Chapter discusses profit maximization, marginal revenue, marginal cost and their relationship with cost curves along with negative profit and shut down condition.

1. Microeconomics for Business
Chapter 04: Individual Firm Decisions
Firms Optimization Behavior
● Every firm wants to maximize profits and it knows cost cur
○ Its own cost curves
○ Exogenously given price, p0
● Every firm wants to maximize its profits
=TR ­ TCiΠ
TC is Total Cost
TR is Total Revenue and is equal to: TR = . qP0
● Marginal Revenue, MR is slope of TR
MR = d TR/ d q
Since the change in revenue per unit
quantity is always going to be constant
i.e. . It means MR = P0 P0
● Marginal Cost, MC is slope of TC
MC = d TC/ d q
● Maximum gap between two functions
exists at a point when slopes of both
functions are same i.e. Max ( ) exists iΠ
when:
d TR/ d q = d TC/ d q
MC = MR = P0
● Maximum profit would be:
Max ( ) = Max (TR ­ TC)iΠ
● Same calculation would also find Maximum loss as well as it is also Max (TR ­ TC).
Factors Impacting TR, TC & Profit
● If exogenous price is to remain same, a change in total fixed cost (TFC) would not impact p0
TR curve, therefore MR would remain same. It will only shift TC curve so MC will remain
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2. Microeconomics for Business
same as well. However the profit i.e. Max (TR ­ TC) will increase or decrease depending on
fixed cost decrease or increase.
● If exogenous price is to remain same, a change in TVC would change the TC curve and p0
so MC will change as well. TR curve will remain same and so would MR. Profit i.e. Max (TR
­ TC) will change depending on the change in TC curve.
● A change in exogenous price only will either make the TR curve less or more steep, p0
therefore MR would change. TC curve and MC would remain same. The profit will increase
or decrease depending on whether the new price is less or more.
Marginal Revenue (MR) & Marginal Cost (MC)
● For an exogenous price , Total p0
Revenue (TR) is a linear line with fixed
slope, therefore MR is constant and is
equal to .P0
● Maximum profit exists when MC & MR
are equal as shown in graph.
● TR at this point can be calculated as
= q* x P0
● MC has no information about TFC,
therefore it is not possible to calculate TC
from this graph.
Marginal Revenue (MR), Marginal Cost MC) & Average Total Cost
● TC = ATC * q
● It means that by plotting ATC on MC and
MR graph, total profit can be calculated.
Π = TR ­ TC
= (q* x ) ­ (ATC x q*)P0
= q* ( ­ ATC)P0
Negative Profit (Loss) & Its Impact
● If ATC is above MR at all points at exogenous price , it means the firm is generatingP0
negative profit i.e. TC is always going to be higher than TR.
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3. Microeconomics for Business
● In the Long Run (where no factor of production is fixed), if profit goes in negative, it means
exit for the firm.
● In the Short Run (where a firm cannot change its fixed cost), if profit goes into negative it
needs to decide:
○ Whether to continue producing q* at MR = MC. OR
○ Shutdown i.e. Stop production until exit. It means waiting to enter Long Run.
● Decision to whether continue or stop production can be made using following condition:
○ If TR < VC while producing q* when MR = MC
Then Stop Production
● When TR < VC, it means that not only FC is loss but production is resulting into additional
loss due to higher VC.
Example:
● In this case, TR is less than VC which means that
not only FC is a loss, but firm cannot cover VC
either. This means running production is generating
even more loss.
○ Area (Z) = Total Revenue
○ Area (Y+Z) = Total Variable Cost
○ Area (X) = Total Fixed Cost
● It shows that running production is producing
additional loss, therefore it is better to shut down.
● If however TR > VC, then it means there is the
revenue is greater than VC and it can help offset
FC loss.
● In example:
○ Area Z = TVC
○ Area (X+Y) = TC
○ Area (Y+Z) = TR
Here the TR > TVC by quantity Y which means
this profit is going to cover some of TFC.
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4. Microeconomics for Business
References:
1. Lectures by Prof. Larry DeBrock
2. http://economics.fundamentalfinance.com/micro_outputdecision.php
3. https://en.wikibooks.org/wiki/Microeconomics/Perfect_Competition
4. https://www.boundless.com/economics/textbooks/boundless­economics­textbook/competitive­
markets­10/production­decisions­in­perfect­competition­67/marginal­cost­profit­maximization­s
trategy­251­12348/
Notes by Fraz Tajammul
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