Transcript Profit Maximization

Chapter 9
MAXIMIZING PROFIT
© 2013 Cengage Learning
Gottheil — Principles of Economics, 7e
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Economic Principles
Entrepreneurial behavior
Total revenue, average revenue,
and marginal revenue
Profit maximization
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Gottheil — Principles of Economics, 7e
2
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
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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
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TOTAL AND MARGINAL REVENUE
CURVES DERIVED FROM SELLING FISH
WHEN P = $0.90
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EXHIBIT 2B
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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?
• R = 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
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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
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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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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
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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
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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
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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