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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

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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?

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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

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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

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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

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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—which is the number of units of output times the price per unit—follows automatically

TR=P*Q

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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

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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

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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

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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

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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 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

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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

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Figure 2a: Profit Maximization

Total Fixed Cost

TC

TR

TR from producing 2nd unit

TR from producing 1st unit

Profit at 3 Units

Profit at 5 Units

$3,500

3,000

2,500

2,000

1,500

1,000

500

Output

Dollars

1 210 3 4 5 6 7 8 9 10

Profit at 7 Units

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Figure 2b: Profit Maximization

profit rises profit falls

MC

MR

0

600

500

400

300

200

100

–100

–200

Output

Dollars

1 2 3 4 5 6 7 8

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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

• 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

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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

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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

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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

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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

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Figure 3: Two Points of Intersection

Q1 Q*

Dollars

Output

AMC

B

MR

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Figure 4: Loss Minimization

Q*

Dollars

Output

TFC

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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

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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

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Figure 4: Loss Minimization

MC

MR Q*

Dollars

Output

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Figure 5: Shut Down

Q*

TC

TR

TVC

TFC

TFC

Loss at Q*

Dollars

Output

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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