How Firms Make Decisions: Profit Maximization

1. How Firms Make Decisions: Profit Maximization

2. The Goal Of Profit Maximization • To analyze decision making at the firm, let’s start with a very basic question • What is the firm trying to maximize? • A firm’s owners will usually want the firm to earn as much profit as possible • We will view the firm as a single economic decision maker whose goal is to maximize its owners’ profit • Why? • Managers who deviate from profit-maximizing for too long are typically replaced either by • Current owners or • Other firms who acquire the underperforming firm and then replace management team with their own • Many managers are well trained in tools of profit-maximization

3. 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 • Accounting profit = Total revenue – Accounting costs • A broader conception of costs (opportunity costs) leads to a second definition of profit • Economic profit = Total revenue – All costs of production • Or Total revenue – (Explicit costs + Implicit costs)

4. Understanding Profit: Two Definitions of Profit • Difference between economic profit and accounting profit is an important one • When they are confused, some serious (and costly) mistakes can result • Proper measure of profit for understanding and predicting firm behavior is economic profit • Unlike accounting profit, economic profit recognizes all the opportunity costs of production—both explicit and implicit costs

5. 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

6. 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 maximum price it can charge • Leads to an alternative definition • Shows maximum price firm can charge to sell any given amount of output

7. Figure 1: The Demand Curve Facing The Firm

8. 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? • Because once we know the level of output, we also know the highest price the firm can charge • Total revenue—which is the number of units of output times the price per unit—follows automatically

9. 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 “least cost method” of production

10. 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

11. The Marginal Revenue and Marginal Cost Approach • Marginal revenue • Change in total revenue from producing one more unit of output • MR = ΔTR / ΔQ • Tells us how much revenue rises per unit increase in output

12. The Marginal Revenue and Marginal Cost Approach • Important things to notice about marginal revenue • When MR is positive, an increase in output causes total revenue to rise • Each time output increases, MR is smaller 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

13. 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

14. 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 one 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

15. Figure 2: Profit Maximization

16. 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

17. 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 MC = MR • 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

18. 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

19. What About Average Costs? • Different types of average cost (ATC, AVC, and AFC) are irrelevant to earning the greatest possible level of profit • Common error—sometimes made even by business managers—is to use average cost in place of marginal cost in making decisions • Problems with this approach • ATC includes many costs that are fixed in short-run—including cost of all fixed inputs such as factory and equipment and design staff • ATC changes as output increases • Correct approach is to use the marginal cost and to consider increases in output one unit at a time • Average cost doesn’t help at all; it only confuses the issue • Average cost should not be used in place of marginal cost as a basis for decisions

20. Figure 3: Two Points of Intersection

21. 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

22. 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 > Q* firm should keep producing • If TR < Q* firm should shut down • If TR = 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

23. Figure 4: Loss Minimization

24. Figure 5: Shut Down

25. 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

26. 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

27. 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

28. 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