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C hapter 9. Maximizing Profit. Economic Principles. Entrepreneurial behavior Total revenue, average revenue, and marginal revenue Profit maximization. Economic Principles. Loss minimization The application of the MR = MC rule Corporate empire building. Profit Maximization.

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c hapter 9

Chapter 9

Maximizing Profit

economic principles
Economic Principles
  • Entrepreneurial behavior
  • Total revenue, average revenue,and marginal revenue
  • Profit maximization

Gottheil - Principles of Economics, 4e

economic principles3
Economic Principles
  • Loss minimization
  • The application of the MR = MC rule
  • Corporate empire building

Gottheil - Principles of Economics, 4e

profit maximization
Profit Maximization

Profit maximization

  • The primary goal of a firm: To achieve the most profit possible from its production and sale of goods or services.

Gottheil - Principles of Economics, 4e

entrepreneurs and profit making
Entrepreneurs and Profit Making

Entrepreneurs must make production decisions that require some degree of expertise in both the mechanics of production and in accounting.

Gottheil - Principles of Economics, 4e

entrepreneurs and profit making6
Entrepreneurs and Profit Making

How do entrepreneurs anticipate what prices will be in the future?

  • Entrepreneurs rely on their best judgment, sometimes on a sixth sense.

Gottheil - Principles of Economics, 4e

profit
Profit

Profit

  • Income earned by entrepreneurs.

Gottheil - Principles of Economics, 4e

slide8

EXHIBIT 1 AVERAGE TOTAL COST AND MARGINAL COST OF PRODUCING FISH PER FISHING RUN ($ PER FISH)

exhibit 1 average total cost and marginal cost of producing fish per fishing run
Exhibit 1: Average Total Cost and Marginal Cost of Producing Fish Per Fishing Run

1. If 11,000 fish are for sale at a price of $0.75, then (using the cost data in Exhibit 1) what is the profit per fish?

  • Profit per fish is (P - ATC).

Gottheil - Principles of Economics, 4e

exhibit 1 average total cost and marginal cost of producing fish per fishing run10
Exhibit 1: Average Total Cost and Marginal Cost of Producing Fish Per Fishing Run

1. If 11,000 fish are for sale at a price of $0.75, then (using the cost data in Exhibit 1) what is the profit per fish?

  • Profit/fish = $(0.75 - 0.68) = $0.07.

Gottheil - Principles of Economics, 4e

exhibit 1 average total cost and marginal cost of producing fish per fishing run11
Exhibit 1: Average Total Cost and Marginal Cost of Producing Fish Per Fishing Run

2. What is the total profit from selling 11,000 fish?

  • Total profit is (P - ATC) × Q.

Gottheil - Principles of Economics, 4e

exhibit 1 average total cost and marginal cost of producing fish per fishing run12
Exhibit 1: Average Total Cost and Marginal Cost of Producing Fish Per Fishing Run

2. What is the total profit from selling 11,000 fish?

  • Total profit = (0.75 - 0.68) × 11,000 = $770.

Gottheil - Principles of Economics, 4e

exhibit 1 average total cost and marginal cost of producing fish per fishing run13
Exhibit 1: Average Total Cost and Marginal Cost of Producing Fish Per Fishing Run

3. What happens to profit if price rises to $0.80, and 11,000 fish are to be sold?

  • Total profit at an output level of 11,000 equals (0.80 - 0.68) × 11,000 = $1,320.

Gottheil - Principles of Economics, 4e

exhibit 1 average total cost and marginal cost of producing fish per fishing run14
Exhibit 1: Average Total Cost and Marginal Cost of Producing Fish Per Fishing Run

4. If price rises to $0.80, are fishers better off to increase catch to 12,000 fish?

  • No. Total profit at an output level of 12,000 equals (0.80 - 0.73) × 12,000 = $840.

Gottheil - Principles of Economics, 4e

exhibit 1 average total cost and marginal cost of producing fish per fishing run15
Exhibit 1: Average Total Cost and Marginal Cost of Producing Fish Per Fishing Run

4. If price rises to $0.80, are fishers better off to increase catch to 12,000 fish?

  • As output increases, average total cost rises from $0.68 to $0.73. Therefore even though output rises, total profit falls.

Gottheil - Principles of Economics, 4e

the mr mc rule
The MR = MC Rule

There are two ways to find the most profitable level of production:

  • Calculate total profit for each and every output level.
  • Calculate whether the last unit produced adds to or subtracts from total profit.

Gottheil - Principles of Economics, 4e

the mr mc rule17
The MR = MC Rule

Total revenue (TR)

  • The price of a good multiplied by the number of units sold.
  • TR = P × Q

Gottheil - Principles of Economics, 4e

the mr mc rule18
The MR = MC Rule

Average revenue (AR)

  • Total revenue divided by the quantity of goods or services sold.
  • AR = TR/Q

Gottheil - Principles of Economics, 4e

the mr mc rule19
The MR = MC Rule

If TR = $22,600, and Q = 200, what is AR?

  • AR = ($22,600/200) = $113.

Gottheil - Principles of Economics, 4e

the mr mc rule20
The MR = MC Rule

Marginal revenue (MR)

  • The change in total revenue generated by the sale of one additional unit of goods or services.
  • MR = (change in TR)/(change in Q)

Gottheil - Principles of Economics, 4e

the mr mc rule21
The MR = MC Rule

If TR rises by $10 when output rises by one unit, what is MR?

  • MR = $10/1 = $10.

Gottheil - Principles of Economics, 4e

slide22

EXHIBIT 2A TOTAL AND MARGINAL REVENUE CURVES DERIVED FROM SELLING FISH WHEN P = $0.90

Gottheil - Principles of Economics, 4e

exhibit 2 total and marginal revenue curves derived from selling fish when p 0 90
Exhibit 2: Total and Marginal Revenue Curves Derived from Selling Fish When P = $0.90

1. Why is marginal revenue equal to price in Exhibit 2?

  • TR = P × Q. Since MR = (change in TR)/(change in Q), then when Q increases by one unit, TR increases by an amount equal to price.

Gottheil - Principles of Economics, 4e

exhibit 2 total and marginal revenue curves derived from selling fish when p 0 9026
Exhibit 2: Total and Marginal Revenue Curves Derived from Selling Fish When P = $0.90

1. Why is marginal revenue equal to price in Exhibit 2?

  • For example, if quantity increases from 2 to 3, and if price is $0.90, then the change in TR is $(2.70 - 1.80) = $0.90. The change in Q is 1. Therefore, MR = $0.90/1 = $0.90.

Gottheil - Principles of Economics, 4e

exhibit 2 total and marginal revenue curves derived from selling fish when p 0 9027
Exhibit 2: Total and Marginal Revenue Curves Derived from Selling Fish When P = $0.90

1. Why is marginal revenue equal to price in Exhibit 2?

  • As a result, MR = price. The marginal revenue curve is a horizontal line at the prevailing price.

Gottheil - Principles of Economics, 4e

exhibit 2 total and marginal revenue curves derived from selling fish when p 0 9028
Exhibit 2: Total and Marginal Revenue Curves Derived from Selling Fish When P = $0.90

2. Why is the TR curve in panel a an upward-sloping straight line?

  • The TR curve is upward-sloping because as output increases, TR increases, since TR = P × Q.

Gottheil - Principles of Economics, 4e

exhibit 2 total and marginal revenue curves derived from selling fish when p 0 9029
Exhibit 2: Total and Marginal Revenue Curves Derived from Selling Fish When P = $0.90

2. Why is the TR curve in panel a an upward-sloping straight line?

  • The TR curve is a straight line because its slope is equal to price, which does not change.

Gottheil - Principles of Economics, 4e

exhibit 2 total and marginal revenue curves derived from selling fish when p 0 9030
Exhibit 2: Total and Marginal Revenue Curves Derived from Selling Fish When P = $0.90

3. What is the difference between TR and TR′ at an output level of 11,000?

  • TR at a quantity of 11,000 is $9,900.

Gottheil - Principles of Economics, 4e

exhibit 2 total and marginal revenue curves derived from selling fish when p 0 9031
Exhibit 2: Total and Marginal Revenue Curves Derived from Selling Fish When P = $0.90

3. What is the difference between TR and TR′ at an output level of 11,000?

  • TR′ at a quantity of 11,000 is $5,500.

Gottheil - Principles of Economics, 4e

exhibit 2 total and marginal revenue curves derived from selling fish when p 0 9032
Exhibit 2: Total and Marginal Revenue Curves Derived from Selling Fish When P = $0.90

3. What is the difference between TR and TR′ at an output level of 11,000?

  • (TR - TR′) = $4,400.

Gottheil - Principles of Economics, 4e

applying the mr mc rule
Applying the MR = MC Rule

MR = MC rule

  • The guideline used by a firm to achieve profit maximization.

Gottheil - Principles of Economics, 4e

applying the mr mc rule34
Applying the MR = MC Rule

The profit maximization guideline is to keep adding to production as long as the marginal revenue gained from adding production is greater than the marginal cost incurred from adding it.

  • When MR > MC, increase production.

Gottheil - Principles of Economics, 4e

slide35

EXHIBIT 3 KEY DATA ON PROFIT MAXIMIZATION

Gottheil - Principles of Economics, 4e

exhibit 3 key data on profit maximization
Exhibit 3: Key Data on Profit Maximization

1. If quantity is 6,000 in Exhibit 3, what should a firm do?

  • Increase quantity
  • Keep quantity the same
  • Reduce quantity

Gottheil - Principles of Economics, 4e

exhibit 3 key data on profit maximization37
Exhibit 3: Key Data on Profit Maximization

1. If quantity is 6,000 in Exhibit 3, what should a firm do?

  • Increase quantity
  • Keep quantity the same
  • Reduce quantity

Gottheil - Principles of Economics, 4e

exhibit 3 key data on profit maximization38
Exhibit 3: Key Data on Profit Maximization

2. If quantity is 14,000 in Exhibit 3, what should a firm do?

  • Increase quantity
  • Keep quantity the same
  • Reduce quantity

Gottheil - Principles of Economics, 4e

exhibit 3 key data on profit maximization39
Exhibit 3: Key Data on Profit Maximization

2. If quantity is 14,000 in Exhibit 3, what should a firm do?

  • Increase quantity
  • Keep quantity the same
  • Reduce quantity

Gottheil - Principles of Economics, 4e

slide40

EXHIBIT 4 APPLYING THE MR = MC RULE

Gottheil - Principles of Economics, 4e

exhibit 4 applying the mr mc rule
Exhibit 4: Applying the MR = MC Rule

If quantity is 13,000 in Exhibit 4, is profit maximized?

  • No. Since the MC curve is above MR curve, profit is smaller at 13,000 than if output is set at 10,000.

Gottheil - Principles of Economics, 4e

maximizing profit on israel s kibbutzim
Maximizing Profit on Israel’s Kibbutzim

According to Professors Levhari and Barkai, does a kibbutz behave as if it were a profit-maximizing firm?

  • Yes. While the trademark of the kibbutz is universal equality, this goal does not interfere with maximizing profit from the kibbutz’s agricultural and manufacturing activities.

Gottheil - Principles of Economics, 4e

maximizing profit on israel s kibbutzim43
Maximizing Profit on Israel’s Kibbutzim

According to Professors Levhari and Barkai, does a kibbutz behave as if it were a profit-maximizing firm?

  • Evidence for profit-maximizing behavior includes a kibbutz switching from one crop to another based on relative prices.

Gottheil - Principles of Economics, 4e

determining maximum profit
Determining Maximum Profit

The formula for determining maximum profit is:

  • (P - ATC) × Qmax.
  • Note that Qmax is the profit-maximizing output level.

Gottheil - Principles of Economics, 4e

slide45

EXHIBIT 5 MEASURING PROFIT MAXIMIZATION

Gottheil - Principles of Economics, 4e

exhibit 5 measuring profit maximization
Exhibit 5: Measuring Profit Maximization

Using the information in Exhibit 5, what is total profit when output is 10,000, price is $0.90, and ATC is $0.645?

  • Profit is $2,550.

Gottheil - Principles of Economics, 4e

exhibit 5 measuring profit maximization47
Exhibit 5: Measuring Profit Maximization

Using the information in Exhibit 5, what is total profit when output is 10,000, price is $0.90, and ATC is $0.645?

  • $2,550 = $(0.90-0.645) × 10,000.

Gottheil - Principles of Economics, 4e

exhibit 5 measuring profit maximization48
Exhibit 5: Measuring Profit Maximization

Using the information in Exhibit 5, what is total profit when output is 10,000, price is $0.90, and ATC is $0.645?

  • Total profit of $2,550 is represented graphically as the area of the shaded rectangle in Exhibit 5.

Gottheil - Principles of Economics, 4e

maximizing profit and minimizing loss
Maximizing Profit and Minimizing Loss

Loss minimization

  • Faced with the certainty of incurring losses, the firm’s goal is to incur the lowest loss possible from its production and sale of goods and services.

Gottheil - Principles of Economics, 4e

maximizing profit and minimizing loss50
Maximizing Profit and Minimizing Loss

If price is less than ATC, but greater than AVC, the firm is better off to produce where MR = MC in the short run, even though profit is negative.

Gottheil - Principles of Economics, 4e

maximizing profit and minimizing loss51
Maximizing Profit and Minimizing Loss

The reason is that if price is less than ATC, but greater than AVC, all variable costs are being paid with revenue, and there is a bit left over to apply toward fixed cost.

Gottheil - Principles of Economics, 4e

maximizing profit and minimizing loss52
Maximizing Profit and Minimizing Loss

If instead the firm shut down when ATC > P > AVC, then the firm would have no revenue to apply toward fixed cost.

Gottheil - Principles of Economics, 4e

maximizing profit and minimizing loss53
Maximizing Profit and Minimizing Loss

Example: Suppose that price is $0.45, AVC = $0.31, output is 7,000, and TFC = $2,000. Should the firm produce or shut down?

  • If the firm produces, then ignoring TFC, the firm clears $(0.45 - 0.31) × 7,000 = $980.

Gottheil - Principles of Economics, 4e

maximizing profit and minimizing loss54
Maximizing Profit and Minimizing Loss

Example: Suppose that price is $0.45, AVC = $0.31, output is 7,000, and TFC = $2,000. Should the firm produce or shut down?

  • This $980 can be applied to paying off part of the $2,000 TFC.

Gottheil - Principles of Economics, 4e

maximizing profit and minimizing loss55
Maximizing Profit and Minimizing Loss

Example: Suppose that price is $0.45, AVC = $0.31, output is 7,000, and TFC = $2,000. Should the firm produce or shut down?

  • If instead the firm were to shut down, there would be no revenue to apply toward paying the $2,000 fixed cost.

Gottheil - Principles of Economics, 4e

maximizing profit and minimizing loss56
Maximizing Profit and Minimizing Loss

Shutdown

  • The cessation of the firm’s activity. The firm’s loss minimization occurs at zero output.

Gottheil - Principles of Economics, 4e

maximizing profit and minimizing loss57
Maximizing Profit and Minimizing Loss

If price is less than both ATC and AVC, the firm is better off to shut down rather than produce.

Gottheil - Principles of Economics, 4e

maximizing profit and minimizing loss58
Maximizing Profit and Minimizing Loss

If price is less than AVC then total revenue is less than total variable cost. Since the entire total variable cost can be avoided by shutting down, the firm is better off to shut down.

Gottheil - Principles of Economics, 4e

maximizing profit and minimizing loss59
Maximizing Profit and Minimizing Loss

If instead the firm were to produce rather than shut down when P < AVC, then the loss would be TFC + (AVC - P) × Q. The firm is better off to shut down and incur a loss of TFC.

Gottheil - Principles of Economics, 4e

slide60

EXHIBIT 6 MINIMIZING LOSS

Gottheil - Principles of Economics, 4e

exhibit 6 minimizing loss
Exhibit 6: Minimizing Loss

1. Using the data in Exhibit 6, what output level should the firm produce if price is $0.45?

  • Loss is minimized when the firm produces a quantity of 7,000.

Gottheil - Principles of Economics, 4e

exhibit 6 minimizing loss62
Exhibit 6: Minimizing Loss

1. Using the data in Exhibit 6, what output level should the firm produce if price is $0.45?

  • MR = MC at a quantity of 7,000, and the loss is $(0.45 - 0.60) × 7,000 = -$1,050.

Gottheil - Principles of Economics, 4e

exhibit 6 minimizing loss63
Exhibit 6: Minimizing Loss

2. Using the data in Exhibit 6, what output level should the firm produce if price is $0.26?

  • Loss is minimized when the firm shuts down.

Gottheil - Principles of Economics, 4e

exhibit 6 minimizing loss64
Exhibit 6: Minimizing Loss

2. Using the data in Exhibit 6, what output level should the firm produce if price is $0.26?

  • While MR = MC at a quantity of 5,000, AVC is $0.28. Total revenue is $1,300, while TVC = $1,400, and so total revenue falls short of TVC by $100.

Gottheil - Principles of Economics, 4e

do firms really behave this way
Do Firms Really Behave This Way?

What is the Lester-Machlup controversy?

  • Princeton’s Richard Lester challenged the idea that entrepreneurs look to the margin for production signals.

Gottheil - Principles of Economics, 4e

do firms really behave this way66
Do Firms Really Behave This Way?

What is the Lester-Machlup controversy?

  • In a survey conducted by Lester, entrepreneurs responded that they did not think in terms of marginal units.

Gottheil - Principles of Economics, 4e

do firms really behave this way67
Do Firms Really Behave This Way?

What is the Lester-Machlup controversy?

  • Fritz Machlup dismissed Lester’s findings on the grounds that the MR = MC theory of profit maximizing doesn’t depend on what entrepreneurs think they do.

Gottheil - Principles of Economics, 4e

do firms really behave this way68
Do Firms Really Behave This Way?

What is the Lester-Machlup controversy?

  • Rather, the MR = MC theory relies on what they actually do.

Gottheil - Principles of Economics, 4e

empire building
Empire Building

Another challenge to the MR = MC rule is based on the argument that decision-makers are not as one-dimensional as marginalists suggest.

Gottheil - Principles of Economics, 4e

empire building70
Empire Building

For example, stockholders typically want the firm to maximize profit. The firm’s managers, on the other hand, see the firm as more than an economic machine grinding out profit for stockholders.

Gottheil - Principles of Economics, 4e

empire building71
Empire Building

The firm has social, political, and historical dimensions that are important to the firm’s managers.

Gottheil - Principles of Economics, 4e

empire building72
Empire Building

The firm that is run by nonowning managers generally chooses to maximize sales, not profit. Success is measured by the size of the production range.

Gottheil - Principles of Economics, 4e

empire building73
Empire Building

The nonowning manager’s goal is empire building.

Gottheil - Principles of Economics, 4e

empire building74
Empire Building

In John Kenneth Galbraith’s view, the primary goal of managers is the survival of the corporation and, in particular, the survival of its managerial bureaucracy.

Gottheil - Principles of Economics, 4e

stakeholder
Stakeholder

Stakeholder

  • Someone who has a personal and consequential interest in the viability of the firm.

Gottheil - Principles of Economics, 4e

empire building76
Empire Building

According to Lester Thurow, “American government may be bureaucratic and inefficient, but American industry is just as bureaucratic an inefficient.”

Gottheil - Principles of Economics, 4e

empire building77
Empire Building

In Galbraith and Thurow’s view, the preservation of the managerial class, even at the expense of profit, is what managers seek.

Gottheil - Principles of Economics, 4e

what survives of marginalism
What Survives of Marginalism?

In the view of many economists, the criticisms of Galbraith and Thurow are interesting and perhaps even useful in explaining some aspects of corporate behavior.

Gottheil - Principles of Economics, 4e

what survives of marginalism79
What Survives of Marginalism?

Yet many economists also argue that these criticisms offer insufficient evidence to seriously undermine the basic postulates of the marginalist economists: Firms must be guided by the MR = MC rule to maximize profit.

Gottheil - Principles of Economics, 4e