How Firms Make Decisions: Profit Maximization CHAPTER How Firms Make Decisions: Profit Maximization © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Understanding Profit Accounting profit Economic profit 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Understanding Profit © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Understanding Profit © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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) © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 The Demand Curve Facing the Firm The table presents information about Ned’s Beds. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Demand Curve Facing Ned’s Beds 1 The Demand Curve Facing the Firm Price per Bed Number of Bed Frames per Day 1 2 3 4 6 5 7 8 9 200 10 450 $600 Demand Curve Facing Ned’s Beds 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. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

1 More Data for Ned’s Beds © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Profit Maximization (a) Dollars Output 1 2 3 4 6 5 7 8 9 500 10 1,000 $3,500 1,500 2,000 2,500 3,000 Panel (a) shows the firm’s total revenue (TR) and total cost (TC) curves. Profit is the vertical distance between the two curves at any level of output. Profit is maximized when that vertical distance is greatest—at 5 units of output. Profit at 7 units TR TC Profit at 5 units Profit at 3 units ΔTR from producing 2nd unit ΔTR from producing 1st unit Total Fixed Cost © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2 Profit Maximization (b) Dollars Output 1 2 3 4 6 5 7 8 9 400 10 100 100 200 300 500 600 $700 -100 -200 Panel (b) shows the firm’s marginal revenue (MR) and marginal cost (MC) curves. Profit is maximized at the level of output closest to where the MR and MC curves cross—at 5 units of output. MC MR Profit rises Profit falls © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

3 Two Points of Intersection Dollars Output MC MR A B 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. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

4 Loss Minimization Dollars TC Loss at Q* TVC TR TFC TFC Output Q* The firm shown here cannot earn a positive profit at any level of output. If it produces anything, it will minimize its loss by producing where the vertical distance between TR and TC is smallest. Because TR exceeds TVC at Q*, the firm will produce there in the short run. TVC TR TFC TFC Q* Dollars Output MC MR Q* © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

5 Shut Down Dollars TC TVC Loss at Q* TFC TR TFC Output Q* 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. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Dealing with Losses Exit In the long run 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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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) © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

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 © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Getting It Right: Continental Airlines Flying jets filled to just 50% of capacity Expanding flights on many routes Higher profits MC = $2,000 per flight © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.