chapter 9 maximizing profit gottheil — principles of economics, 7e © 2013 cengage learning 1

Chapter 9Chapter 9

MAXIMIZING PROFITMAXIMIZING PROFIT

Gottheil — Principles of Economics, 7e© 2013 Cengage Learning1

Economic PrinciplesEconomic Principles

© 2013 Cengage Learning Gottheil — Principles of Economics, 7e2

Entrepreneurial behavior

Total revenue, average revenue,and marginal revenue

Profit maximization

Economic PrinciplesEconomic Principles


Loss minimization

The application of the MR = MC rule

Corporate empire building

Profit MaximizationProfit Maximization


Profit maximization

• The primary goal of a firm: To achieve the most profit possible from its production and sale of goods or services.

Entrepreneurs and Profit Entrepreneurs and Profit MakingMaking


Entrepreneurs must make production decisions that require some degree of expertise in both the mechanics of production and in accounting.

Entrepreneurs and Profit Entrepreneurs and Profit MakingMaking


How do entrepreneurs anticipate what prices will be in the future?• Entrepreneurs rely on their best judgment,

sometimes on a sixth sense.

ProfitProfit


Profit

• Income earned by entrepreneurs.


EXHIBIT 1 AVERAGE TOTAL COST AND MARGINAL COST OF PRODUCING FISH PER FISHING RUN ($ PER FISH)

Exhibit 1: Average Total Cost and Exhibit 1: Average Total Cost and Marginal Cost of Producing Fish Marginal Cost of Producing Fish

per Fishing Runper 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).

Exhibit 1: Average Total Cost Exhibit 1: Average Total Cost and Marginal Cost of Producing and Marginal Cost of Producing

Fish per Fishing RunFish 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.




2. What is the total profit from selling 11,000 fish?

• Total profit is (P – ATC) × Q.




2. What is the total profit from selling 11,000 fish?

• Total profit = (0.75 – 0.68) × 11,000 = $770.




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.




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.




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.

The MR = MC RuleThe 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.



Total revenue (TR)

• The price of a good multiplied by the number of units sold.

TR = P × Q



Average revenue (AR)

• Total revenue divided by the quantity of goods or services sold.

AR = TR/Q



If TR = $22,600, and Q = 200, what is AR?

• AR = ($22,600/200) = $113



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)



If TR rises by $10 when output rises by one unit, what is MR?

• MR = $10/1 = $10.


EXHIBIT 2A TOTAL AND MARGINAL REVENUE CURVES DERIVED FROM SELLING FISH WHEN P = $0.90


EXHIBIT 2B TOTAL AND MARGINAL REVENUE CURVES DERIVED FROM SELLING FISH WHEN P = $0.90


EXHIBIT 2C TOTAL AND MARGINAL REVENUE CURVES DERIVED FROM SELLING FISH WHEN P = $0.90

Exhibit 2: Total and Marginal Exhibit 2: Total and Marginal Revenue Curves Derived from Revenue Curves Derived from Selling Fish When Selling Fish When PP = $0.90 = $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.




• 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.




• As a result, MR = price. The marginal revenue curve is a horizontal line at the prevailing price.



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.



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.



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.



• TR′ at a quantity of 11,000 is $5,500.




• (TR - TR′) = $4,400


Applying the MR = MC RuleApplying the MR = MC Rule


MR = MC rule

• The guideline used by a firm to achieve profit maximization.

Applying the MR = MC RuleApplying 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.


EXHIBIT 3 KEY DATA ON PROFIT MAXIMIZATION

Exhibit 3: Key Data on Profit Exhibit 3: Key Data on Profit MaximizationMaximization


1. If quantity is 6,000 in Exhibit 3, what should a firm do?• Increase quantity

• Keep quantity the same

• Reduce quantity





• Reduce quantity



2. If quantity is 14,000 in Exhibit 3, what should a firm do?

• Increase quantity


• Reduce quantity


EXHIBIT 4 APPLYING THE MR = MC RULE

Exhibit 4: Applying the Exhibit 4: Applying the MR = MC RuleMR = 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.

Determining Maximum ProfitDetermining Maximum Profit


The formula for determining maximum profit is:• (P – ATC) × Qmax

Note that Qmax is the profit-maximizing output level.


EXHIBIT 5 MEASURING PROFIT MAXIMIZATION

Exhibit 5: Measuring Profit Exhibit 5: Measuring Profit MaximizationMaximization


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.



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



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.

Maximizing Profit and Maximizing Profit and Minimizing LossMinimizing 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.



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.



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.



If instead the firm shut down when ATC > P > AVC, then the firm would have no revenue to apply toward fixed cost.



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.



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.



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.



Shutdown

• The cessation of the firm’s activity. The firm’s loss minimization occurs at zero output.



If price is less than both ATC and AVC, the firm is better off to shut down rather than produce.



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.



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.


EXHIBIT 6 MINIMIZING LOSS

Exhibit 6: Minimizing LossExhibit 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.



• MR = MC at a quantity of 7,000, and the loss is $(0.45 - 0.60) × 7,000 = –$1,050.





• Loss is minimized when the firm shuts down.



• 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.


Do Firms Really Behave Do Firms Really Behave This Way?This Way?


What is the Lester-Machlup controversy?• Princeton’s Richard Lester challenged the

idea that entrepreneurs look to the margin for production signals.



What is the Lester-Machlup controversy?• In a survey conducted by Lester,

entrepreneurs responded that they did not think in terms of marginal units.



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.



• Rather, the MR = MC theory relies on what they actually do.

What is the Lester-Machlup controversy?

Empire BuildingEmpire Building


Another challenge to the MR = MC rule is based on the argument that decision makers are not as one-dimensional as marginalists suggest.



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.



The firm has social, political, and historical dimensions that are important to the firm’s managers.



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.



The nonowning manager’s goal is 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.

StakeholderStakeholder


Stakeholder

• Someone who has a personal and consequential interest in the viability of the firm.



In Galbraith and Thurow’s view, the preservation of the managerial class, even at the expense of profit, is what managers seek.

What Survives of Marginalism?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.

What Survives of Marginalism?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.

chapter 9 maximizing profit gottheil — principles of economics, 7e © 2013 cengage learning 1

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