The Goal Of Profit MaximizationTwo Definitions of ProfitSlide 3Why Are There Profits?The Firm’s Constraints: DemandFigure 1: The Demand Curve Facing The FirmTotal RevenueThe Cost ConstraintTotal Revenue and Total Cost ApproachThe Marginal Revenue and Marginal Cost ApproachSlide 11Using MR and MC to Maximize ProfitsProfit Maximization Using GraphsFigure 2a: Profit MaximizationFigure 2b: Profit MaximizationThe TR and TC Approach Using GraphsThe MR and MC Approach Using GraphsAn Important ProvisoHall & Leiberman; Economics: Principles And Applications, 2004 1The Goal Of Profit Maximization•What is the firm’s goal?•A firm’s owners will want the firm to earn as much profit as possible•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 ownHall & Leiberman; Economics: Principles And Applications, 2004 2Two Definitions of Profit•Profit = sales revenue minus costs of production•Accounting profit = Total revenue – Accounting costs•Economic profit = Total revenue – All costs of production = Total revenue – (Explicit costs + Implicit costs)•This last term is the opportunity cost of productionHall & Leiberman; Economics: Principles And Applications, 2004 3Two Definitions of Profit•Proper measure of profit for understanding and predicting firm behavior is economic profit–Unlike accounting profit, economic profit recognizes all the opportunity costs of production—both explicit and implicit costsHall & Leiberman; Economics: Principles And Applications, 2004 4Why Are There Profits?•Economists view profit as a payment for •Risk-taking–Someone—the owner—had to be willing to take the initiative to set up the business•This individual assumed the risk that business might fail and the initial investment be lost–Innovation•In almost any business you will find that some sort of innovation was needed to get things startedHall & Leiberman; Economics: Principles And Applications, 2004 5The Firm’s Constraints: Demand •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 outputHall & Leiberman; Economics: Principles And Applications, 2004 6Figure 1: The Demand Curve Facing The FirmHall & Leiberman; Economics: Principles And Applications, 2004 7Total 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?•Total revenue— PxQHall & Leiberman; Economics: Principles And Applications, 2004 8The Cost Constraint•Every firm wants to reduce costs, but there is a limit to how low costs can go•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 levelHall & Leiberman; Economics: Principles And Applications, 2004 9Total 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 greatestHall & Leiberman; Economics: Principles And Applications, 2004 10The 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 outputHall & Leiberman; Economics: Principles And Applications, 2004 11The Marginal Revenue and Marginal Cost Approach•What does it mean when MR is positive? •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 outputHall & Leiberman; Economics: Principles And Applications, 2004 12Using 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 _____ than marginal cost (MR __ MC)–Converse of this statement is also true•An increase in output will lower profit whenever marginal revenue is ___ than marginal cost (MR ___ MC)What should the firm do when MC>MR?What should the firm do when MC<MR?Hall & Leiberman; Economics: Principles And Applications, 2004 13Profit Maximization Using Graphs•How is the marginal revenue curve related to the total revenue curve•Total revenue (TR) is plotted one the vertical axis, and quantity (Q) on the horizontal axis•So what is the marginal revenue?Hall & Leiberman; Economics: Principles And Applications, 2004 14Figure 2a: Profit MaximizationTotal 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 UnitsHall & Leiberman; Economics: Principles And Applications, 2004 15Figure 2b: Profit Maximizationprofit rises profit fallsMCMR0600500400300200100–100–200OutputDollars1 2 3 4 5 678Hall & Leiberman; Economics: Principles And Applications, 2004 16The 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 curveHall & Leiberman; Economics: Principles And Applications, 2004 17The MR and MC Approach Using Graphs•Figure 2 also illustrates the MR and MC approach to maximizing profits•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 levelHall & Leiberman;
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