Output Level
Loss
A negative profit--when
total cost exceeds total
revenue
The Profit-Maximizing
Output Level
Marginal Revenue
The change in total
revenue from producing
one more unit of output.
The Importance of Marginal
Decision Making: A Broader View
Marginal Approach to Profit
A firm maximized its profit by
taking any action that adds more
to its revenue than to its cost.
Dealing with Losses
•The Short Run and the Shutdown
Rule
•The Long Run: The Exit
Decision
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.
Dealing With Losses
Exit
A permanent cessation of
production when a firm leaves
an industry.
The Goal of the Firm
Revisited
•The Principal-Agent Problem
•The Principal-Agent Problem at the
Firm
•The Assumption of Profit
Maximization
The Goal of the Firm
Revisited
Principal
A person or group that
hires someone to do a job.
The Goal of the Firm
Revisited
Agent
A person hired to do a
job.
The Goal of the Firm
Revisited
Principal-Agent Problem
The situation that arises when an
agent has interests that conflict
with the principal’s, and has the
ability to pursue those interests.
The Goal of the Firm
Revisited
Stockholder Revolt
When owners, dissatisfied
with the profits they are
earning, replace the firm’s
management teams.
The Goal of the Firm
Revisited
Hostile Takeover
When outsiders buy up a
firm’s shares with the goal of
replacing the management
team and increasing profits.
The Goal of the Firm
Revisited
Friendly Takeover
When a firm’s management
arranges a takeover by another
firm deemed unlikely to fire
them.
The Goal of the Firm
Revisited
White Knight
A firm that undertakes a
friendly takeover.
The Goal of the Firm
Revisited
Stock Options
Rights to purchase shares
of stock at a prespecified
price.