Decision-Making at the firm level - The Goal Of Profit Maximization

• To analyze decision making at the firm, start with a basic question– What is the firm trying to maximize?

• A firm’s owners will usually want the firm to earn as much profit as possible

• We will view the firm as a single economic decision maker whose goal is to maximize its owners’ profit

• Why?– Managers who deviate from profit-maximizing for too long are

typically replaced either by• Current owners or • Other firms who acquire the underperforming firm and then replace

management team with their own– Many managers are well trained in tools of profit-maximization

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– Accounting profit = Total revenue – Accounting costs

• A broader conception of costs (opportunity costs) leads to a second definition of profit– Economic profit = Total revenue – All costs of

production– Or Total revenue – (Explicit costs + Implicit costs)

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 maximum price it can charge

• Leads to an alternative definition– Shows maximum price firm can charge to sell any

given amount of output

Figure 1: The Demand Curve Facing The Firm

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?

• Because once we know the level of output, we also know the highest price the firm can charge

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

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 “least cost method” of

production

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

The Marginal Revenue and Marginal Cost Approach

• Marginal revenue–Change in total revenue from

producing one more unit of output• MR = ΔTR / ΔQ

• Tells us how much revenue rises per unit increase in output

The Marginal Revenue and Marginal Cost Approach

• Important things to notice about marginal revenue– When MR is positive, an increase in output causes total revenue to

rise– Each time output increases, MR is smaller 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

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

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 one 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

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

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

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

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 MC = MR• 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

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

What About Average Costs?

• Different types of average cost (ATC, AVC, and AFC) are irrelevant to earning the greatest possible level of profit– Common error—sometimes made even by business managers—

is to use average cost in place of marginal cost in making decisions

• Problems with this approach– ATC includes many costs that are fixed in short-run—including cost of all

fixed inputs such as factory and equipment and design staff– ATC changes as output increases

• Correct approach is to use the marginal cost and to consider increases in output one unit at a time– Average cost doesn’t help at all; it only confuses the issue

• Average cost should not be used in place of marginal cost as a basis for decisions

Figure 3: Two Points of Intersection

Q1 Q*

Dollars

Output

AMC

B

MR

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