Transcript Total profit - Choose your book for Principles of Economics, by Fred

Chapter 9
Maximizing Profit
© 2002 South-Western
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.
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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?
• 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
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activities.
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 profitmaximizing 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
Shut down
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 one-dimensional 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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