Microeconomics Principles and

Applications 6th Edition Hall Solutions

Manual
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 CHAPTER 8
HOW FIRMS MAKE DECISIONS: PROFIT MAXIMIZATION

SPECIAL NOTE:

While most other texts present the theory of the firm in the context of pure competition, Hall
and Lieberman develop the theory first for a generic, imperfectly competitive firm. This has
two key advantages:

• First, students find the case of pure competition—with its horizontal demand curve—
unfamiliar and counterintuitive. It seems natural to them that a firm will have to lower
its price in order to sell more output, i.e., that the firm faces a downward-sloping
demand curve. Students have an easier time mastering the theory of profit
maximization when it is presented in the familiar world of imperfect competition,
rather than in the quirky world of pure competition.

• Second, by developing the full theory of the firm before pure competition, students can
more easily distinguish which aspects of the theory apply in all market structures (the
marginal approach to profit maximization, the shutdown rule for the short run, the exit
rule for the long run); and which apply only in pure competition (e.g., the horizontal
demand curve, the identity of marginal revenue and price, zero long-run profit, the
existence of a market supply curve, etc.).

MASTERY GOALS

The objectives of this chapter are to:

1. Explain and justify the assumption that firms maximize profit.
2. Use the concept of opportunity cost to explain the difference between accounting
profit and economic profit, and to explain why economic profit is a more useful
concept for understanding the behavior of firms.
3. Discuss what firm owners contribute to production that entitles them to economic
profit.
4. Describe the constraints faced by firms.
5. Use both the total revenue/total cost approach and the marginal revenue/marginal cost
approach (including graphs) to explain how a firm finds its profit-maximizing output
level.
6. Explain how a firm deals with economic losses in the short run (the shutdown rule).
7. Explain how a firm deals with economic losses in the long run (the exit decision).

84
 Chapter 8 How Firms Make Decisions: Profit Maximization 85

THE CHAPTER IN A NUTSHELL

Chapter 8 explains how a firm sets its price and output level in the short run under the
assumption that the firm’s goal is to maximize its economic profit. Economic profit is the
difference between a firm’s sales revenue and all of its costs of production, including implicit
costs. Since implicit costs are important in understanding the behavior of firms, economic
profit is used instead of accounting profit. Accounting profit is the difference between a firm’s
sales revenue and its accounting costs. Accounting costs generally do not include implicit
costs.
Firms face revenue and cost constraints. The demand curve facing a firm shows the maximum
price the firm can charge to sell any given amount of output. From the demand curve, we can
derive the firm’s total revenue for each quantity of output it might choose to produce.
Marginal revenue is the change in total revenue from producing one more unit of output. The
firm uses its production function, and the prices is must pay for its inputs, to determine the
least-cost method of producing any given output level. Therefore, for any level of output the
firm might want to produce, it must pay the cost of the “least-cost method” of production.
There are two approaches to finding a firm’s short-run profit-maximizing level of output. In
the total revenue and total cost approach, the firm calculates profit as the difference between
total revenue and total cost, and produces the quantity of output where profit is greatest. In the
marginal revenue and marginal cost approach, the firm maximizes profit when it sets marginal
revenue equal to marginal cost. These two approaches are demonstrated with tables and
graphs.
If a firm finds that, no matter what output level it chooses, it suffers an economic loss in the
short run, its goal changes to loss minimization. In the short run, a firm should operate—even
with a loss—as long as its total revenue is great enough to cover its total variable costs. It
should shut down if total revenue is less than total variable costs, and should be indifferent
between shutting down and producing if total revenue is equal to total variable costs. In the
long run, by contrast, a firm should exit the industry when it has any size loss.
The chapter ends with two real-world examples of firms that failed or succeeded—based on
their ability to use marginal revenue-marginal cost analysis to maximize profit.

DEFINITIONS
In order presented in chapter.

Accounting profit: Total revenue minus accounting costs.

Economic profit: Total revenue minus all costs of production, explicit and implicit.

Demand curve facing the firm: A curve that indicates, for different prices, the quantity of
output that customers will purchase from a particular firm.
Total revenue: The total inflow of receipts from selling a given amount of output.
86 Instructor’s Manual for Economics: Principles and Applications, 6e

Loss: The difference between total cost (TC) and total revenues (TR) when TC>TR.

Marginal revenue: The change in total revenue from producing one more unit of output.

Marginal approach to profit: A firm maximizes its profit by taking any action that adds more
to its revenue than to its cost.

Shutdown rule: in the short run, the firm should continue to produce if total revenue exceeds
total variable costs; otherwise it should shut down.

Exit: A permanent cessation of production when a firm leaves an industry.

TEACHING TIPS

1. Students often have questions about how long the short run lasts. Emphasize that the
short run lasts as long as some resource is fixed, and this will be different for different
firms. Ask them to come up with examples of different industries, identify the inputs
that would be fixed for the greatest length of time, and thereby determine how long it
would take for a firm in that industry to vary all its inputs. For example, it may take
just a few weeks for a moving company to increase or decrease the quantity of its
“most fixed” input (trucks), while it may take many months for an airline to do the
same.
2. Remind students that the one big question they should learn to answer in this chapter
is “How many units of output should a firm produce in the short run?” To answer this
question, they must learn how to interpret the relationships between TR and TC, and
TR and TVC. Fortunately, there are only five possible situations to remember that they
learned by following these steps:
Step 1. Check to see if TR ever exceeds TC. If it does, then produce the quantity of
output that maximizes the difference between TR and TC. Earn an economic profit.
Step 2. If TR never exceeds TC then check to see if TR ever equals TC. If it does, then
produce the quantity of output where TR and TC are equal. Earn zero economic profit
(which is positive accounting profit).
Step 3. If TR is always less than TC then (1) compare TR to TVC, as follows, to decide
how much output to produce in the short run, and (2) make plans to exit the industry.
a. Check to see if TR exceeds TVC. If so, produce the quantity of output that
maximizes the difference between TR and TVC. Earn an economic loss, but use TR
to cover all variable costs and some fixed costs. Operate under these conditions
until exit is possible.
b. If TR never exceeds TVC, check to see if TR ever equals TVC. If so, produce the
quantity of output where TR equals TVC. Earn an economic loss, but use TR to
cover all variable costs. Fixed costs must be covered out of the owners’ pockets.
Operate under these conditions until exit is possible.
 Chapter 8 How Firms Make Decisions: Profit Maximization 87

c. If TR is always less than TVC, then produce 0 units of output in the short run. Earn
an economic loss. Incur no variable costs. Fixed costs must be covered out of the
owners’ pockets. Operate under these conditions until exit is possible.
3. The steps in Tip 2 can also be organized into a flow chart.

DISCUSSION STARTERS

1. Students frequently have problems understanding the logic behind the short-run
shutdown rule. They mistakenly think that a firm should operate with a loss as long as
TR exceeds TFC. Here is a useful counterexample: Provide the numbers for columns
1–4 for the following table. Have students complete columns 5–7, and use their
answers to demonstrate that, although this firm can cover its TFC at 8 or more units of
output, it does not minimize its losses at these levels. It minimizes losses by shutting
down in the short run, where the firm’s owners pay only $40 out of their pockets.
(1) (2) (3) (4) (5) (6) (7)
Quantity Price per TFC TVC TC TR Out-of-
of unit of Pocket
Output Output Losses
0 $5 $40 $0 $40 $0 –$40
1 5 40 50 90 5 –85
2 5 40 40 80 10 –70
3 5 40 30 70 15 –55
4 5 40 40 80 20 –60
5 5 40 50 90 25 –65
6 5 40 60 100 30 –70
7 5 40 70 110 35 –75
8 5 40 80 120 40 –80
9 5 40 90 130 45 –85
10 5 40 100 140 50 –90

ANSWERS, SOLUTIONS, AND EXERCISES

PROBLEM SET
1. Explicit cost: $30 for gas, motel, lift tickets, and miscellaneous expenses
Implicit cost: $30 for Saturday wages
$30 for Sunday wages
Total cost: $90
2. a. Annual explicit costs:
cost of office equipment: $3,600
programmer’s salary: 25,000
heat and light: $50  12 = 600
total explicit costs: $29,200
88 Instructor’s Manual for Economics: Principles and Applications, 6e

b. Annual implicit costs:

salary foregone: $35,000
investment income
foregone: $10,000  .05 = 500
rent foregone: $250  12 = 3,000
total implicit costs: $38,500
c. Congratulations are not in order since economic profit for the year is $55,000 –
($29,200 + $38,500) = –$12,700.
3. To answer this question, it helps to first construct the following table:
Quantity Total Marginal Total Marginal Total
Revenue Revenue Cost Cost Profit
0 0 $200,000 –$200,000
$225,000 $50,000
1 $225,000 $250,000 –$25,000
$125,000 $25,000
2 $350,000 $275,000 $75,000
$100,000 $50,000
3 $450,000 $325,000 $125,000
$50,000 $75,000
4 $500,000 $400,000 $100,000
–$50,000 $100,000
5 $450,000 $500,000 –$50,000

a. From the table, marginal revenue of increasing output from 2 to 3 units is

$100,000; marginal cost of the fifth unit produced is $100,000.
b. To maximize total revenue, Titan should produce 4 units of output. To maximize
total profit, Titan should produce 3 units of output.
c. Titan’s fixed cost is $200,000. Marginal cost first declines and then increases as
output increases.
4. The profit-maximizing level of output is 14. As the firm chooses to produce the 11th,
12th and 13th unit MR>MC so it is clear that they should continue to increase their
quantity and thereby increase profits. As the firm considers the production of the 14th
unit they see that MR=MC, i.e. they cannot make any additional profit by producing
the 14th unit. Hence, we deduce that the firm is indifferent between producing 13 or 14
units because their overall profit is the same. They would definitely not produce the
15th unit as MR<MC, which indicates that they would earn negative profit on the 15th
unit, or equivalently that their overall profit would be lower if they produced 15 units
than if they produced 14.
 Chapter 8 How Firms Make Decisions: Profit Maximization 89

5. Firm A
Quantity Total Marginal Total Marginal Total
Revenue Revenue Cost Cost Variable
Cost
0 0 $250 0
$125 $150
1 $125 $400 $150
$75 $100
2 $200 $500 $250
$25 $50
3 $225 $550 $300
–$25 $50
4 $200 $600 $350
–$75 $100
5 $125 $700 $450

In the short run, this firm should not produce since its marginal cost exceeds its
marginal revenue at all levels of output. ALTERNATIVELY, it should shut down
since total variable cost exceeds total revenue at EVERY level of output.
Firm B
Quantity Total Marginal Total Marginal Total
Revenue Revenue Cost Cost Variable
Cost
0 0 $500 0
$500 $200
1 $500 $700 $200
$300 $200
2 $800 $900 $400
$100 $200
3 $900 $1100 $600
–$100 $200
4 $800 $1300 $800
–$300 $200
5 $500 $1500 $1000

In the short run, the firm should produce 2 units of output, since its marginal revenue
exceeds its marginal cost as it moves from 0 to 1 and 1 to 2 units of output. When
output rises from 2 to 3 units, the marginal revenue of the 3rd unit ($100) is less than
the marginal cost of that unit ($200).
6. a. If the firm’s fixed costs are $3,000 per day, then its variable costs are $7,000 -
$3,000 = $4,000 per day. Since its total revenue is less than this amount, this firm
should shut down in the short run.
90 Instructor’s Manual for Economics: Principles and Applications, 6e

b. Since the firm is earning enough total revenue to cover these variable costs, it
should continue to operate in the short run.
7. a. Your foregone labor income and your foregone interest are implicit costs. The
other costs are all explicit costs.
b. It depends on the change in your electric bill, which presumably varies according
to usage. If your electric bill will increase by less than $800, then you should rent
out your restaurant to The Breakfast Club.
8. a. The tax hike does not affect Ned’s MC and MR curves.
b. Ned should continue to produce 5 beds in the short run.
9. a.
Output Total Marginal
Profit Profit
0 -$300
$250
1 -$50
$350
2 $300
$350
3 $650
$200
4 $850
$50
5 $900
-$100
6 $800
-$250
7 $550
-$400
8 $150
-$550
9 -$400
-$700
10 -$1,100

b. Because we can define marginal profit as MP = MR – MC., then the rule for
finding the profit-maximizing output in terms of marginal profit will say that the
firm should increase output whenever MP > 0 and decrease output when MP < 0.
 Chapter 8 How Firms Make Decisions: Profit Maximization 91

10. a. When price falls from $450 to $400, quantity rises from 5 to 6 units per day.
%∆P = ($400 - $450) / $425 = -11.8%.
%∆Q = (6 – 5) / 5.5 = 18.2%.
ED = 18.2% / 11.8% = 1.54
When price falls from $400 to $350, quantity rises from 6 to 7 units per day.
%∆P = ($350 - $400) / $375 = -13.3%.
%∆Q = (7 – 6) / 6.5 = 15.4%.
ED = 15.4% / 13.3% = 1.16.
When price falls from $350to $300, quantity rises from 7 to 8 units per day.
%∆P = ($300 - $350) / $325 = -15.4%.
%∆Q = (8 – 7) / 7.5 = 13.3%.
ED = 13.3% / 15.4% = 0.86
b. In Table 1, Total revenue rises when output rises from 5 to 6, and from 6 to 7.
These are the output changes for which demand was found to be elastic (ED > 1) in
part a. When demand is elastic, a drop in price (and a rise in quantity) should
increase total revenue. So the rise in total revenue is consistent with the
elasticities.
Total revenue falls when output rises from 7 to 8. For this output change, demand
was found to be inelastic (ED < 1) in part a. When demand is inelastic, a drop in
price (and a rise in quantity) should decrease total revenue. So the behavior of
total revenue is once again consistent with the elasticities.
c. In Table 1, marginal revenue is positive when output rises from 5 to 6, and from 6
to 7. These are the output changes for which demand was found to be elastic (ED
> 1) in part a. When demand is elastic, a drop in price (and a rise in quantity)
should increase total revenue, which means marginal revenue should be positive.
So these values for marginal revenue are consistent with the elasticities.
Marginal revenue is negative when output rises from 7 to 8. For this output
change, demand was found to be inelastic (ED < 1) in part a. When demand is
inelastic, a drop in price (and a rise in quantity) should decrease total revenue,
which means marginal revenue should be negative. So the value of marginal
revenue is once again consistent with the elasticities.
11. a. Total revenue is $10 x 1,000 = $10,000 per year. Total explicit cost is $2,400 per
year. So accounting profit = Total revenue – explicit costs = $10,000 - $2,400 =
$7,600.
b. The $80,000 spent to develop the app is a sunk cost, and not an ongoing cost to the
business. However, the $1,000,000 they could get if they sold the patent creates an
ongoing cost to the business: This money could be invested at 5% per year, giving
them $50,000 in interest. Thus, by continuing to run the business, they forego
interest of $50,000 per year – an implicit cost. Adding this implicit cost to the
explicit cost of the server, total cost = $52,400. Economic profit = Total Revenue
– Total Cost = $10,000 - $52,400 = -$42,400, or a loss of $42,400 per year.
92 Instructor’s Manual for Economics: Principles and Applications, 6e

c. The marginal cost of selling another download is zero, because they pay a flat fee
for their server regardless of how many downloads they sell, and there are no
variable costs for selling an app (at least, none that are mentioned in the problem).
d. In the short run, they should keep operating. The problem tells us that it would
take more than a few months to sell the patent, so they cannot escape the fixed cost
of the foregone interest during this time. And in this problem, there are no variable
inputs, so TVC = 0. Therefore, TR > TVC at their current (p-profit maximizing or
loss minimizing) output level, and the firm should stay open.
e. In the long run, there are no fixed costs (the patent can be sold and the foregone
interest no longer sacrificed). So they should sell the business and exit, because
economic profit is negative (the firm is suffering a loss).
f. If demand is elastic, lowering the price would cause total revenue to increase.
Total cost will not change (because there are no variable costs, more downloads do
not affect costs). With total revenue increasing, and total cost unchanged, profit
will rise. So if demand is elastic over the stated range, $10 would not be the profit
maximizing price. They should lower the price to increase profit. (In fact, they
should lowering the price at least down to $5, because demand is elastic down to
$5. We don’t know if demand remains elastic at prices lower than $5, so can’t say
exactly how low the price should go.)
12. a. Over the short run (a few months), the bakery’s TFC = $4,000 per month, and its
TVC = $1 x 5,000 = $5,000 per month, so TC = TFC + TVC = $4,000 + $5,000 =
$9,000. The bakery’s total revenue is $1.50 x 5,000 = $7,500 per month. So
monthly profit = TR – TC = $7,500 - $9,000 = -$1,500 (a monthly loss of $1,500).
b. Over the short run (for the next few months), the bakery should keep operating,
because TR of $7,5000 is greater than TVC of $5,000. Staying open gives the
bakery an operating profit, and helps it pay its fixed costs.
c. If the bakery’s current plant is also its least cost plant, it will not be able to reduce
costs in the long run. Since it will be suffering a long-run loss, it should exit the
industry in the long run (i.e., after a year has passed and its lease runs out).

MORE CHALLENGING
13. a. The new MR curve will be flat.
b. Each MR figure will now be $275.
c. Ned should now sell 6 beds.
 Chapter 8 How Firms Make Decisions: Profit Maximization 93

14. To answer this question, we need to compare the marginal revenue and marginal cost
of the action. Marginal cost can be computed from average total cost by first
computing total cost.
Unit ATC TC MC
74 $10,000 $740,000
$160,000
75 $12,000 $900,000
$164,000
76 $14,000 $1,064,000

The marginal cost for the 76th unit is $164,000. Marginal revenue of the 76th unit is
what Backus Electronics is offering to pay for it, or $150,000. Howell should not
accept the offer since marginal cost exceeds marginal revenue.

EXPERIENTIAL EXERCISE
Use The Wall Street Journal to find an example of the principal-agent problem. In your
example, who is the agent and who is the principal? Is there evidence that the agent’s interests
conflict with the principal’s and that the agent has the ability to pursue his or her interests?
How can this problem be resolved?