MEDITERRANEAN SCHOOL OF BUSINESS

COURSE: ECO 5101 BUSINESS ECONOMICS

PROFESSOR: Alec Hansen, Ph.D.

DATE: October 2019

10/03/2020 SOUTH MEDITERRANEAN UNIVERSITY 1

SESSION 2c
PROFIT MAXIMIZATION

2
 Firms’ Decisions
Profit maximizing behavior
The total revenue and total cost approach
The marginal revenue and marginal cost
approach
Short-run: shut down rule
Long-run: exit rule

3
 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?
Total revenue—which is the number of units of output times
the price per unit—follows automatically
TR = P x Q

4
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

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

5
The Marginal Revenue and Marginal
Cost Approach
Marginal Cost: change in total cost from producing one more unit of
output
Marginal revenue: change in total revenue from producing one more
unit of output

The GOLDEN RULE OF ECONOMICS

TO MAXIMIZE PROFIT, SET QUANTITY WHERE MR=MC

6
The Marginal Revenue and Marginal
Cost Approach
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

7
 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
Dollars
$3,500
TC
3,000 Profit at 7
Units
2,500 Profit at 5
Units
2,000 Profit at 3 TR
1,500 Units

1,000
DTR from producing 2nd unit
500
DTR from producing 1st unit
Total Fixed
Cost 0 1 2 3 4 5 6 7 8 9 10
Output

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 Profit Maximization
Dollars

600
MC
500
400
300
200
100
0
1 2 3 4 5 6 7 8 Output
–100
–200 profit rises profit falls
MR

10
11
 Exercise
Demand: Q = 100 – P
Costs: MC = AC = 10
Hence P = 100 – Q
Revenue: R = PQ = (100 -Q) Q
MC = AC = 10 implies that costs are C = 10 Q
Profit: Π = R-C
= (100-Q)Q -10 Q = (100Q -Q2)-10Q

Want to find Q* (and therefore P*) that maximizes Π

12
 Solution
Profit: Π = (100Q -Q2) -10Q
Take derivative:
d Π/dQ = (100 -2Q) – 10 [ = MR – MC ]

Profits are maximized where dΠ/dQ = 0

(100 -2Q) – 10 = 0 [MR – MC = 0]
Q* = 45
Insert profit-maximizing value of Q into demand equation: P*
= 100 - Q = 55

13
 Profit Maximization by Monopoly
MC curve crosses MR curve from below
$60 MC

40 E

10,000 30,000
MR

14
The Shutdown Rule
When

• P>ATC, profit > 0  causes and more firms enter and price falls

• If AVC < P < ATC, continue operation despite losses

• If P< AVC, shut down
• If forecast says P < ATC for foreseeable future, exit  causes price to rise
eventually

15
Dealing With Losses: The Short-Run
and the Shutdown Rule
Guideline—called the shutdown rule—for a loss-
making firm
• Let Q* be output level at which MR = MC
• Then in the short-run
◦ If TR >TVC at Q* firm should keep producing
◦ If TR < TVC at Q* firm should shut down
◦ If TR = TVC at 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
16
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

17
18
19
Shutdown or not?

P
Dollars MC ATC
AVC
70
60
50

40
30

Q
500

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Shutdown or not?

P
Dollars MC ATC
AVC
70
60
50

40
30

Q
500

21
Shutdown or not?

P
Dollars MC ATC
70 AVC

60
50

30

Q
500

22
Shutdown or not?

Dollars MC ATC
70 AVC

60
50

30

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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

24
 Success of Continental Airlines
In the early 60s, all airlines were following a simple rule:
they would only offer a flight if, on average, 65% of the seats
could be filled since only then could the flight break even
Continental Airlines was doing something that seemed like a
horrible mistake: flying jets to just 50% of capacity and was
actually expanding flights on many routes.
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

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 Success of Continental Airlines
The 65% of capacity rule was derived as follows: The total
cost of the airline divided by the number of flights during the
year to obtain the average cost of a flight. This came to
about $4,000
A jet had to be 65% full in order to earn ticket sales of
$4,000. The industry regarded any flight that repeatedly took
off with less than 65% capacity as a money loser and
canceled it.
An airline’s average cost per flight includes many costs that
are fixed and are therefore irrelevant to the decision to add or
subtract a flight (interest on debt, reservation system, etc.)

26
 Marginal Analysis
Continental management has decided to try the marginal approach
to profit
Whenever a new flight was being considered, every department in
the company was asked to determine the additional cost they would
have to bear
These came out to be only $2,000 per flight
The marginal revenue of flight filled at 50% capacity was $3,000.
Hence offering the flight would increase profit
This is why Continental was expanding routes even when it could
fill only 50% of its seats
 Today, of course, all airlines use this approach

27
U-Shaped Average Cost Curve

28
 Minimum Efficient Scale and Total
Demand
When the MES is small relative to the maximum
potential market, market should be populated by
many small firms, each producing for only a tiny
share of the market

In some cases the MES occurs at 25% of the

maximum potential market. In this type of market,
expect to see a few large competitors

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Industry Analysis
4 main structures

Perfect Competition
Monopolistic Competition
Oligopoly
Monopoly
 Many Small Firms
Dollars LRATCTypical Firm

$160 F

E
80

DMarket

0 1,000 3,000 100,000

Units per Month

31
 Natural Monopoly
LRATCTypical Firm
Dollars

$160

80

DMarket

0 100,000
Units per Month

32
 Oligopoly
Dollars
LRATCTypical Firm
$200 H F

E
80
DMarket

0 25,000 100,000
Units per Month

33
Perfect competition and
monopoly

34
Perfect Competition
Competitive Equilibrium in the long run

Entire market perspective Individual firm perspective

35
1. How does market respond in short run to exogenous increase in demand (D 1)?
2. How does market respond in the long run? (new suppliers enter market, shifting supply curve to S 1)

Entire market perspective Individual firm perspective

Note: how are ‘economic profits’ different from ‘normal profits’?

36
How does Competition Maximize Welfare?

37
 What Is A Monopoly?

A monopoly firm is the only seller of a good or service with no

close substitutes

38
 Monopoly
Negative reputation of monopoly is in many ways
deserved
• Unfair prices, extraordinary power, lack of innovation, “rent-
seeking behavior”
• This negative characterization sometimes goes too far
Monopolies should be avoided in many markets, but
in others it may be the best way to organize production

39
What does a Monopolist Do?
Price

M
P2

P1 C

Q2 Q1 Quantity

40
 What does a Monopolist Do?

Compared with a firm in perfectly competitive market,

a monopolist moves along the demand curve to
produce less but charge a higher price
• To earn higher profit rather than zero economic profit (e.g.
normal returns)
• The ability of a monopolist to raise its price above the
competitive level by reducing output is known as market
power

41
 The Sources of Monopoly
Existence of a monopoly means that something is causing
other firms to stay out of the market
What barrier prevents additional firms from entering the
market?
• Several possible answers
◦ Exclusive access to a natural resource or technology
◦ Economies of scale
◦ Legal barriers
◦ Patents
◦ Network externalities
42
 Economies of Scale
Economies of scale: Costs falling as output rises
The higher output, the lower LRATC or the lower unit
cost

If economies of scale persist to the point where the

monopoly is producing for entire market, the market is a
natural monopoly
• one firm can operate at lower average cost than can two or
more firms

43
Figure 2: A Natural Monopoly from Economies of Scale
Dollars

Natural monopolist’s
break-even price

P M

LRATC

DMarket

Q Quantity
Relevant output range

44
 Legal Barrier
Protection of Intellectual Property
Government strikes a compromise
• Allows creators of intellectual property to enjoy a
monopoly and earn economic profit, but only for a limited
period of time
• Once time is up, other sellers are allowed to enter the
market, and it is hoped that competition among them will
bring down prices

45
 Network Externalities
Exist when an increase in network’s membership
increases its value to current and potential members
Advantages of joining a large network
• more beneficial than joining a small network
The value to consumers of a good rises as the number of
people who also use the good rises
• Example: computer operating systems
◦ Microsoft Windows

46
 Monopoly Goals & Constraints
Goal of a monopoly—Maximize profit
• like that of any firm
Noncompetitive firms make ONE decision
• Once firm determines its output level, it has also determined its price
Constraints
• Cost constraint for any level of possible Q
◦ Technology of production
◦ Price it must pay for its inputs
• Demand constraint
◦ maximum price monopolist can charge, given Q

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 Exercise
Demand: Q = 100 – P
Costs: MC = AC = 10
Hence P = 100 – Q
Revenue: R = PQ = (100 -Q) Q
MC = AC = 10 implies that costs are C = 10 Q
Profit: Π = R-C
= (100-Q)Q -10 Q = (100Q -Q2)-10Q

Want to find Q (and therefore P) that maximizes Π

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 Solution
Profit: Π = (100Q -Q2) -10Q
Take derivative:
d Π/dQ = (100 -2Q) – 10 [ = MR – MC ]

Profits are maximized where dΠ/dQ = 0

(100 -2Q) – 10 = 0 [MR – MC = 0]
Q = 45
Insert profit-maximizing value of Q into demand equation: P
= 100 - Q = 55

49
 Profit Maximization by Monopoly
MC curve crosses MR curve from below
$60 MC

40 E

10,000 30,000
MR

50
CASE STUDY: Lille Tissages
Review the cost table:
Which items can be classified as FC
and which ones as AC?
First assume all info is correct and reliable
Then question assumptions using common sense and take into account any
potential uncertainty

51
How does Competition Maximize Welfare?

52
Quiz
Demand: P = 100 – Q
Cost: TC = 30Q
Find Q*, the profit-maximizing level of output, and P*, the profit-maximizing
price.

53
 Profit And Loss
A monopoly earns a profit whenever P > ATC
• Profit is the shadow area in the Figure 4(a)
◦ Height equal to P - ATC
◦ Width equal to level of output

A monopoly suffers a loss whenever P < ATC

• Loss is the shadow area in the Figure 4(b)
◦ Height equal to ATC - P
◦ Width equal to level of output

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Figure 4: Monopoly Profit and Loss
(a) (b)
Dollars Dollars ATC
MC ATC MC AVC
$50
E E
$40 40
32 Total Loss

Total
Profit

D D
10,000 10,000
MR MR

55
 Short-Run Equilibrium
Monopoly may earn an economic profit or suffer an economic
loss
What if a monopoly suffers a loss in short-run?
• Any firm should shut down if P < AVC at output level where MR =
MC

If a government monopoly suddenly finds that P < AVC,

government will usually not allow it to shut down
• Instead they often use tax revenue to make up for firm’s losses

56
 Long-Run Equilibrium
Perfectly competitive firms earn zero economic profit in the long-
run equilibrium
However, monopolies may earn economic profit in the long-run
A privately owned monopoly suffering an economic loss in long-
run will exit the industry

57
 Comparing Monopoly to Perfect Competition
In perfect competition, economic profit is relentlessly reduced
to zero by entry of other firms
In monopoly,
• economic profit can continue indefinitely
• have a higher price and lower output than an otherwise similar
perfectly competitive market
◦ earns economic profit for this reason
Consumers lose in several ways
• Pay more for output they buy
• Due to higher prices, they buy less output
• Lower rate of innovation

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