Transcript Principles of Economics Third Edition by Fred Gottheil

Chapter 9
Maximizing Profit
© 2005 Thomson
Economic Principles
Entrepreneurial behavior
Total revenue, average revenue,
and marginal revenue
Profit maximization
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Economic Principles
Loss minimization
The application of the
MR = MC rule
Corporate empire building
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Profit Maximization
Profit maximization
• The primary goal of a firm: To achieve
the most profit possible from its
production and sale of goods or services.
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Entrepreneurs and Profit
Making
Entrepreneurs must make
production decisions that require
some degree of expertise in both
the mechanics of production and
in accounting.
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Entrepreneurs and Profit
Making
How do entrepreneurs anticipate
what prices will be in the future?
• Entrepreneurs rely on their best
judgment, sometimes on a sixth sense.
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Profit
Profit
• Income earned by entrepreneurs.
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EXHIBIT 1
AVERAGE TOTAL COST AND MARGINAL
COST OF PRODUCING FISH PER FISHING
RUN ($ PER FISH)
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Exhibit 1: Average Total Cost and
Marginal Cost of Producing Fish Per
Fishing Run
1. If 11,000 fish are for sale at a
price of $0.75, then (using the
cost data in Exhibit 1) what is the
profit per fish?
• Profit per fish is (P - ATC).
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Exhibit 1: Average Total Cost and
Marginal Cost of Producing Fish
Per Fishing Run
1. If 11,000 fish are for sale at a
price of $0.75, then (using the
cost data in Exhibit 1) what is the
profit per fish?
• Profit/fish = $(0.75 - 0.68) = $0.07.
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Exhibit 1: Average Total Cost and
Marginal Cost of Producing Fish
Per Fishing Run
2. What is the total profit from
selling 11,000 fish?
• Total profit is (P - ATC) × Q.
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Exhibit 1: Average Total Cost and
Marginal Cost of Producing Fish
Per Fishing Run
2. What is the total profit from
selling 11,000 fish?
• Total profit = (0.75 - 0.68) × 11,000 = $770.
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Exhibit 1: Average Total Cost and
Marginal Cost of Producing Fish
Per Fishing Run
3. What happens to profit if price
rises to $0.80, and 11,000 fish are
to be sold?
• Total profit at an output level of 11,000
equals (0.80 - 0.68) × 11,000 = $1,320.
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Exhibit 1: Average Total Cost and
Marginal Cost of Producing Fish
Per Fishing Run
4. If price rises to $0.80, are fishers
better off to increase catch to
12,000 fish?
• No. Total profit at an output level of 12,000
equals (0.80 - 0.73) × 12,000 = $840.
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Exhibit 1: Average Total Cost and
Marginal Cost of Producing Fish
Per Fishing Run
4. If price rises to $0.80, are fishers
better off to increase catch to
12,000 fish?
• As output increases, average total cost
rises from $0.68 to $0.73. Therefore even
though output rises, total profit falls.
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The MR = MC Rule
There are two ways to find the most
profitable level of production:
• Calculate total profit for each and every
output level.
• Calculate whether the last unit produced
adds to or subtracts
from total profit.
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The MR = MC Rule
Total revenue (TR)
• The price of a good multiplied by the
number of units sold.
TR = P × Q
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The MR = MC Rule
Average revenue (AR)
• Total revenue divided by the quantity of
goods or services sold.
AR = TR/Q
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The MR = MC Rule
If TR = $22,600, and Q = 200,
what is AR?
• AR = ($22,600/200) = $113.
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The MR = MC Rule
Marginal revenue (MR)
• The change in total revenue generated
by the sale of one additional unit of goods
or services.
MR = (change in TR)/(change in Q)
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The MR = MC Rule
If TR rises by $10 when output
rises by one unit, what is MR?
• MR = $10/1 = $10.
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EXHIBIT 2A
TOTAL AND MARGINAL REVENUE
CURVES DERIVED FROM SELLING FISH
WHEN P = $0.90
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EXHIBIT 2B
TOTAL AND MARGINAL REVENUE
CURVES DERIVED FROM SELLING FISH
WHEN P = $0.90
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EXHIBIT 2C TOTAL AND MARGINAL REVENUE
CURVES DERIVED FROM SELLING FISH
WHEN P = $0.90
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Exhibit 2: Total and Marginal Revenue
Curves Derived from Selling Fish When
P = $0.90
1. Why is marginal revenue equal
to price in Exhibit 2?
• TR = P × Q. Since MR = (change in
TR)/(change in Q), then when Q increases
by one unit, TR increases by an amount
equal to price.
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Exhibit 2: Total and Marginal Revenue
Curves Derived from Selling Fish When
P = $0.90
1. Why is marginal revenue equal
to price in Exhibit 2?
• For example, if quantity increases from
2 to 3, and if price is $0.90, then the
change in TR is $(2.70 - 1.80) = $0.90.
The change in Q is 1. Therefore,
MR = $0.90/1 = $0.90.
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Exhibit 2: Total and Marginal Revenue
Curves Derived from Selling Fish When
P = $0.90
1. Why is marginal revenue equal
to price in Exhibit 2?
• As a result, MR = price. The marginal
revenue curve is a horizontal line at the
prevailing price.
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Exhibit 2: Total and Marginal Revenue
Curves Derived from Selling Fish When
P = $0.90
2. Why is the TR curve in panel a
an upward-sloping straight line?
• The TR curve is upward-sloping because
as output increases, TR increases, since TR
= P × Q.
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Exhibit 2: Total and Marginal Revenue
Curves Derived from Selling Fish When
P = $0.90
2. Why is the TR curve in panel a
an upward-sloping straight line?
• The TR curve is a straight line because
its slope is equal to price, which does not
change.
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Exhibit 2: Total and Marginal Revenue
Curves Derived from Selling Fish When
P = $0.90
3. What is the difference between
TR and TR′ at an output level of
11,000?
• TR at a quantity of 11,000 is $9,900.
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Exhibit 2: Total and Marginal Revenue
Curves Derived from Selling Fish When
P = $0.90
3. What is the difference between
TR and TR′ at an output level of
11,000?
• TR′ at a quantity of 11,000 is $5,500.
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Exhibit 2: Total and Marginal Revenue
Curves Derived from Selling Fish When
P = $0.90
3. What is the difference between
TR and TR′ at an output level of
11,000?
• (TR - TR′) = $4,400.
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Applying the MR = MC Rule
MR = MC rule
• The guideline used by a firm to achieve
profit maximization.
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Applying the MR = MC Rule
The profit maximization guideline is to
keep adding to production as long as
the marginal revenue gained from
adding production is greater than the
marginal cost incurred from adding it.
• When MR > MC, increase production.
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EXHIBIT 3
KEY DATA ON PROFIT MAXIMIZATION
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Exhibit 3: Key Data on Profit
Maximization
1. If quantity is 6,000 in Exhibit 3,
what should a firm do?
• Increase quantity
• Keep quantity the same
• Reduce quantity
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Exhibit 3: Key Data on Profit
Maximization
1. If quantity is 6,000 in Exhibit 3,
what should a firm do?
• Increase quantity
• Keep quantity the same
• Reduce quantity
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Exhibit 3: Key Data on Profit
Maximization
2. If quantity is 14,000 in Exhibit 3,
what should a firm do?
• Increase quantity
• Keep quantity the same
• Reduce quantity
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Exhibit 3: Key Data on Profit
Maximization
2. If quantity is 14,000 in Exhibit 3,
what should a firm do?
• Increase quantity
• Keep quantity the same
• Reduce quantity
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EXHIBIT 4
APPLYING THE MR = MC RULE
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Exhibit 4: Applying the
MR = MC Rule
If quantity is 13,000 in Exhibit 4,
is profit maximized?
• No. Since the MC curve is above MR
curve, profit is smaller at 13,000 than if
output is set at 10,000.
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Maximizing Profit on Israel’s
Kibbutzim
According to Professors Levhari and
Barkai, does a kibbutz behave as if it
were a profit-maximizing firm?
• Yes. While the trademark of the kibbutz is
universal equality, this goal does not interfere
with maximizing profit from the kibbutz’s
agricultural and manufacturing
activities.
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Maximizing Profit on Israel’s
Kibbutzim
According to Professors Levhari and
Barkai, does a kibbutz behave as if it
were a profit-maximizing firm?
• Evidence for profit-maximizing behavior
includes a kibbutz switching from one crop
to another based on relative prices.
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Determining Maximum Profit
The formula for determining
maximum profit is:
• (P - ATC) × Qmax.
Note that Qmax is the profit-maximizing
output level.
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EXHIBIT 5
MEASURING PROFIT MAXIMIZATION
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Exhibit 5: Measuring Profit
Maximization
Using the information in Exhibit
5, what is total profit when
output is 10,000, price is $0.90,
and ATC is $0.645?
• Profit is $2,550.
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Exhibit 5: Measuring Profit
Maximization
Using the information in Exhibit
5, what is total profit when
output is 10,000, price is $0.90,
and ATC is $0.645?
• $2,550 = $(0.90-0.645) × 10,000.
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Exhibit 5: Measuring Profit
Maximization
Using the information in Exhibit
5, what is total profit when
output is 10,000, price is $0.90,
and ATC is $0.645?
• Total profit of $2,550 is represented
graphically as the area of the shaded
rectangle in Exhibit 5.
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Maximizing Profit and
Minimizing Loss
Loss minimization
• Faced with the certainty of incurring
losses, the firm’s goal is to incur the
lowest loss possible from its production
and sale of goods and services.
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Maximizing Profit and
Minimizing Loss
If price is less than ATC, but
greater than AVC, the firm is better
off to produce where MR = MC in
the short run, even though profit is
negative.
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Maximizing Profit and
Minimizing Loss
The reason is that if price is less
than ATC, but greater than AVC,
all variable costs are being paid
with revenue, and there is a bit left
over to apply toward fixed cost.
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Maximizing Profit and
Minimizing Loss
If instead the firm shut down
when ATC > P > AVC, then the
firm would have no revenue to
apply toward fixed cost.
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Maximizing Profit and
Minimizing Loss
Example: Suppose that price is
$0.45, AVC = $0.31, output is 7,000,
and TFC = $2,000. Should the firm
produce or shut down?
• If the firm produces, then ignoring TFC,
the firm clears $(0.45 - 0.31) × 7,000
= $980.
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Maximizing Profit and
Minimizing Loss
Example: Suppose that price is
$0.45, AVC = $0.31, output is
7,000, and TFC = $2,000. Should
the firm produce or shut down?
• This $980 can be applied to paying off
part of the $2,000 TFC.
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Maximizing Profit and
Minimizing Loss
Example: Suppose that price is
$0.45, AVC = $0.31, output is
7,000, and TFC = $2,000. Should
the firm produce or shut down?
• If instead the firm were to shut down,
there would be no revenue to apply
toward paying the $2,000 fixed cost.
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Maximizing Profit and
Minimizing Loss
Shutdown
• The cessation of the firm’s activity. The
firm’s loss minimization occurs at zero
output.
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Maximizing Profit and
Minimizing Loss
If price is less than both ATC and
AVC, the firm is better off to shut
down rather than produce.
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Maximizing Profit and
Minimizing Loss
If price is less than AVC then
total revenue is less than total
variable cost. Since the entire
total variable cost can be avoided
by shutting down, the firm is
better off to shut down.
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Maximizing Profit and
Minimizing Loss
If instead the firm were to
produce rather than shut down
when P < AVC, then the loss
would be TFC + (AVC - P) × Q.
The firm is better off to shut
down and incur a loss of TFC.
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EXHIBIT 6
MINIMIZING LOSS
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Exhibit 6: Minimizing Loss
1. Using the data in Exhibit 6,
what output level should the firm
produce if price is $0.45?
• Loss is minimized when the firm produces
a quantity of 7,000.
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Exhibit 6: Minimizing Loss
1. Using the data in Exhibit 6,
what output level should the firm
produce if price is $0.45?
• MR = MC at a quantity of 7,000, and the
loss is $(0.45 - 0.60) × 7,000 = -$1,050.
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Exhibit 6: Minimizing Loss
2. Using the data in Exhibit 6,
what output level should the firm
produce if price is $0.26?
• Loss is minimized when the firm shuts
down.
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Exhibit 6: Minimizing Loss
2. Using the data in Exhibit 6,
what output level should the firm
produce if price is $0.26?
• While MR = MC at a quantity of 5,000, AVC
is $0.28. Total revenue is $1,300, while TVC =
$1,400, and so total revenue falls short
of TVC by $100.
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Do Firms Really Behave
This Way?
What is the Lester-Machlup
controversy?
• Princeton’s Richard Lester challenged the
idea that entrepreneurs look to the margin
for production signals.
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Do Firms Really Behave
This Way?
What is the Lester-Machlup
controversy?
• In a survey conducted by Lester,
entrepreneurs responded that they did not
think in terms of marginal units.
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Do Firms Really Behave
This Way?
What is the Lester-Machlup
controversy?
• Fritz Machlup dismissed Lester’s findings
on the grounds that the MR = MC theory of
profit maximizing doesn’t depend on what
entrepreneurs think they do.
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Do Firms Really Behave
This Way?
What is the Lester-Machlup
controversy?
• Rather, the MR = MC theory relies on
what they actually do.
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Empire Building
Another challenge to the MR = MC
rule is based on the argument that
decision-makers are not as onedimensional as marginalists
suggest.
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Empire Building
For example, stockholders typically
want the firm to maximize profit.
The firm’s managers, on the other
hand, see the firm as more than an
economic machine grinding out
profit for stockholders.
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Empire Building
The firm has social, political, and
historical dimensions that are
important to the firm’s managers.
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Empire Building
The firm that is run by nonowning
managers generally chooses to
maximize sales, not profit. Success
is measured by the size of the
production range.
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Empire Building
The nonowning manager’s goal is
empire building.
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Empire Building
In John Kenneth Galbraith’s view,
the primary goal of managers is the
survival of the corporation and, in
particular, the survival of its
managerial bureaucracy.
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Stakeholder
Stakeholder
• Someone who has a personal and
consequential interest in the viability of
the firm.
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Empire Building
According to Lester Thurow,
“American government may be
bureaucratic and inefficient, but
American industry is just as
bureaucratic an inefficient.”
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Empire Building
In Galbraith and Thurow’s view,
the preservation of the managerial
class, even at the expense of profit,
is what managers seek.
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What Survives of Marginalism?
In the view of many economists, the
criticisms of Galbraith and Thurow
are interesting and perhaps even
useful in explaining some aspects of
corporate behavior.
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What Survives of Marginalism?
Yet many economists also argue
that these criticisms offer
insufficient evidence to seriously
undermine the basic postulates of
the marginalist economists: Firms
must be guided by the MR = MC
rule to maximize profit.
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