The Goal Of Profit MaximizationTo analyze decision making at the firm, lets start with a very basic questionWhat is the firm trying to maximize?A firms owners will usually want the firm to earn as much profit as possibleWe will view the firm as a single economic decision maker whose goal is to maximize its owners profitWhy?Managers who deviate from profit-maximizing for too long are typically replaced either byCurrent owners or Other firms who acquire the underperforming firm and then replace management team with their ownMany managers are well trained in tools of profit-maximization

Understanding Profit: Two Definitions of ProfitProfit is defined as the firms sales revenue minus its costs of productionIf we deduct only costs recognized by accountants, we get one definition of profitAccounting profit = Total revenue Accounting costsA broader conception of costs (opportunity costs) leads to a second definition of profitEconomic profit = Total revenue All costs of productionOr Total revenue (Explicit costs + Implicit costs)

Why Are There Profits?Economists view profit as a payment for two necessary contributions Risk-takingSomeonethe ownerhad to be willing to take the initiative to set up the businessThis individual assumed the risk that business might fail and the initial investment be lostInnovationIn almost any business you will find that some sort of innovation was needed to get things started

The Firms Constraints: The Demand ConstraintDemand curve facing firm is a profit constraintCurve that indicates for different prices, quantity of output customers will purchase from a particular firmCan flip demand relationship aroundOnce firm has selected an output level, it has also determined the maximum price it can chargeLeads to an alternative definitionShows maximum price firm can charge to sell any given amount of output

Figure 1: The Demand Curve Facing The Firm

Total RevenueThe total inflow of receipts from selling a given amount of outputEach time the firm chooses a level of output, it also determines its total revenueWhy?Because once we know the level of output, we also know the highest price the firm can chargeTotal revenuewhich is the number of units of output times the price per unitfollows automatically

The Cost ConstraintEvery firm struggles to reduce costs, but there is a limit to how low costs can goThese limits impose a second constraint on the firmThe 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 levelFor any level of output the firm might want to produceIt must pay the cost of the least cost method of production

The Total Revenue And Total Cost ApproachAt any given output level, we knowHow much revenue the firm will earnIts cost of productionLossA negative profitwhen total cost exceeds total revenueIn the total revenue and total cost approach, the firm calculates Profit = TR TC at each output level Selects output level where profit is greatest

The Marginal Revenue and Marginal Cost ApproachMarginal revenueChange in total revenue from producing one more unit of outputMR = TR / QTells us how much revenue rises per unit increase in output

The Marginal Revenue and Marginal Cost ApproachImportant things to notice about marginal revenueWhen MR is positive, an increase in output causes total revenue to riseEach time output increases, MR is smaller than the price the firm charges at the new output levelWhen a firm faces a downward sloping demand curve, each increase in output causes Revenue gainFrom selling additional output at the new priceRevenue lossFrom having to lower the price on all previous units of outputMarginal revenue is therefore less than the price of the last unit of output

Using MR and MC to Maximize ProfitsMarginal revenue and marginal cost can be used to find the profit-maximizing output levelLogic 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 trueAn 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 outputFirm should increase output whenever MR > MC, and decrease output when MR < MC

Figure 2(a): Profit MaximizationTotal Fixed CostTCTRDTR from producing 2nd unitDTR from producing 1st unitProfit at 3 UnitsProfit at 5 UnitsProfit at 7 Units

Figure 2(b): Profit Maximizationprofit risesprofit fallsMCMR

The MR and MC Approach Using GraphsFigure 2 also illustrates the MR and MC approach to maximizing profitsCan summarize MC and MR approachTo maximize profits the firm should produce level of output closest to point where MC = MRLevel of output at which the MC and MR curves intersectThis rule is very usefulallows us to look at a diagram of MC and MR curves and immediately identify profit-maximizing output level

An Important ProvisoImportant exception to this ruleSometimes MC and MR curves cross at two different pointsIn this case, profit-maximizing output level is the one at which MC curve crosses MR curve from below

What About Average Costs?Different types of average cost (ATC, AVC, and AFC) are irrelevant to earning the greatest possible level of profitCommon errorsometimes made even by business managersis to use average cost in place of marginal cost in making decisionsProblems with this approachATC includes many costs that are fixed in short-runincluding cost of all fixed inputs such as factory and equipment and design staffATC changes as output increasesCorrect approach is to use the marginal cost and to consider increases in output one unit at a timeAverage cost doesnt help at all; it only confuses the issueAverage cost should not be used in place of marginal cost as a basis for decisions

Dealing With Losses: The Short Run and the Shutdown RuleYou might think that a loss-making firm should always shut down its operation in the short runHowever, it makes sense for some unprofitable firms to continue operatingThe question isShould this firm produce at Q* and suffer a loss? The answer is yesif the firm would lose even more if it stopped producing and shut down its operationIf, 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 costsBut if the firm cannot even cover its operating costs when it stays open, it should shut down

Dealing With Losses: The Short-Run and the Shutdown RuleGuidelinecalled the shutdown rulefor a loss-making firmLet Q* be output level at which MR = MCThen in the short-runIf TR > Q* firm should keep producingIf TR < Q* firm should shut downIf TR = Q* firm should be indifferent between shutting down and producingThe shutdown rule is a powerful predictor of firms decisions to stay open or cease production in short-run

Figure 4(a): Loss Minimization

Figure 4(b): Loss MinimizationMCMR Q*

Figure 5: Shut DownQ*TCTRTVCTFC TFCLoss at Q*

The Long Run: The Exit DecisionWe only use term shut down when referring to short-runIf a firm stops production in the long-run it is termed an exitA firm should exit the industry in long- run Whenat its best possible output levelit has any loss at all

Using The Theory: Getting It WrongThe Failure of Franklin National BankIn the mid-1970s, Franklin National Bankone of the largest banks in the United Stateswent bankruptIn mid-1974, John Sadlik, Franklins CFO, asked his staff to compute average cost to bank of a dollar in loanable fundsDetermined to be 7 At the time, all banksincluding Franklinwere charging interest rates of 9 to 9.5% to their best customersOrdered his loan officers to approve any loan that could be made to a reputable borrower at 8% interest

Using The Theory: Getting It WrongThe Failure of Franklin National BankWhere 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 marketNot surprisingly, these loanswhich never should have been madecaused Franklins profits to decreaseWithin a year the bank had lost hundreds of millions of dollarsThis, together with other management errors, caused bank to fail

Using The Theory: Getting It RightThe Success of Continental AirlinesContinental Airlines was doing something that seemed like a horrible mistakeYet Continentals profitsalready higher than industry averagecontinued to growA serious mistake was being made by the other airlines, not ContinentalUsing average cost instead of marginal cost to make decisionsContinentals management, led by its vice-president of operations, had decided to try marginal approach to profit