1. ECON 211 ELEMENTS OF ECONOMICS I
Session 5– Profit Maximization (Part 2)
Lecturer: Dr. (Mrs.) Nkechi S. Owoo, Department of Economics
Contact Information:

2. Session Overview
Session 5 explains how a firm sets its price and output level in the short run under the assumption that the firm’s goal is to maximize its economic profit.
There are two approaches to finding a firm’s short-run profit-maximizing level of output.
In the total revenue and total cost approach, the firm calculates profit as the difference between total revenue and total cost, and produces the quantity of output where profit is greatest.
In the marginal revenue and marginal cost approach, the firm maximizes profit when it sets marginal revenue equal to marginal cost.
These two approaches are demonstrated with tables and graphs.

3. Session Outline
The key topics to be covered in the session are as follows:
Total Revenue and Total Cost Approach
Marginal Revenue and Marginal Cost Approach

4. Reading List
Hall and Lieberman
Chapter 7, pp:

5. The total revenue- total cost approach
Topic One
The total revenue- total cost approach

6. The Profit-Maximizing Output Level
How do firms decide on the level of output that will earn the greatest possible profit?
Profit
Total revenue (TR) minus total cost (TC) at each output level
The firm chooses the output level where profit is greatest
Loss
Total cost (TC) minus total revenue (TR), when TC > TR
Given that we are including all costs (implicit and explicit), the profits and losses are economic profits and losses
In the table below, the profit-maximizing output for Neds Beds is 5 units per day
This is where the difference between total costs and total revenue is greatest, as illustrated on slide 8

7. Demand and Total Revenue
The Demand Curve Facing the Firm

8. Profit Maximization: TR-TC
Maximize Profit = TR-TC
-greatest vertical distance between TR and TC curves
-TR curve above the TC curve.
$3,500
3,000
2,500
2,000
1,500
1,000
500
Output
Dollars 1 2 3 4 5 6 7 8 9 10 TC
Profit at 7 Units
Profit at 5 Units
Profit at 3 Units TR
DTR from producing 2nd unit
DTR from producing 1st unit
Total Fixed Cost

9. The marginal revenue- marginal cost approach
Topic One
The marginal revenue- marginal cost approach

10. The Profit-Maximizing Output Level
There is another way to determine the profit-maximizing output level, using marginal concepts
A firm’s marginal revenue is the change in total revenue from producing one more unit of output .
It may be illustrated mathematically as: MR=ΔTR/ΔQ
The marginal revenue tells us how much revenue rises per unit increase in output

11. The Profit-Maximizing Output Level
There are two things to note about the marginal revenue
When MR is positive, an increase in output causes TR to rise; and when the MR is negative, an increase in output causes TR to fall
Each time output increases, MR is smaller than the price the firm charges at the new output level
This is because of the downward sloping demand curve facing the firm
In order to sell more output, the firm must lower its price

12. Using MR and MC to Maximize Profits
Increase output whenever MR > MC
An increase in output will raise profit if MR > MC
Decrease output when MR < MC
An increase in output will lower profit if MR < MC
Profits are maximized when MR= MC
[Average costs (ATC, AVC, AFC)
Irrelevant to profit maximization]
We can illustrate profit maximization using the MR/MC approach with some graphs

13. Profit Maximization: MR=MC
600
500
400
300
200
100
–100
–200
Output
Dollars 1 2 3 4 5 6 7 8
Maximize profit: MR=MC
- MC and MR curves intersect.
$700 MC 9 10
profit rises
profit falls MR

14. Profit Maximization: MR= MC
To maximize profits, the firm should produce the quantity of output closest to the point where MC= MR, or where the two curves intersect
However, the MC and MR cross at two different points
In this case, the profit-maximizing output level is the one at which the MC curve crosses the MR curve from below
The figure on the next slide illustrates this
Point A cannot be the profit-maximizing output level because below Q1, MC> MR so profits fall as output increases towards Q1.
Profits increase beyond Q1 as MC< MR
Point B is the profit-maximizing output level because once we arrive at Q*, further increases in output will reduce profits

15. Profit Maximization: MR=MC
Two Points of Intersection
Dollars
Output
Profit-maximizing output level
-MC curve crosses MR curve from below MC A B MR Q1 Q*

16. Dealing with Losses
So far, we have dealt with the pleasant case of firms earning profits and how they can select their profit-maximizing output level
But what about a firm that cannot earn profits at any output level?
What should it do?
The answer depends on the time horizon
Short run or long run

17. Dealing with Losses The short run and the Shutdown rule
In the short run, the firm should continue to produce if total revenue exceeds total variable costs; otherwise, it should shut down
i.e. stop producing temporarily
It is not always the case that a loss-making firm should shut down in the short run
It depends on whether it is covering its variable costs or not

18. Dealing with Losses
A firm that is making losses will minimize its losses by producing where the vertical distance between TR and TC is smallest
In the figure below, the firm should keep producing because TR > TVC
This implies that by staying open, the firm can earn more than enough revenue to cover its operating costs
Therefore, this firm would be making an operating profit i.e. (TR> TC), which can help to cover fixed costs

19. Dealing with Losses Loss Minimization (a) TC Dollars Loss at Q*
Output
Loss at Q*
TR>TVC
Loss <TFC
TVC
TFC Q* TR
TFC

20. Dealing with Losses Figure 4 Loss Minimization (b) Dollars Output MCQ* MR

21. Dealing with Losses
On the other hand, if TR< TVC, a firm is suffering an operating loss and should certainly shut down
Continuing to produce only adds to the firms loss, increasing the total loss beyond fixed costs
See the next slide

22. Dealing with Losses Figure 5 Shut Down TC Dollars
Output
Loss at Q* , TVC>TR
Shut down, produce nothing,
Loss=TFC in the short run
TVC
TFC Q* TR
TFC

23. Dealing with Losses
This suggests the following guideline, also called the shutdown rule:
If Q* is the output level at which MR= MC, in the short run:
If TR>TVC - keep producing
If TR < TVC - shut down
If TR = TVC - indifferent between shutting down and producing

24. The Long Run: The Exit Decision
The shut down rule applies only in the short run
A firm may also decide to stop producing in the long run, or exit the market
Exit
A permanent cessation of production when a firm leaves an industry
A firm should exit the industry in the long run when - at its best possible output level - it has any loss at all

25. References
Economics: Principles and Applications: Hall R.E. and Lieberman M. (2008), Thomson/ South Western (4th Edition)