Ch06 Cmba 401

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Ch06 Cmba 401

  1. 1. Chapter 6 How Firms Make Decisions: Profit Maximization
  2. 2. The Goal Of Profit Maximization <ul><li>To analyze decision making at the firm, let’s start with a very basic question </li></ul><ul><ul><li>What is the firm trying to maximize? </li></ul></ul><ul><li>A firm’s owners will usually want the firm to earn as much profit as possible </li></ul><ul><li>We will view the firm as a single economic decision maker whose goal is to maximize its owners’ profit </li></ul><ul><li>Why? </li></ul><ul><ul><li>Managers who deviate from profit-maximizing for too long are typically replaced either by </li></ul></ul><ul><ul><ul><li>Current owners or </li></ul></ul></ul><ul><ul><ul><li>Other firms who acquire the underperforming firm and then replace management team with their own </li></ul></ul></ul><ul><ul><li>Many managers are well trained in tools of profit-maximization </li></ul></ul>
  3. 3. Understanding Profit: Two Definitions of Profit <ul><li>Profit is defined as the firm’s sales revenue minus its costs of production </li></ul><ul><li>If we deduct only costs recognized by accountants, we get one definition of profit </li></ul><ul><ul><li>Accounting profit = Total revenue – Accounting costs </li></ul></ul><ul><li>A broader conception of costs (opportunity costs) leads to a second definition of profit </li></ul><ul><ul><li>Economic profit = Total revenue – All costs of production </li></ul></ul><ul><ul><li>Or Total revenue – (Explicit costs + Implicit costs) </li></ul></ul>
  4. 4. Why Are There Profits? <ul><li>Economists view profit as a payment for two necessary contributions </li></ul><ul><li>Risk-taking </li></ul><ul><ul><li>Someone—the owner—had to be willing to take the initiative to set up the business </li></ul></ul><ul><ul><ul><li>This individual assumed the risk that business might fail and the initial investment be lost </li></ul></ul></ul><ul><ul><li>Innovation </li></ul></ul><ul><ul><ul><li>In almost any business you will find that some sort of innovation was needed to get things started </li></ul></ul></ul>
  5. 5. The Firm’s Constraints: The Demand Constraint <ul><li>Demand curve facing firm is a profit constraint </li></ul><ul><ul><li>Curve that indicates for different prices, quantity of output customers will purchase from a particular firm </li></ul></ul><ul><li>Can flip demand relationship around </li></ul><ul><ul><li>Once firm has selected an output level, it has also determined the maximum price it can charge </li></ul></ul><ul><li>Leads to an alternative definition </li></ul><ul><ul><li>Shows maximum price firm can charge to sell any given amount of output </li></ul></ul>
  6. 6. Figure 1: The Demand Curve Facing The Firm
  7. 7. Total Revenue <ul><li>The total inflow of receipts from selling a given amount of output </li></ul><ul><li>Each time the firm chooses a level of output, it also determines its total revenue </li></ul><ul><ul><li>Why? </li></ul></ul><ul><ul><ul><li>Because once we know the level of output, we also know the highest price the firm can charge </li></ul></ul></ul><ul><li>Total revenue—which is the number of units of output times the price per unit—follows automatically </li></ul>
  8. 8. The Cost Constraint <ul><li>Every firm struggles to reduce costs, but there is a limit to how low costs can go </li></ul><ul><ul><li>These limits impose a second constraint on the firm </li></ul></ul><ul><li>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 </li></ul><ul><li>For any level of output the firm might want to produce </li></ul><ul><ul><li>It must pay the cost of the “least cost method” of production </li></ul></ul>
  9. 9. The Total Revenue And Total Cost Approach <ul><li>At any given output level, we know </li></ul><ul><ul><li>How much revenue the firm will earn </li></ul></ul><ul><ul><li>Its cost of production </li></ul></ul><ul><li>Loss </li></ul><ul><ul><li>A negative profit—when total cost exceeds total revenue </li></ul></ul><ul><li>In the total revenue and total cost approach, the firm calculates Profit = TR – TC at each output level </li></ul><ul><ul><li>Selects output level where profit is greatest </li></ul></ul>
  10. 10. The Marginal Revenue and Marginal Cost Approach <ul><li>Marginal revenue </li></ul><ul><ul><li>Change in total revenue from producing one more unit of output </li></ul></ul><ul><ul><ul><li>MR = Δ TR / Δ Q </li></ul></ul></ul><ul><li>Tells us how much revenue rises per unit increase in output </li></ul>
  11. 11. The Marginal Revenue and Marginal Cost Approach <ul><li>Important things to notice about marginal revenue </li></ul><ul><ul><li>When MR is positive, an increase in output causes total revenue to rise </li></ul></ul><ul><ul><li>Each time output increases, MR is smaller than the price the firm charges at the new output level </li></ul></ul><ul><li>When a firm faces a downward sloping demand curve, each increase in output causes </li></ul><ul><ul><li>Revenue gain </li></ul></ul><ul><ul><ul><li>From selling additional output at the new price </li></ul></ul></ul><ul><ul><li>Revenue loss </li></ul></ul><ul><ul><ul><li>From having to lower the price on all previous units of output </li></ul></ul></ul><ul><ul><li>Marginal revenue is therefore less than the price of the last unit of output </li></ul></ul>
  12. 12. Using MR and MC to Maximize Profits <ul><li>Marginal revenue and marginal cost can be used to find the profit-maximizing output level </li></ul><ul><ul><li>Logic behind MC and MR approach </li></ul></ul><ul><ul><ul><li>An increase in output will always raise profit as long as marginal revenue is greater than marginal cost (MR > MC) </li></ul></ul></ul><ul><ul><li>Converse of this statement is also true </li></ul></ul><ul><ul><ul><li>An increase in output will lower profit whenever marginal revenue is less than marginal cost (MR < MC) </li></ul></ul></ul><ul><ul><li>Guideline firm should use to find its profit-maximizing level of output </li></ul></ul><ul><ul><ul><li>Firm should increase output whenever MR > MC, and decrease output when MR < MC </li></ul></ul></ul>
  13. 13. Figure 2(a): 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 Profit at 7 Units $3,500 3,000 2,500 2,000 1,500 1,000 500 Output Dollars 1 2 1 0 3 4 5 6 7 8 9 10
  14. 14. Figure 2(b): 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
  15. 15. The MR and MC Approach Using Graphs <ul><li>Figure 2 also illustrates the MR and MC approach to maximizing profits </li></ul><ul><li>Can summarize MC and MR approach </li></ul><ul><ul><li>To maximize profits the firm should produce level of output closest to point where MC = MR </li></ul></ul><ul><ul><ul><li>Level of output at which the MC and MR curves intersect </li></ul></ul></ul><ul><li>This rule is very useful — allows us to look at a diagram of MC and MR curves and immediately identify profit-maximizing output level </li></ul>
  16. 16. An Important Proviso <ul><li>Important exception to this rule </li></ul><ul><ul><li>Sometimes MC and MR curves cross at two different points </li></ul></ul><ul><ul><li>In this case, profit-maximizing output level is the one at which MC curve crosses MR curve from below </li></ul></ul>
  17. 17. What About Average Costs? <ul><li>Different types of average cost (ATC, AVC, and AFC) are irrelevant to earning the greatest possible level of profit </li></ul><ul><ul><li>Common error—sometimes made even by business managers—is to use average cost in place of marginal cost in making decisions </li></ul></ul><ul><ul><ul><li>Problems with this approach </li></ul></ul></ul><ul><ul><ul><ul><li>ATC includes many costs that are fixed in short-run—including cost of all fixed inputs such as factory and equipment and design staff </li></ul></ul></ul></ul><ul><ul><ul><ul><li>ATC changes as output increases </li></ul></ul></ul></ul><ul><li>Correct approach is to use the marginal cost and to consider increases in output one unit at a time </li></ul><ul><ul><li>Average cost doesn’t help at all; it only confuses the issue </li></ul></ul><ul><li>Average cost should not be used in place of marginal cost as a basis for decisions </li></ul>
  18. 18. Dealing With Losses: The Short Run and the Shutdown Rule <ul><li>You might think that a loss-making firm should always shut down its operation in the short run </li></ul><ul><ul><li>However, it makes sense for some unprofitable firms to continue operating </li></ul></ul><ul><li>The question is </li></ul><ul><ul><li>Should this firm produce at Q * and suffer a loss? </li></ul></ul><ul><ul><ul><li>The answer is yes—if the firm would lose even more if it stopped producing and shut down its operation </li></ul></ul></ul><ul><li>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) </li></ul><ul><ul><li>Should not shut down because operating profit can be used to help pay fixed costs </li></ul></ul><ul><ul><li>But if the firm cannot even cover its operating costs when it stays open, it should shut down </li></ul></ul>
  19. 19. Dealing With Losses: The Short-Run and the Shutdown Rule <ul><li>Guideline—called the shutdown rule—for a loss-making firm </li></ul><ul><ul><li>Let Q* be output level at which MR = MC </li></ul></ul><ul><ul><li>Then in the short-run </li></ul></ul><ul><ul><ul><li>If TR > Q* firm should keep producing </li></ul></ul></ul><ul><ul><ul><li>If TR < Q* firm should shut down </li></ul></ul></ul><ul><ul><ul><li>If TR = Q* firm should be indifferent between shutting down and producing </li></ul></ul></ul><ul><li>The shutdown rule is a powerful predictor of firms’ decisions to stay open or cease production in short-run </li></ul>
  20. 20. Figure 4(a): Loss Minimization Q* Dollars Output TFC
  21. 21. Figure 4(b): Loss Minimization MC MR Q* Dollars Output
  22. 22. Figure 5: Shut Down Q* TC TR TVC TFC TFC Loss at Q* Dollars Output
  23. 23. The Long Run: The Exit Decision <ul><li>We only use term shut down when referring to short-run </li></ul><ul><li>If a firm stops production in the long-run it is termed an exit </li></ul><ul><li>A firm should exit the industry in long- run </li></ul><ul><ul><li>When—at its best possible output level—it has any loss at all </li></ul></ul>
  24. 24. Using The Theory: Getting It Wrong — The Failure of Franklin National Bank <ul><li>In the mid-1970’s, Franklin National Bank—one of the largest banks in the United States—went bankrupt </li></ul><ul><li>In mid-1974, John Sadlik, Franklin’s CFO, asked his staff to compute average cost to bank of a dollar in loanable funds </li></ul><ul><ul><li>Determined to be 7 ¢ </li></ul></ul><ul><ul><li>At the time, all banks—including Franklin—were charging interest rates of 9 to 9.5% to their best customers </li></ul></ul><ul><ul><li>Ordered his loan officers to approve any loan that could be made to a reputable borrower at 8% interest </li></ul></ul>
  25. 25. Using The Theory: Getting It Wrong — The Failure of Franklin National Bank <ul><li>Where did Franklin get the additional funds it was lending out? </li></ul><ul><ul><li>Were borrowed not at 7%, the average cost of funds, but at 9 to 11%, the cost of borrowing in the federal funds market </li></ul></ul><ul><li>Not surprisingly, these loans—which never should have been made—caused Franklin’s profits to decrease </li></ul><ul><ul><li>Within a year the bank had lost hundreds of millions of dollars </li></ul></ul><ul><ul><li>This, together with other management errors, caused bank to fail </li></ul></ul>
  26. 26. Using The Theory: Getting It Right — The Success of Continental Airlines <ul><li>Continental Airlines was doing something that seemed like a horrible mistake </li></ul><ul><ul><li>Yet Continental’s profits—already higher than industry average—continued to grow </li></ul></ul><ul><li>A serious mistake was being made by the other airlines, not Continental </li></ul><ul><ul><li>Using average cost instead of marginal cost to make decisions </li></ul></ul><ul><li>Continental’s management, led by its vice-president of operations, had decided to try marginal approach to profit </li></ul>

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