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I
n early 1996, the managers of Nintendo America, Inc., knew that they had awinner on their hands: the Nintendo 64 video-game player. With this new prod-uct, players would be able to jump, fly, and even swim through a variety of three-dimensional fantasy worlds, with images more spectacular and action muchfaster than in any competing product.Then came the hard questions. Where should the new product be produced: Japan, the United States, or perhaps Hong Kong? How should the company raisethe funds to pay the costs of production? When should it bring the product to mar-ket? How much should it spend on advertising, and in which types of media? Andfinally, what price should the company charge, and how many units should it planto produce?These last decisions—how much to produce and what price to charge—are thefocus of this chapter. In the end, Nintendo planned to produce 500,000 units, anddecided to charge $199. But why didn’t it charge a lower price that would allowit to sell more output? Or a higher price that would give it more profit on eachunit sold?Although this chapter concentrates on firms’ decisions about price and outputlevel, the tools you will learn apply to many other firm decisions. How muchshould MasterCard spend on advertising? How late should Starbucks keep its cof-fee shops open? How many copies should
Newsweek
give away free to potentialsubscribers? Should movie theaters offer Wednesday afternoon showings that onlya few people attend? This chapter will help you understand how firms answerthese sorts of questions.
THE GOAL OF PROFIT MAXIMIZATION
To analyze decision making at the firm, let’s start with a very basic question: Whatis the firm trying to maximize?Economists have given this question a lot of thought. Some firms—especiallylarge ones—are complex institutions in which many different groups of peoplework together. A firm’s owners will usually want the firm to earn as much profit as
HOW FIRMS MAKE DECISIONS:PROFIT MAXIMIZATION
CHAPTER
7
CHAPTER OUTLINE
The Goal of Profit MaximizationUnderstanding Profit
Two Definitions of ProfitWhy Are There Profits?
The Firm’s Constraints
The Demand ConstraintThe Cost Constraint
The Profit-Maximizing OutputLevel
The Total Revenue and Total CostApproachThe Marginal Revenue and Mar-ginal Cost ApproachProfit Maximization Using GraphsWhat About Average Costs?
The Importance of MarginalDecision Making:A Broader ViewDealing with Losses
The Short Run and the ShutdownRuleThe Long Run: The Exit Decision
The Goal of the Firm Revisited
The Principal-Agent ProblemThe Principal-Agent Problem atthe FirmThe Assumption of ProfitMaximization
Using the Theory: Getting It Wrong and Getting It Right
Getting It Wrong: The Failure of Franklin National Bank Getting It Right: The Success of Continental Airlines
 
possible. But the workers and managers who actually run the firm may have otheragendas. They may try to divert the firm away from profit maximization in orderto benefit themselves. For now, let’s assume that workers and managers are faithfulservants of the firm’s owners. That is,Why do we make this assumption? Because it has proven so
useful 
in under-standing how firms behave. Toward the end of the chapter, we’ll come back tothe important topic of different groups within the firm and the potential conflictsamong them.
UNDERSTANDING PROFIT
Profit is defined as the firm’s
sales revenue
minus its
costs of production
. There iswidespread agreement over how to measure the firm’s revenue, the flow of moneyinto the firm. But there are two different conceptions of the firm’s costs, and eachof them leads to a different definition of profit.
TWO DEFINITIONS OF PROFIT
One conception of costs is the one used by accountants. With a few exceptions,accountants consider only
explicit 
costs, where money is actually paid out.
1
If wededuct only the costs recognized by accountants, we get one definition of profit:
Accounting profit
Total revenue
Accounting costs.
But economics, as you have learned, has a much broader view of cost—
op- portunity cost.
For the firm’s owners, opportunity cost is the total value of 
ev-erything 
sacrificed to produce output. This includes not only the explicit costsrecognized by accountants—such as wages and salaries and outlays on raw mate-rials—but also
implicit costs,
when something is given up but no money changeshands. For example, if an owner contributes his own time or money to the firm,there will be foregone wages or foregone investment income—both implicit costsfor the firm.This broader conception of costs leads to a second definition of profit:
Economic profit
Total revenue
 All 
costs of production
Total revenue
(Explicit costs
Implicit costs)
The difference between economic profit and accounting profit is an important one;when they are confused, some serious (and costly) mistakes can result. An examplemight help make the difference clear.Suppose you own a firm that produces T-shirts, and you want to calculate yourprofit over the year. Your bookkeeper provides you with the following information:
188Chapter 7
How Firms Make Decisions: Profit Maximization
1
One exception is
depreciation,
a charge for the gradual wearing out of the firm’s plant and equip-ment. Accountants include this as a cost even though no money is actually paid out.
Accounting profit
Total revenue mi-nus accounting costs.
Economic profit
Total revenue mi-nus all costs of production, explicitand implicit.
Identify Goals and Constraints
We will view the firm as a single economic decision maker whose goal is tomaximize its owners’ profit.
 
 Total Revenue from Selling T-shirts$300,000
Cost of raw materials$80,000Wages and salaries150,000Electricity and phone20,000Advertising cost40,000
 Total Explicit Cost290,000Accounting Profit$ 10,000
From the looks of things, your firm is earning a profit, so you might feel prettygood. Indeed, if you look only at
money
coming in and
money
going out, you haveindeed earned a profit—$10,000 for the year ... in
accounting 
profit.But suppose that in order to start your business you invested $100,000 of yourown money—money that could have been earning $6,000 in interest if you’d put itin the bank instead. Also, you are using two extra rooms in your own house as afactory—rooms that could have been rented out for $4,000 per year. Finally, youare managing the business full time, without receiving a separate salary, and youcould instead be working at a job earning $40,000 per year. All of these costs—theinterest, rent, and salary you
could 
have earned—are implicit costs that have notbeen taken into account by your bookkeeper. They are part of the opportunity costof your firm, because they are sacrifices you made to operate your business.Now let’s look at this business from the economist’s perspective and calculateyour
economic
profit.
 Total Revenue from Selling T-shirts$300,000
Cost of raw materials$80,000Wages and salaries150,000Electricity and phone20,000Advertising cost40,000
 Total Explicit Costs$290,000
Investment income foregone$6,000Rent foregone4,000Salary foregone40,000
 Total Implicit Costs$50,000 Total Costs$340,000Economic Profit
$40,000
From an economic point of view, your business is not profitable at all, but is ac-tually losing $40,000 per year! But wait—how can we say that your firm is suffer-ing a loss when it takes in more money than it pays out? Because, as we’ve seen,your
opportunity cost 
—the value of what you are giving up to produce your out-put—includes more than just money costs. When
all 
costs are considered—implicitas well as explicit—your total revenue is not sufficient to cover what you have sac-rificed to run your business. You would do better by shifting your time, yourmoney, and your spare room to some alternative use.Which of the two definitions of profit is the correct one? Either one of them, de-pending on the reason for measuring it. For tax purposes, the government is inter-ested in profits as measured by accountants. The government cares only about themoney you’ve earned, not what you
could 
have earned had you done something elsewith your money or your time.However, for our purposes—understanding the behavior of firms—economicprofit is clearly better. Should your T-shirt factory stay in business? Should it expand
Understanding Profit
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