Post on 19-Jan-2016
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Theory of The Firm:- Profit maximization
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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
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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)
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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
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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
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Figure 1: The Demand Curve Facing The Firm
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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
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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
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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
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The Marginal Revenue and Marginal Cost Approach
Marginal revenueChange in total revenue from
producing one more unit of output•MR = ΔTR / ΔQ
Tells us how much revenue rises per unit increase in output
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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
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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
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Profit Maximization
Total Fixed Cost
TC
TR
TR from producing 2nd unit
TR from producing 1st unit
Profit at 3 Units
Profit at 5 Units
$3,500
3,000
2,500
2,000
1,500
1,000
500
Output
Dollars
1 210 3 4 5 6 7 8 9 10
Profit at 7 Units
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Profit Maximization
profit rises profit falls
MC
MR
0
600
500
400
300
200
100
–100
–200
Output
Dollars
1 2 3 4 5 6 7 8
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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
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An Important Proviso
Important exception to this ruleSometimes 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
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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
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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
Lieberman & Hall; Introduction to Economics, 2005 19
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
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Loss Minimization
Q*
Dollars
Output
TFC
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Loss Minimization
MC
MR Q*
Dollars
Output
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Shut Down
Q*
TC
TR
TVC
TFC
TFC
Loss at Q*
Dollars
Output
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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