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Slide1
How Firms Make Decisions: Profit Maximization
CHAPTER
1
© 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.Slide2
The Goal of Profit MaximizationThe firmA single economic decision maker
Goal: to maximize its owners’ profitDecisionsWhat price to chargeHow much to produce
2
© 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.Slide3
Understanding ProfitAccounting profit Total revenue minus accounting costsEconomic profit
Total revenue minus all costs of production, explicit and implicitProfitPayment for two contributions of entrepreneurs: risk taking and innovation
3
© 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.Slide4
Understanding Profit4
© 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.Slide5
Understanding Profit5
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Understanding ProfitEconomic profit Proper measure of profit: for
understanding and predicting the behavior of firmsRecognizes all the opportunity costs of productionExplicit costs and implicit costs
6
© 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.Slide7
The Firm’s ConstraintsDemand curve facing the firmTells us, for different prices
The quantity of output that customers will purchase from a particular firmShows us the maximum price the firm can charge to sell any given amount of outputOne firm; All
buyers (potential customers)
7
© 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.Slide8
The table presents information about Ned’s Beds.The Demand Curve Facing the Firm
8
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1Slide9
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.
The Demand Curve Facing the Firm
9
© 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
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 BedsSlide10
The Firm’s ConstraintsTotal revenue, TR The total inflow of receipts from selling a given amount of
outputDemand and total revenueEach time the firm chooses a level of output, it also determines its total
revenue
10
© 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.Slide11
The Firm’s ConstraintsTotal Revenue and ElasticityLower price: sell
more outputIf ED
> 1 (elastic demand): total revenue will riseIf 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
11
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The Profit-Maximizing Output LevelTotal revenue and total cost approachProfit is the difference between TC and TR at each output level
The firm chooses the output level where profit is greatestLoss Difference between total cost (TC) and total revenue (TR)
When TC > TR
12
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The Profit-Maximizing Output LevelMarginal revenue (MR =
ΔTR / ΔQ
)Change in total revenue from producing one more unit of outputChange 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
13
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The Profit-Maximizing Output LevelWhen MR is positiveAn increase in output causes total revenue to rise
When MR is negativeAn increase in output causes total revenue to fallAs output increasesMR is smaller than the price
14
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More Data for Ned’s Beds15
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1Slide16
The Profit-Maximizing Output LevelDownward-sloping demand curveEach increase in output causes
A revenue gain: from selling additional output at the new priceA revenue
loss: from having to lower the price on all previous units of outputMarginal revenue is less than the price of the last unit of output
16
© 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.Slide17
The Profit-Maximizing Output LevelAn increase in outputWill always raise profit as long as MR>MC
Will always lower profit whenever MR<MCMarginal revenue and marginal cost approachProfit-maximizing output level
Increase output whenever MR>MCDecrease output when MR< MC
17
© 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.Slide18
The Profit-Maximizing Output LevelMarginal revenue for any change in outputIs equal to the slope of the total revenue curve along that interval
TC and TR approach using graphsMaximize profitProduce 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
18
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The Profit-Maximizing Output LevelMC and MR approach using graphsMaximize profit
Produce the quantity of output closest to the point where MC = MRMC and MR curves intersectMC curve crosses the MR curve from
below
19
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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
Maximization (a)
20
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2
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
TC
TR
Profit at
7 units
Profit at
3 units
Δ
TR from producing 1st unit
Profit at
5 units
Δ
TR from producing 2nd unit
Total Fixed CostSlide21
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.
Profit Maximization
(b)
21
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2
Dollars
Output
1
2
3
4
6
5
7
8
9
400
10
0
100
200
300
500
600
$700
-100
-200
MR
MC
Profit rises
Profit fallsSlide22
The Profit-Maximizing Output LevelA ProvisoSometimes the MC
and MR curves cross at two different pointsThe profit-maximizing output level is the one at which the MC curve crosses the MR curve from
below
22
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Sometimes the MR and MC curves intersect twice. The profit-maximizing
level of output is always found where MC crosses MR from below
.Two Points of Intersection
23
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3
Dollars
Output
Q
1
Q
*
MR
MC
B
ASlide24
The Profit-Maximizing Output LevelAverage costsIrrelevant 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
24
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Dealing with LossesShutdown rule in the short runThe 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 producingIf TR < TVC at Q*, the firm should shut downIf TR = TVC at Q*, the firm should be indifferent between shutting down and producing
25
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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.
Loss
Minimization
26
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4
Dollars
Output
Q
*
TC
TR
TFC
TFC
TVC
Loss at Q
*
Dollars
Output
Q
*
MC
MRSlide27
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.Shut Down
27
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5
Dollars
Output
Q
*
TR
TFC
TFC
TVC
Loss at Q
*
TCSlide28
Dealing with LossesExit A permanent cessation of production when a firm leaves an industry
In the long runA firm should exit the industry when—at its best possible output level—it has any loss at all
28
© 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.Slide29
Getting It Wrong: The Failure of Franklin National Bank
Mid-1974s, Franklin National Bank’s manager
Average cost of $1 in loans = 7 centsOffered loans at 8% interest (MR)Borrowed in federal funds market at 9-11%
interest (MC)
29
© 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.Slide30
Getting It Right: Continental Airlines
1960’s, all other airlinesOffer a flight only if, on average, 65% of the seats could be filled with paying passengers
ATC = $4,000 per flight
30
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Getting It Right: Continental Airlines
Continental Airlines
Flying jets filled to just 50% of capacityExpanding flights on many routesHigher profitsMC = $2,000 per flight
31
© 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.