CHAPTER

How Firms Make Decisions:

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 The Goal of Profit Maximization
• The firm
– A single economic decision maker
– Goal: to maximize its owners’ profit
– Decisions
• What price to charge
• How much to produce

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 Understanding Profit
• Accounting profit
– Total revenue minus accounting costs
• Economic profit
– Total revenue minus all costs of
production, explicit and implicit
• Profit
– Payment for two contributions of
entrepreneurs: risk taking and innovation

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Understanding Profit

4
Understanding Profit

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 Understanding Profit
• Economic profit
– Proper measure of profit: for
understanding and predicting the behavior
of firms
– Recognizes all the opportunity costs of
production
• Explicit costs and implicit costs

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 The Firm’s Constraints
• Demand curve facing the firm
– Tells us, for different prices
• The quantity of output that customers will
purchase from a particular firm
– Shows us the maximum price the firm can
charge to sell any given amount of output
– One firm; All buyers (potential customers)

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Figure 1
The Demand Curve Facing the Firm

The table presents

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Figure 1
The Demand Curve Facing the Firm
Price
per Bed

$600

450
Demand Curve
Facing Ned’s
Beds
200

1 2 3 4 5 6 7 8 9 10 Number of Bed
Frames per Day
The table presents information about Ned’s Beds. Data from the first two columns are plotted in
the figure to show the demand curve facing the firm. At any point along that demand curve, the
product of price and quantity equals total revenue, which is given in the third column of the
table.
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 The Firm’s Constraints
• Total revenue, TR
– The total inflow of receipts from selling a
given amount of output
• Demand and total revenue
– Each time the firm chooses a level of
output, it also determines its total revenue

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 The Firm’s Constraints
• Total Revenue and Elasticity
– Lower price: sell more output
• If ED > 1 (elastic demand): total revenue will
rise
• If ED < 1 (inelastic demand): total revenue will
fall
• The cost constraint (minimizing costs)
– Given production technology
– Firm must pay prices for each of the inputs
that it uses
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 The Profit-Maximizing Output Level
• Total revenue and total cost approach
– Profit is the difference between TC and TR
at each output level
– The firm chooses the output level where
profit is greatest
• Loss
– Difference between total cost (TC) and
total revenue (TR)
– When TC > TR

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 The Profit-Maximizing Output Level
• Marginal revenue (MR = ΔTR / ΔQ)
– Change in total revenue from producing
one more unit of output
– Change in the firm’s total revenue (TR)
divided by the change in its output (Q)
– Tells us how much revenue rises per unit
increase in output

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 The Profit-Maximizing Output Level
• When MR is positive
– An increase in output causes total revenue
to rise
• When MR is negative
– An increase in output causes total revenue
to fall
• As output increases
– MR is smaller than the price

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Table 1
More Data for Ned’s Beds

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 The Profit-Maximizing Output Level
• Downward-sloping demand curve
– Each increase in output causes
• A revenue gain: from selling additional output
at the new price
• A revenue loss: from having to lower the price
on all previous units of output
– Marginal revenue is less than the price of
the last unit of output

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 The Profit-Maximizing Output Level
• An increase in output
– Will always raise profit as long as MR>MC
– Will always lower profit whenever MR<MC
• Marginal revenue and marginal cost
approach
– Profit-maximizing output level
– Increase output whenever MR>MC
– Decrease output when MR< MC

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 The Profit-Maximizing Output Level
• Marginal revenue for any change in output
– Is equal to the slope of the total revenue
curve along that interval
• TC and TR approach using graphs
– Maximize profit
– Produce the quantity of output where the
vertical distance between the TR and TC
curves is greatest
– And the TR curve lies above the TC curve

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 The Profit-Maximizing Output Level
• MC and MR approach using graphs
– Maximize profit
– Produce the quantity of output closest to
the point where MC = MR
• MC and MR curves intersect
• MC curve crosses the MR curve from below

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Figure 2
Profit Maximization (a)
Dollars
$3,500 Panel (a) shows
Profit at the firm’s total
7 units TC
3,000 revenue (TR)
and total cost
Profit at
(TC) curves.
2,500 5 units Profit is the
vertical distance
2,000 Profit at between the two
3 units TR curves at any
level of output.
1,500
Profit is
maximized when
1,000 that vertical
ΔTR from producing 2nd unit
distance is
500 greatest—at 5
ΔTR from producing 1st unit units of output.

Total Fixed
1 2 3 4 5 6 7 8 9 10
Cost
Output

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Figure 2
Profit Maximization (b)
Dollars
$700
Panel (b) shows the
MC firm’s marginal
600 revenue (MR) and
marginal cost (MC)
500 curves. Profit is
maximized at the
400 level of output
closest to where the
300 MR and MC curves
cross—at 5 units of
200 output.

100

0
1 2 3 4 5 6 7 8 9 10 Output
-100
Profit rises Profit falls MR
-200

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 The Profit-Maximizing Output Level
• A Proviso
– Sometimes the MC and MR curves cross
at two different points
– The profit-maximizing output level is the
one at which the MC curve crosses the
MR curve from below

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Figure 3
Two Points of Intersection
Dollars
MC
A

MR

Output
Q1 Q*
Sometimes the MR and MC curves intersect twice. The profit-maximizing level of output is
always found where MC crosses MR from below.
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 The Profit-Maximizing Output Level
• Average costs
– Irrelevant to profit maximizing decisions
• Marginal approach to profit
– A firm maximizes its profit by taking any
action that adds more to its revenue than
to its cost: MR > MC

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 Dealing with Losses
• Shutdown rule in the short run
– The firm should continue to produce if TR
> TVC (otherwise, it should shut down)
– Let Q* be the output level at which
MR=MC
• If TR > TVC at Q*, the firm should keep
producing
• If TR < TVC at Q*, the firm should shut down
• If TR = TVC at Q*, the firm should be
indifferent between shutting down and
producing
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Figure 4
Loss Minimization
Dollars TC
Loss The firm shown here
at Q* TVC cannot earn a
positive profit at any
level of output. If it
produces anything, it
TR will minimize its loss
TFC by producing where
TFC the vertical distance
between TR and TC
Output is smallest. Because
Q*
TR exceeds TVC at
Dollars MC Q*, the firm will
produce there in the
short run.

Q* Output
MR

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Figure 5
Shut Down
Dollars
TC

TVC
Loss
at Q*

TFC

TR
TFC

Q* Output

At Q*, this firm’s total variable cost exceeds its total revenue. The best policy is to shut down,
produce nothing, and suffer a loss equal to TFC in the short run.

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 Dealing with Losses
• Exit
– A permanent cessation of production when
a firm leaves an industry
• In the long run
– A firm should exit the industry when—at its
best possible output level—it has any loss
at all

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 Getting It Wrong:
The Failure of Franklin National Bank
• Mid-1974s, Franklin National Bank’s
manager
– Average cost of $1 in loans = 7 cents
– Offered loans at 8% interest (MR)
– Borrowed in federal funds market at 9-11%
interest (MC)

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 Getting It Right:
Continental Airlines
• 1960’s, all other airlines
– Offer a flight only if, on average, 65% of
the seats could be filled with paying
passengers
– ATC = $4,000 per flight

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 Getting It Right:
Continental Airlines
• Continental Airlines
– Flying jets filled to just 50% of capacity
– Expanding flights on many routes
– Higher profits
– MC = $2,000 per flight

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