Behzad Azarhoushang How Firms Make Decisions: Profit Maximization

Outline The Goal of Profit Maximization The Firms’ Constraints The Profit-Maximizing Output Level Dealing with Losses

The Goal of Profit Maximization Decision making process Product price Working hours Budget planning Example: Apple iPhone 3G in 2008 Which suppliers? Location of assembly? Advertising budget? What price? Producing 15 million cellphone at $399

What is the firm trying to maximize? Firm as a single economic decision maker whose goal is to maximize its owners’ profit (sake of simplicity) Principle-agent problems Two definitions of profit: Accounting profit = Total revenue – Accounting costs Economic profit = Total revenue – (explicit costs + implicit costs) Profit as payment for two contributions of entrepreneurs: risk taking and innovation (Google) The Goal of Profit Maximization

The Firms’ Constraints Firms faces two constraints: revenue and costs Revenue constraints Demand curve (1): for different prices, the quantity of output that customers will choose to purchase from that firm (individual firm but all buyers) Demand curve (2): shows us the maximum price the firm can charge to sell any given amount of output (one degree of freedom; price or level of output). Firms generally chose the level of output Total revenue: total inflow of receipts from selling output

Cost constraint Every firm would love to decrease costs as much as possible but there is limit for doing so Given production technology determines the different combinations of inputs the firm can use to produce its output. Firms must pay prices for each of the inputs that it used Together, the firm’s technology and the prices of inputs determine the cheapest way to produce any given level of output (looking for cheapest possible way). The Firms’ Constraints

The Profit-Maximizing Output Level How does a firm find the level of output that will earn it the greatest profit? Total revenue and cost approach: The firm’s profit as the difference between total revenue (TR) and total costs (TC) Highest revenue does not always show the highest profit The difference between TC and TR if TC>TR is called Loss The Marginal Revenue and Marginal Cost Approach MR: change in the firms’ TR divided by change in its output (Q) or MR = ∆TR/ ∆Q MC: change in the firms’ TC divided by change in its output (Q) or MC = ∆TC/ ∆Q MR (MC) tells us how much revenue (costs) rises per unit increases in output

When a firm faces a demand curve, each increase in output will lead to gain and loss in revenue due to downward slope of demand curve MR will always equal the difference between the gain and loss in revenue Using MR and MC to maximize profit An increase in output will always rise profit if MR>MC An increase in output will always lower profit if MR<MC To find the profit maximizing output level, the firms should increase output whenever MR>MC, and decrease output whenever MR<MC The Profit-Maximizing Output Level

Profit Maximization using graphs MR for any change in output is equal to the slop of TR curve along that interval MC for any change in output is equal to the slop of TC curve along that interval To maximize profit, the firm should produce the quantity of output where the vertical distance between TR and TC is the greatest and TR lies above TC To maximize profit, the firm should produce the quantity of output closest to the point where MR = MC – that is, the quantity of output at which MR and MC curves intersect A proviso: sometimes MC and MR curves cross at 2 different points. In this case, the profit-maximizing output level is the one at which MC curve crosses MR curve from below The Profit-Maximizing Output Level

What about a firm that cannot earn a positive profit at any output level? What should it do? Depends on time horizon The short-run Paying for fixed costs TC>TR highest profit will be the one with the least negative value (loss minimization) Q* where the distance between TC and TR curve is smallest In marginal approach: MC and MR intersect at Q* Should from suffer from losses? Yes, until its costs is less than TFC Dealing with Losses

Shutdown rule TVC or firm’s operating costs If TR>TVC (operating profit) 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 In the short-run, the firm should continue to produce if total revenue exceeds total variable costs; otherwise, it should shut down. Dealing with Losses

The long-run and the exit decision The shutdown rule applies only in short-run, a time horizon too short for the firm to escape its commitment to pay for fixed inputs Exit: a permanent cessation of production when a firm leaves an industry Dealing with Losses