1. C hapter 9 Maximizing Profit © 2002 South-Western

2. 2 Economic Principles Entrepreneurial behavior Total revenue, average revenue, and marginal revenue Profit maximization

3. 3 Economic Principles Loss minimization The application of the MR=MC rule Corporate empire building

4. 4 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.

5. 5 Entrepreneurs and Profit Making Entrepreneurs must make production decisions that require some degree of expertise in both the mechanics of production and in accounting.

6. 6 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.

7. 7 Profit Profit Income earned by entrepreneurs.

8. 8 EXHIBIT 1AVERAGE TOTAL COST AND MARGINAL COST OF PRODUCING FISH PER FISHING RUN ($ PER FISH)

9. 9 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).

10. 10 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.

11. 11 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.

12. 12 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.

13. 13 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.

14. 14 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.

15. 15 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.

16. 16 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.

17. 17 The MR=MC Rule Total revenue (TR) The price of a good multiplied by the number of units sold. TR = P*Q

18. 18 The MR=MC Rule Average revenue (AR) Total revenue divided by the quantity of goods or services sold. AR = TR/Q

19. 19 The MR=MC Rule If TR = $22,600, and Q = 200, what is AR? AR = ($22,600/200) = $113.

20. 20 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)

21. 21 The MR=MC Rule If TR rises by $10 when output rises by one unit, what is MR? MR = $10/1 = $10.

22. 22 EXHIBIT 2ATOTAL AND MARGINAL REVENUE CURVES DERIVED FROM SELLING FISH WHEN P = $0.90

23. 23 EXHIBIT 2BTOTAL AND MARGINAL REVENUE CURVES DERIVED FROM SELLING FISH WHEN P = $0.90

24. 24 EXHIBIT 2CTOTAL AND MARGINAL REVENUE CURVES DERIVED FROM SELLING FISH WHEN P = $0.90

25. 25 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.

26. 26 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.

27. 27 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.

28. 28 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.

29. 29 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.

30. 30 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.

31. 31 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.

32. 32 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.

33. 33 Applying the MR=MC Rule MR=MC rule The guideline used by a firm to achieve profit maximization.

34. 34 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.

35. 35 EXHIBIT 3KEY DATA ON PROFIT MAXIMIZATION

36. 36 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.

37. 37 Exhibit 3: Key Data on Profit Maximization 1. If quantity is 6,000 in Exhibit 3, what should a firm do? Increase quantity.

38. 38 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.

39. 39 Exhibit 3: Key Data on Profit Maximization 2. If quantity is 14,000 in Exhibit 3, what should a firm do? Reduce quantity.

40. 40 EXHIBIT 4APPLYING THE MR = MC RULE

41. 41 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.

42. 42 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.

43. 43 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.

44. 44 Determining Maximum Profit The formula for determining maximum profit is: (P-ATC)*Q max. Note that Q max is the profit- maximizing output level.

45. 45 EXHIBIT 5MEASURING PROFIT MAXIMIZATION

46. 46 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.

47. 47 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.

48. 48 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.

49. 49 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.

50. 50 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.

51. 51 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.

52. 52 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.

53. 53 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.

54. 54 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.

55. 55 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.

56. 56 Maximizing Profit and Minimizing Loss Shut down The cessation of the firm’s activity. The firm’s loss minimization occurs at zero output.

57. 57 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.

58. 58 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.

59. 59 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.

60. 60 EXHIBIT 6MINIMIZING LOSS

61. 61 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.

62. 62 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.

63. 63 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.

64. 64 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.

65. 65 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.

66. 66 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.

67. 67 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.

68. 68 Do Firms Really Behave This Way? What is the Lester-Machlup controversy? Rather, the MR=MC theory relies on what they actually do.

69. 69 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.

70. 70 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.

71. 71 Empire Building The firm has social, political, and historical dimensions that are important to the firm’s managers.

72. 72 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.

73. 73 Empire Building The nonowning manager’s goal is empire building.

74. 74 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.

75. 75 Stakeholder Stakeholder Someone who has a personal and consequential interest in the viability of the firm.

76. 76 Empire Building According to Lester Thurow, “American government may be bureaucratic and inefficient, but American industry is just as bureaucratic an inefficient.”

77. 77 Empire Building In Galbraith and Thurow’s view, the preservation of the managerial class, even at the expense of profit, is what managers seek.

78. 78 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.

79. 79 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.