Download Chapter 6 - How Firms Make Decisions: Profit Maximization

Chapter 6
How Firms Make
Decisions:
Profit Maximization
INTRODUCTION TO ECONOMICS 2e / LIEBERMAN & HALL
CHAPTER 6 / HOW FIRMS MAKE DECISIONS: PROFIT MAXIMIZATION
©2005, South-Western/Thomson Learning
Slides by John F. Hall
Animations by Anthony Zambelli
The Goal Of Profit Maximization
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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
Lieberman & Hall; Introduction to Economics, 2005
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Understanding Profit: Two Definitions
of Profit
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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)
Lieberman & Hall; Introduction to Economics, 2005
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Understanding Profit: Two Definitions
of Profit
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Difference between economic profit and
accounting profit is an important one
 When they are confused, some serious (and
costly) mistakes can result
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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
Lieberman & Hall; Introduction to Economics, 2005
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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
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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
Lieberman & Hall; Introduction to Economics, 2005
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The Firm’s Constraints: The Demand
Constraint
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Demand curve facing firm is a profit constraint
 Curve that indicates for different prices, quantity of output
customers will purchase from a particular firm
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Can flip demand relationship around
 Once firm has selected an output level, it has also
determined the maximum price it can charge
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Leads to an alternative definition
 Shows maximum price firm can charge to sell any given
amount of output
Lieberman & Hall; Introduction to Economics, 2005
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Figure 1: The Demand Curve Facing
The Firm
Lieberman & Hall; Introduction to Economics, 2005
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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?
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• Because once we know the level of output, we also
know the highest price the firm can charge
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Total revenue—which is the number of units
of output times the price per unit—follows
automatically
Lieberman & Hall; Introduction to Economics, 2005
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The Cost Constraint
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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
Lieberman & Hall; Introduction to Economics, 2005
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The Total Revenue And Total Cost Approach
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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
Lieberman & Hall; Introduction to Economics, 2005
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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
Lieberman & Hall; Introduction to Economics, 2005
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The Marginal Revenue and Marginal
Cost Approach
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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
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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
Lieberman & Hall; Introduction to Economics, 2005
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Using MR and MC to Maximize Profits
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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
Lieberman & Hall; Introduction to Economics, 2005
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Profit Maximization Using Graphs
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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
Lieberman & Hall; Introduction to Economics, 2005
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Figure 2(a): 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
Lieberman & Hall; Introduction to Economics, 2005
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3
4
5
6
7
8
9
10
Output
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Figure 2(b): Profit Maximization
Dollars
600
MC
500
400
300
200
100
0
–100
–200
1
2
3
profit rises
Lieberman & Hall; Introduction to Economics, 2005
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5
6
7
profit falls
8
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
Lieberman & Hall; Introduction to Economics, 2005
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The MR and MC Approach Using
Graphs
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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
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This rule is very useful—allows us to look at a
diagram of MC and MR curves and immediately
identify profit-maximizing output level
Lieberman & Hall; Introduction to Economics, 2005
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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
Lieberman & Hall; Introduction to Economics, 2005
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What About Average Costs?
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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
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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
Lieberman & Hall; Introduction to Economics, 2005
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Figure 3: Two Points of Intersection
Dollars
MC
A
B
MR
Q1
Lieberman & Hall; Introduction to Economics, 2005
Q*
Output
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Dealing With Losses: The Short Run
and the Shutdown Rule
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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
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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
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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
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costs
But if the firm cannot even cover its operating costs when it stays open, it
should shut down
Lieberman & Hall; Introduction to Economics, 2005
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Dealing With Losses: The Short-Run
and the Shutdown Rule
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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
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The shutdown rule is a powerful predictor of firms’
decisions to stay open or cease production in shortrun
Lieberman & Hall; Introduction to Economics, 2005
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Figure 4(a): Loss Minimization
Dollars
TFC
Q*
Lieberman & Hall; Introduction to Economics, 2005
Output
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Figure 4(b): Loss Minimization
Dollars
MC
Q*
Lieberman & Hall; Introduction to Economics, 2005
MR
Output
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Figure 5: Shut Down
Dollars
TC
TVC
Loss at Q*
TFC
TR
TFC
Q*
Lieberman & Hall; Introduction to Economics, 2005
Output
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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
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any loss at all
Lieberman & Hall; Introduction to Economics, 2005
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Using The Theory: Getting It Wrong—The
Failure of Franklin National Bank
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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
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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
Lieberman & Hall; Introduction to Economics, 2005
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Using The Theory: Getting It Wrong—The
Failure of Franklin National Bank
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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
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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
Lieberman & Hall; Introduction to Economics, 2005
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Using The Theory: Getting It Right—
The Success of Continental Airlines
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Continental Airlines was doing something that
seemed like a horrible mistake
 Yet Continental’s profits—already higher than industry
average—continued to grow
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A serious mistake was being made by the other
airlines, not Continental
 Using average cost instead of marginal cost to make
decisions
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Continental’s management, led by its vice-president
of operations, had decided to try marginal approach
to profit
Lieberman & Hall; Introduction to Economics, 2005
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