How Firms Make

Decisions:
Profit Maximization
 Objectives

• To identify the decision making of the firms that

leads to profit maximization;

• to become aware of the different goals of profit

maximization;

• To relate and combine the learning of profit

maximization in analyzing the business world.
2
 The Goal Of Profit Maximization

• To analyze decision making at the firm, let’s start with a very

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
3
 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) 4
 Understanding Profit: Two
Definitions of Profit
• Difference between economic profit and accounting
profit is an important one
• When they are confused, some serious (and costly) mistakes
can result
• 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
costs
5
 Why Are There Profits?

• Economists view profit as a payment for two necessary

contributions
• 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 started
6
 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
7
Figure 1: The Demand Curve
Facing The Firm

8
 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
9
 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
10
 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
11
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
12
 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
13
 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
14
 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
15
 Figure 2(a): Profit Maximization
Dollar
s$3,50
0 TC
3,00 Profit at 7
0 Units
2,50 Profit at 5
0 Units
2,00 Profit at 3
0 TR
1,50 Units
0
1,00
ΔTR from producing 2nd
0
50 unit
ΔTR from producing 1st
Total Fixed0 unit
Cost 0 1 2 3 4 5 6 7 8 9 1
016
Output
 Figure 2(b): Profit Maximization
Dollar
s
60
0 MC
50
0
40
0
30
0
20
0
10
0
0
1 2 3 4 5 6 7 8 Output
–10
0 profit profit
–20
rises falls MR
17
0
 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

18
 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
19
 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 20
 Figure 3: Two Points of Intersection
Dollar
s

MC
A

MR

Q Q Output
21

1
*
 What About Average Costs?
• Different types of average cost 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
22
 Dealing With Losses: The Short
Run and the Shutdown Rule
• You might think that a loss-making firm should always shut down its operation
in the short run
• However, it makes sense for some unprofitable firms to continue operating
• The question is
• Should this firm produce at Q* and suffer a loss?
• The answer is yes—if the firm would lose even more if it stopped producing and shut down
its operation

• If, by staying open, a firm can earn more than enough revenue to cover its
operating costs, then it is making an operating profit (TR > TVC)
• Should not shut down because operating profit can be used to help pay fixed costs
• But if the firm cannot even cover its operating costs when it stays open, it should
shut down

23
 Dealing With Losses: The
Short-Run and the Shutdown Rule
• Guideline—called the shutdown rule—for a
loss-making firm
• Let Q* be output level at which MR = MC
• Then in the short-run
• If TR > Q* firm should keep producing
• If TR < Q* firm should shut down
• If TR = Q* firm should be indifferent between shutting down
and producing
• The shutdown rule is a powerful predictor of firms’
decisions to stay open or cease production in
short-run
24
 Figure 4(a): Loss Minimization
Dollar
s

TFC

Q Output
25

*
 Figure 5: Shut Down
Dollar TC
s

Loss at TVC
Q*
TFC

TR
TFC

Q Output
26

*
 Figure 4(b): Loss Minimization
Dollar
s
MC

MR Output
27
Q*
 The Long Run: The Exit Decision

• We only use term shut down when referring to

short-run
• If a firm stops production in the long-run it is termed
an exit
• A firm should exit the industry in long- run
• When—at its best possible output level—it has any loss at
all

28