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Firms’ Decisions. The goal of profit maximization Two definitions of profit The firm’s constraints The total revenue and total cost approach The marginal revenue and marginal cost approach short-run: shut down rule Long-run: exit rule. The Goal Of Profit Maximization.

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Firms decisions
Firms’ Decisions

  • The goal of profit maximization

  • Two definitions of profit

  • The firm’s constraints

  • The total revenue and total cost approach

  • The marginal revenue and marginal cost approach

  • short-run: shut down rule

  • Long-run: exit rule

The goal of profit maximization
The Goal Of Profit Maximization

  • What is the firm trying to maximize?

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

  • We will view the firm as a single economic decision maker whose goal is to_______________

  • Why?

Understanding profit two definitions of profit
Understanding Profit: Two Definitions of Profit

  • 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

    • ____________ = Total revenue – Accounting costs

  • A broader conception of costs (opportunity costs) leads to a second definition of profit

    • ____________= Total revenue – All costs of production

    • Or Total revenue – (Explicit costs + Implicit costs)

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

Why are there profits
Why Are There Profits?

  • Economists view profit as a payment for two necessary contributions

  • 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

The firm s constraints the demand constraint
The Firm’s 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 ________ price it can charge

  • Leads to an alternative definition

    • Shows __________ price firm can charge to sell any given amount of output

Total revenue
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


The cost constraint
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 “__________” of production

The total revenue and total cost approach
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, the firm calculates Profit = TR – TC at each output level

    • Selects output level where profit is greatest

The marginal revenue and marginal cost approach
The Marginal Revenue and Marginal Cost Approach

  • Marginal Cost

    Change in total cost from producing one more unit of output

    • MR = ________

  • Marginal revenue

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

      • MR = _________

  • MR tells us how much revenue rises per unit increase in output

  • The marginal revenue and marginal cost approach1
    The Marginal Revenue and Marginal Cost Approach

    • Important things to notice about marginal revenue

      • When MR is ____, an increase in output causes total revenue to rise

      • Each time output increases, MR is ______ 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

    Using mr and mc to maximize profits
    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

    Profit maximization using graphs
    Profit Maximization Using Graphs

    • Both approaches to maximizing profit (using totals or using marginals) can be seen even more clearly with graphs

    • Marginal revenue curve has an important relationship to total revenue curve

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

      • Slope along any interval is ΔTR / ΔQ

      • Which is the definition of marginal revenue

        • Marginal revenue for any change in output is equal to slope of total revenue curve along that interval

    Figure 2a profit maximization






















    Figure 2a: Profit Maximization


    Profit at 7 Units

    Profit at 5 Units

    Profit at 3 Units


    DTR from producing 2nd unit

    DTR from producing 1st unit

    Total Fixed Cost

    Figure 2b profit maximization




















    Figure 2b: Profit Maximization


    profit rises

    profit falls


    The tr and tc approach using graphs
    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

    The mr and mc approach using graphs
    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 __________

        • 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

    • Different types of average cost (ATC, AVC, and AFC) are irrelevant to earning the greatest possible level of profit

    Using the theory getting it wrong the failure of franklin national bank
    Using The Theory: Getting It Wrong—The Failure of Franklin National Bank

    • In the mid-1970’s, Franklin National Bank—one of the largest banks in the United States—went bankrupt

    • In mid-1974, John Sadlik, Franklin’s CFO, asked his staff to compute average cost to bank of a dollar in loanable funds

      • Determined to be 7¢

      • At the time, all banks—including Franklin—were 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

    Using the theory getting it wrong the failure of franklin national bank1
    Using The Theory: Getting It Wrong—The 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 loans—which never should have been made—caused Franklin’s 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

    Using the theory getting it right the success of continental airlines
    Using The Theory: Getting It Right—The Success of Continental Airlines

    • Continental Airlines was doing something that seemed like a horrible mistake

      • 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

    • Continental’s management, led by its vice-president of operations, had decided to try marginal approach to profit

    An important proviso
    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

    Figure 3 two points of intersection



    Figure 3: Two Points of Intersection







    Figure 4 loss minimization





    Figure 4: Loss Minimization

    Dealing with losses the short run and the shutdown rule
    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

    Dealing with losses the short run and the shutdown rule1
    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

    Figure 4 loss minimization1



    Figure 4: Loss Minimization




    Figure 5 shut down



    Figure 5: Shut Down



    Loss at Q*





    The long run the exit decision
    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