1 Firms’ Decisions The goal of profit maximization Two definitions of profit The firm’s...
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Transcript of 1 Firms’ Decisions The goal of profit maximization Two definitions of profit The firm’s...
1
Firms’ Decisions
• The goal of profit maximization
• Two definitions of profit
• The firm’s constraints
• The total revenue and total cost approach
• The marginal revenue and marginal cost approach
• short-run: shut down rule
• Long-run: exit rule
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The Goal Of Profit Maximization
• What is the firm trying to maximize?
• A firm’s owners will usually want the firm to earn as much _____ as possible
• We will view the firm as a single economic decision maker whose goal is to_______________
• Why?
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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– ____________ = Total revenue – Accounting costs
• A broader conception of costs (opportunity costs) leads to a second definition of profit– ____________= Total revenue – All costs of production– Or Total revenue – (Explicit costs + Implicit costs)
• Proper measure of profit for understanding and predicting firm behavior is economic profit
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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
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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 ________ price it can charge
• Leads to an alternative definition– Shows __________ price firm can charge to sell any
given amount of output
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Figure 1: The Demand Curve Facing The Firm
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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?
• Total revenue—which is the number of units of output times the price per unit—follows automatically
TR=P*Q
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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 “__________” of production
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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
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The Marginal Revenue and Marginal Cost Approach
• Marginal Cost Change in total cost from producing one
more unit of output• MR = ________
• Marginal revenue– Change in total revenue from producing one
more unit of output• MR = _________
• MR tells us how much revenue rises per unit increase in output
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The Marginal Revenue and Marginal Cost Approach
• Important things to notice about marginal revenue– When MR is ____, an increase in output causes total revenue to rise– Each time output increases, MR is ______ 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
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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
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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 on 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
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Figure 2a: Profit Maximization
Total Fixed Cost
TC
TR
TR from producing 2nd unit
TR from producing 1st unit
Profit at 3 Units
Profit at 5 Units
$3,500
3,000
2,500
2,000
1,500
1,000
500
Output
Dollars
1 210 3 4 5 6 7 8 9 10
Profit at 7 Units
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Figure 2b: Profit Maximization
profit rises profit falls
MC
MR
0
600
500
400
300
200
100
–100
–200
Output
Dollars
1 2 3 4 5 6 7 8
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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
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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 __________• 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
• Different types of average cost (ATC, AVC, and AFC) are irrelevant to earning the greatest possible level of profit
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Using The Theory: Getting It Wrong—The Failure of Franklin National Bank
• In the mid-1970’s, Franklin National Bank—one of the largest banks in the United States—went bankrupt
• In mid-1974, John Sadlik, Franklin’s CFO, asked his staff to compute average cost to bank of a dollar in loanable funds– Determined to be 7¢ – At the time, all banks—including Franklin—were
charging interest rates of 9 to 9.5% to their best customers
– Ordered his loan officers to approve any loan that could be made to a reputable borrower at 8% interest
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Using The Theory: Getting It Wrong—The Failure of Franklin National Bank
• Where did Franklin get the additional funds it was lending out?– Were borrowed not at 7%, the average cost of funds,
but at 9 to 11%, the cost of borrowing in the federal funds market
• Not surprisingly, these loans—which never should have been made—caused Franklin’s profits to decrease– Within a year the bank had lost hundreds of millions of
dollars– This, together with other management errors, caused
bank to fail
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Using The Theory: Getting It Right—The Success of Continental Airlines
• Continental Airlines was doing something that seemed like a horrible mistake– Yet Continental’s profits—already higher than industry
average—continued to grow
• A serious mistake was being made by the other airlines, not Continental– Using average cost instead of marginal cost to make
decisions
• Continental’s management, led by its vice-president of operations, had decided to try marginal approach to profit
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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
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Figure 3: Two Points of Intersection
Q1 Q*
Dollars
Output
AMC
B
MR
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Figure 4: Loss Minimization
Q*
Dollars
Output
TFC
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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
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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 >TVC at Q* firm should keep producing• If TR < TVC at Q* firm should shut down• If TR = TVC at 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
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Figure 4: Loss Minimization
MC
MR Q*
Dollars
Output
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Figure 5: Shut Down
Q*
TC
TR
TVC
TFC
TFC
Loss at Q*
Dollars
Output
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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