Slides by John F. Hall
Animations by Anthony Zambelli
INTRODUCTION TO ECONOMICS 2e / LIEBERMAN & HALLCHAPTER 6 / HOW
FIRMS MAKE DECISIONS: PROFIT MAXIMIZATION ©2005, South-
Western/Thomson Learning
Chapter 6How Firms MakeDecisions:Profit Maximization
Lieberman & Hall;
Introduction to Economics
, 2005
2
The Goal Of Profit Maximization
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 aretypically replaced either by
•
Current owners or
•
Other firms who acquire the underperforming firm and then replacemanagement team
with their own
Many managers are well trained in tools of profit-maximizatio
Lieberman & Hall;
Introduction to Economics
, 2005fit
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
hy Are There Profits?
Economists view profit as a payment for twonecessary contributions
Risk-taking
Someone
—
the owner
—
had to be willing to takethe initiative to set up the business
•
This individual assumed the risk that business mightfail and the initial investment be lost
Innovation
•
In almost any business you will find that some sort ofinnovation was needed to get things
started
Lieberman & Hall;
Introduction to Economics
, 2005he Firm’s Constraints: The Demand
Constraint
Demand curve facing firm is a profit constraint
Curve that indicates for different prices, quantity of outputcustomers will purchase from
a particular firm
Can flip demand relationship around
Once firm has selected an output level, it has alsodetermined the maximum price it can charge
Leads to an alternative definition
Shows maximum price firm can charge to sell any givenamount of output
Lieberman & Hall;
Introduction to Economics
, 20051: The De
Lieberman & Hall;
Introduction to Economics
, 2005
Total Revenue
The total inflow of receipts from selling agiven 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 alsoknow the highest price the firm can charge
Total revenue
—
which is the number of unitsof output times the price per unit
Lieberman & Hall;
Introduction to Economics
, 2005
The Cost Constraint
Every firm struggles to reduce costs, but there is alimit to how low costs can go
These limits impose a second constraint on the firm
The firm uses its production function, and the pricesit must pay for its inputs, to
determine the least costmethod of producing any given output level
For any level of output the firm might want toproduce
It must pay the cost of the ―least cost method‖ of
production
Lieberman & Hall;
Introduction to Economics
, 2005
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 profit
—
when total cost exceeds total revenue
In the total revenue and total cost approach, thefirm calculates Profit = TR
–
TC at each output level
Selects output level where profit is greatest
Lieberman & Hall;
Introduction to Economics
, 2005
10
The Marginal Revenue and MarginalCost Approach
Marginal revenue
Change in total revenue fromproducing one more unit of output
•
MR =
Δ
TR /
Δ
Q
Tells us how much revenue risesper unit increase in output
Lieberman & Hall;
Introduction to Economics
, 2005
11
The Marginal Revenue and MarginalCost Approach
Important things to notice about marginal revenue
When MR is positive, an increase in output causes total revenue torise
Each time output increases, MR is smaller than the price the firmcharges at the new
output level
When a firm faces a downward sloping demand curve, eachincrease 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 ofoutput
Lieberman & Hall;
Introduction to Economics
, 2005
12
Using MR and MC to Maximize Profits
Marginal revenue and marginal cost can be used tofind the profit-maximizing output
level
Logic behind MC and MR approach
•
An increase in output will always raise profit as long as marginalrevenue is greater than
marginal cost (MR > MC)
Converse of this statement is also true
•
An increase in output will lower profit whenever marginal revenueis less than marginal
cost (MR < MC)
Guideline firm should use to find its profit-maximizinglevel of output
•
Firm should increase output whenever MR > MC, and decreaseoutput when MR < MC
Lieberman & Hall;
Introduction to Economics
, 2005
13
Figure 2(a): Profit Maximization
Total FixedCost
TC
TR
D
TR from producing 2nd unit
D
TR from producing 1st unit
Profit at 3UnitsProfit at 5
Units
$3,5003,0002,5002,0001,5001,000500
Output
Dollars
1 210 3 4 5 6 7 8 9 10Profit at 7Units
Lieberman & Hall;
Introduction to Economics
, 2005
14
Figure 2(b): Profit Maximization
profit rises profit falls
MC
MR
0
600500400300200100
–
100
–
200
Output
Dollars
1 2 3 4 5 6
7
8
Lieberman & Hall;
Introduction to Economics
, 2005
e MR and MC Approach UsingGraphs
Figure 2 also illustrates the MR and MC approachto maximizing profits
Can summarize MC and MR approach
To maximize profits the firm should produce level ofoutput closest to point where MC = MR
•
Level of output at which the MC and MR curves intersect
This rule is very useful
—
allows us to look at adiagram of MC and MR curves and immediatelyidentify profit-
maximizing output level
Lieberman & Hall;
Introduction to Economics
, 2005
16
An Important Proviso
Important exception to this rule
Sometimes MC and MR curves cross attwo different points
In this case, profit-maximizing output levelis the one at which MC curve crosses MRcurve from below
Lieberman & Hall;
Introduction to Economics
, 2005
17
What About Average Costs?
Different types of average cost (ATC, AVC, and AFC) areirrelevant to earning the
greatest possible level of profit
Common error
—
sometimes made even by business managers
—
isto use average cost in place of marginal cost in making decisions
•
Problems with this approach
ATC includes many costs that are fixed in short-run
—
including cost of allfixed inputs such as factory and equipment and design staff
ATC changes as output increases
Correct approach is to use the marginal cost and to considerincreases 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 costas a basis for decisions
Lieberman & Hall;
Introduction to Economics
, 2005
18
Dealing With Losses: The Short Runand the Shutdown Rule
You might think that a loss-making firm should always shut down itsoperation 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 andshut down its operation
If, by staying open, a firm can earn more than enough revenue to coverits operating
costs, then it is making an operating profit (TR > TVC)
Should not shut down because operating profit can be used to help pay fixedcosts
But if the firm cannot even cover its operating costs when it stays open, it
should shut down
Lieberman & Hall;
Introduction to Economics
, 2005
19
Dealing With Losses: The Short-Runand 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 > Q* firm should keep producing
•
If TR < Q* firm should shut down
•
If TR = Q* firm should be indifferent between shutting down andproducing
The shutdown rule is a powerful predictor of firms’
decisions to stay open or cease production in short-run
Lieberman & Hall;
Introduction to Economics
, 2005
20
Figure 4(a): Loss Minimization
Q*
Dollars
Output
TFC
Lieberman & Hall;
Introduction to Economics
, 2005
21
Figure 4(b): Loss Minimization
MC
MR
Q*
Dollars
Output
Lieberman & Hall;
Introduction to Economics
, 2005
22
Figure 5: Shut Down
Q*
TC
TR
TVC
TFC
TFC
Loss at
Q*
Dollars
Output
Lieberman & Hall;
Introduction to Economics
, 2005
23
The Long Run: The Exit Decision
We only use term shut down when referringto short-run
If a firm stops production in the long-run it istermed an exit
A firm should exit the industry in long- run
When
—
at its best possible output level
—
it hasany loss at all
Lieberman & Hall;
Introduction to Economics
, 2005
24
Using The Theory: Getting It Wrong
—
TheFailure of Franklin National Bank
In the mid-
1970’s, Franklin National Bank—
one ofthe largest banks in the United States
—
wentbankrupt
In mid-
1974, John Sadlik, Franklin’s CFO, asked
his staff to compute average cost to bank of a dollarin loanable funds
Determined to be 7¢
At the time, all banks
—
including Franklin
—
were charginginterest rates of 9 to 9.5% to their best customers
Ordered his loan officers to approve any loan that couldbe made to a reputable
borrower at 8% interest
Lieberman & Hall;
Introduction to Economics
, 2005
25
Using The Theory: Getting It Wrong
—
TheFailure of Franklin National Bank
Where did Franklin get the additional funds it waslending out?
Were borrowed not at 7%, the average cost of funds, butat 9 to 11%, the cost of
borrowing in the federal fundsmarket
Not surprisingly, these loans
—
which never shouldhave been made
—caused Franklin’s profits to
decrease
Within a year the bank had lost hundreds of millions ofdollars
This, together with other management errors, causedbank to fail
Lieberman & Hall;
Introduction to Economics
, 2005
26
Using The Theory: Getting It Right
—
The Success of Continental Airlines
Continental Airlines was doing something thatseemed like a horrible mistake
Yet Continental’s profits—
already higher than industryaverage
—
continued to grow
A serious mistake was being made by the otherairlines, not Continental
Using average cost instead of marginal cost to makedecisions
Continental’s management, led by its vice
-presidentof operations, had decided to try marginal approachto profit
