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The Goal Of Profit Maximization PowerPoint PPT Presentation


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The Goal Of Profit Maximization. What is the firm’s goal? A firm’s owners will want the firm to earn as much profit as possible Why? Managers who deviate from profit-maximizing for too long are typically replaced either by Current owners or

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The Goal Of Profit Maximization

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The goal of profit maximization l.jpg

The Goal Of Profit Maximization

  • What is the firm’s goal?

  • A firm’s owners will want the firm to earn as much profit as possible

  • 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


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Two Definitions of Profit

  • Profit = sales revenue minus costs of production

  • Accounting profit = Total revenue – Accounting costs

  • Economic profit = Total revenue – All costs of production = Total revenue – (Explicit costs + Implicit costs)

  • This last term is the opportunity cost of production


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Two Definitions of Profit

  • Proper measure of profit for understanding and predicting firm behavior is economic profit

    • Unlike accounting profit, economic profit recognizes all the opportunity costs of production—both explicit and implicit costs


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Why Are There Profits?

  • Economists view profit as a payment for

  • Risk-taking

    • Someone—the owner—had 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


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The Firm’s Constraints: Demand

  • 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


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Figure 1: The Demand Curve Facing The Firm


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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— PxQ


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The Cost Constraint

  • Every firm wants to reduce costs, but there is a limit to how low costs can go

  • 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


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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, the firm calculates Profit = TR – TC at each output level

    • Selects output level where profit is greatest


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The Marginal Revenue and Marginal Cost Approach

  • Marginal revenue

    • Change in total revenue from producing one more unit of output

      • MR = ΔTR / ΔQ

  • Tells us how much revenue rises per unit increase in output


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The Marginal Revenue and Marginal Cost Approach

  • What does it mean when MR is positive?

  • 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


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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 _____ than marginal cost (MR __ MC)

    • Converse of this statement is also true

      • An increase in output will lower profit whenever marginal revenue is ___ than marginal cost (MR ___ MC)

        What should the firm do when MC>MR?

        What should the firm do when MC<MR?


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Profit Maximization Using Graphs

  • How is the marginal revenue curve related to the total revenue curve

  • Total revenue (TR) is plotted one the vertical axis, and quantity (Q) on the horizontal axis

  • So what is the marginal revenue?


Figure 2a profit maximization l.jpg

Dollars

$3,500

3,000

2,500

2,000

1,500

1,000

500

0

1

1

2

3

4

5

6

7

8

9

10

Output

Figure 2a: Profit Maximization

TC

Profit at 7 Units

Profit at 5 Units

Profit at 3 Units

TR

DTR from producing 2nd unit

DTR from producing 1st unit

Total Fixed Cost


Figure 2b profit maximization l.jpg

Dollars

600

500

400

300

200

100

0

Output

7

1

2

3

4

5

6

8

–100

–200

Figure 2b: Profit Maximization

MC

profit rises

profit falls

MR


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The TR and TC Approach Using Graphs

  • To maximize profit, firm should

    • Produce quantity of output where vertical distance between TR and TC curves is greatest and

    • TR curve lies above TC curve


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The MR and MC Approach Using Graphs

  • Figure 2 also illustrates the MR and MC approach to maximizing profits

  • 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 useful—allows us to look at a diagram of MC and MR curves and immediately identify profit-maximizing output level


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    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

      • Why????


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