Chapter 7The Goal Of Profit MaximizationTwo Definitions of ProfitThe Firm’s ConstraintsDemand and Total RevenueSlide 6The Cost ConstraintThe Profit-Maximizing Output LevelProfit Maximization: TR-TCSlide 10Using MR and MC to Maximize ProfitsProfit Maximization: MR=MCSlide 13Dealing with LossesSlide 15Slide 16Slide 17The Long Run: The Exit DecisionGetting It WrongGetting It RightPublic GoodsSlide 22Private, Public and Mixed GoodsAsymmetric informationMarket and Government SolutionsChapter 7How Firms Make Decisions:Profit MaximizationECONOMICS: Principles and Applications, 4e HALL & LIEBERMAN, © 2008 Thomson South-Western2The Goal Of Profit Maximization•The firm –A single economic decision maker–Goal: to maximize its owners’ profit•Profit–Sales revenue minus costs of production3Two Definitions of Profit•Accounting profit –Total revenue minus accounting costs•Economic profit –Total revenue minus all costs of production–Recognizes all the opportunity costs of production - both explicit costs and implicit costs4The Firm’s Constraints•Demand curve facing the firm– A curve that indicates, for different prices, the quantity of output that customers will purchase from a particular firm.–Maximum price the firm can charge to sell any given amount of output•Total revenue–The total inflow of receipts from selling a given amount of output5Demand and Total Revenue•Figure 1 The Demand Curve Facing the Firm6Demand and Total Revenue•Figure 1 The Demand Curve Facing the FirmPricePer BedNumber of BedFrames per Day$60045025Demand CurveFacing Ned’s Beds7The Cost Constraint•For any level of output the firm might want to produce, it must pay the cost of the “least cost method” of production –Production function–Prices of inputs•Total cost – implicit and explicit costs8The Profit-Maximizing Output Level•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 > TR9Profit Maximization: TR-TCTotal Fixed CostTCTRTR from producing 2nd unitTR from producing 1st unitProfit at 3 UnitsProfit at 5 Units$3,5003,0002,5002,0001,5001,000500OutputDollars1 210 3 4 5 6 7 8 9 10Profit at 7 Units•Figure 2 Profit MaximizationMaximize Profit = TR-TC-greatest vertical distance between TR and TC curves-TR curve above the TC curve.10The Profit-Maximizing Output Level•Marginal revenue–The change in total revenue from producing one more unit of output MR=ΔTR/ΔQ–how much revenue rises per unit increase in output•Increase in output•revenue gain - from selling additional output•revenue loss - lower the price on all output11Using 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•Average costs (ATC, AVC, AFC)–Irrelevant to profit maximization12Profit Maximization: MR=MCprofit rises profit fallsMCMR0600500400300200100–100–200OutputDollars1 2 3 4 5 678$7009 10•Figure 2 Profit MaximizationMaximize profit: MR=MC- MC and MR curves intersect.13Profit Maximization: MR=MCQ1Q*DollarsOutputAMCBMR•Figure 3 Two Points of IntersectionProfit-maximizing output level-MC curve crosses MR curve from below14Dealing with Losses•Shutdown rule–In the short run, the firm should continue to produce if total revenue exceeds total variable costs; otherwise, it should shut down•MR=MC, Q*; in the short run:–If TR>TVC - keep producing–If TR < TVC - shut down–If TR = TVC - indifferent between shutting down and producing15Dealing with Losses•Figure 4 Loss Minimization (a)TCTVCTRDollarsOutputTFCLoss at Q* TR>TVC Loss <TFCTFCQ*16Dealing with LossesMCMR Q*DollarsOutput•Figure 4 Loss Minimization (b)17TRDealing with Losses•Figure 5 Shut DownTCTVCDollarsOutputTFCLoss at Q* , TVC>TRShut down, produce nothing, Loss=TFC in the short runTFCQ*18The Long Run: The Exit Decision•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 all19Getting It Wrong•The Failure of Franklin National Bank •Mid-1970’s - Franklin National Bank–Went bankrupt•Calculated average cost to the bank of a dollar in loanable funds = 7¢ •Interest rates = 9 to 9.5% •Approved loans to reputable borrowers at 8%•The bank - borrowed at 9 to 11%; •Profits decreased20Getting It Right•The Success of Continental Airlines–Mid 1960s - Other airlines•Offered a flight if 65% of seats sold•Used average cost to make decisions–Continental Airlines•Flying jets filled to just 50% capacity•Expanded flights on many routes•Increase profits•Used marginal cost approach to make decisions21Public Goods•Rivalry–One person’s consumption of a unit of a good or service means that no one else can consume that unit•Excludability–The ability to exclude those who do not pay for a good from consuming it•Pure private good–Is both rivalrous and excludable22Public Goods•Pure public good–Nonrival and nonexcludable –Provided by government without charge•Marketable public good–Excludable and nonrival –Provided by the market for a price•Common Resource–Nonexcludable and rival–Free of charge23Private, Public and Mixed GoodsNonexcludableExcludableMarketable Public Goods•Software•Digital Music and VideoPure Public Good•National Defense•Legal System•Urban parksCommon Resources•Fish in international waters•Earth’s atmospherePure Private Good •Food•Clothing•Housing Rival Nonrival•Figure 5 Pure Private, Pure Public and Mixed Goods24Asymmetric information•One party to a transaction has relevant information not known by the other party–Adverse selection – quality–Moral hazard - lack of information about someone’s future behavior–Principal–agent problem25Market and Government Solutions•Market solutions:–Reputation–Behavior–Contingent contract•Government
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