How Firms Make Decisions: Profit Maximization: Slides by John F. Hall

Slides by John F.
Hall
Animations by Anthony Zambelli
INTRODUCTION TO ECONOMICS 2e / LIEBERMAN & HALL
CHAPTER 6 / HOW FIRMS MAKE DECISIONS: PROFIT MAXIMIZATION
2005, South-Western/Thomson Learning
Chapter 6
How Firms Make
Decisions:
Profit Maximization
Lieberman & Hall; Introduction to Economics, 2005
2
The Goal Of Profit Maximization
To analyze decision making at the firm, lets start with a very
basic question
What is the firm trying to maximize?
A firms 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
3
Understanding Profit: Two Definitions
of Profit
Profit is defined as the firms 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)
4
Why Are There Profits?
Economists view profit as a payment for two
necessary contributions
Risk-taking
Someonethe ownerhad 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
5
The Firms 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
6
Figure 1: The Demand Curve Facing
The Firm
7
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 revenuewhich is the number of units
of output times the price per unitfollows
automatically
8
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
9
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 profitwhen 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
10
The Marginal Revenue and Marginal
Cost Approach
Marginal revenue
Change in total revenue from
producing one more unit of output
MR = TR / Q
Tells us how much revenue rises
per unit increase in output
11
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

12
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
13
Figure 2(a): Profit Maximization
Total Fixed
Cost
TC
TR
DTR from producing 2nd unit
DTR from producing 1st unit
Profit at 3
Units
Profit at 5
Units
$3,500
3,000
2,500
2,000
1,500
1,000
500
Output
Dollars
1 2 1 0 3 4 5 6 7 8 9 10
Profit at 7
Units
14
Figure 2(b): Profit Maximization
profit rises profit falls
MC
MR
0
600
500
400
300
200
100
100
200
Output
Dollars
1 2 3 4 5 6 7 8
15
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 usefulallows us to look at a
diagram of MC and MR curves and immediately
identify profit-maximizing output level
16
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
17
What About Average Costs?
Different types of average cost (ATC, AVC, and AFC) are
irrelevant to earning the greatest possible level of profit
Common errorsometimes made even by business managersis
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-runincluding 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 doesnt help at all; it only confuses the issue
Average cost should not be used in place of marginal cost
as a basis for decisions
18
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 yesif 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

19
Dealing With Losses: The Short-Run
and the Shutdown Rule
Guidelinecalled the shutdown rulefor a loss-
making 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
20
Figure 4(a): Loss Minimization
Q*
Dollars
Output
TFC
21
Figure 4(b): Loss Minimization
MC
MR
Q*
Dollars
Output
22
Figure 5: Shut Down
Q*
TC
TR
TVC
TFC
TFC
Loss at Q*
Dollars
Output
23
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
Whenat its best possible output levelit has
any loss at all
24
Using The Theory: Getting It WrongThe
Failure of Franklin National Bank
In the mid-1970s, Franklin National Bankone of
the largest banks in the United Stateswent
bankrupt
In mid-1974, John Sadlik, Franklins CFO, asked
his staff to compute average cost to bank of a dollar
in loanable funds
Determined to be 7
At the time, all banksincluding Franklinwere 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
25
Using The Theory: Getting It WrongThe
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 loanswhich never should
have been madecaused Franklins 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
26
Using The Theory: Getting It Right
The Success of Continental Airlines
Continental Airlines was doing something that
seemed like a horrible mistake
Yet Continentals profitsalready higher than industry
averagecontinued to grow
A serious mistake was being made by the other
airlines, not Continental
Using average cost instead of marginal cost to make
decisions
Continentals management, led by its vice-president
of operations, had decided to try marginal approach
to profit

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