CHAPTER 7
HOW FIRMS MAKE DECISIONS:
PROFIT MAXIMIZATION
ANSWERS TO ONLINE REVIEW QUESTIONS
1. Accounting profit is total revenue minus accounting costs, where accounting costs are
mainly explicit costs. Economists measure profit as total revenue minus all costs (that
is, both explicit costs and implicit costs are deducted).
2. A firm can earn an accounting profit at the same time it is suffering an economic loss.
For example, consider an entrepreneur who purchases $100,000 worth of raw
materials and foregoes a salary of $50,000 to devote his time to his business. If his
total revenues equal 120,000, he has earned an accounting profit of $20,000, and an
economic loss of $30,000. It is not possible to earn an economic profit while at the
same time suffer an accounting loss.
3. Profit is payment for risk taking and innovation. Answers to the second part of the
question will vary.
4. A market demand curve gives the quantity demanded by all consumers from all firms
in the market for each price. The demand curve facing the firm gives the quantity
demanded from a single firm.
5. The two constraints on the firm’s ability to earn profit are (1) rising marginal costs and
(2) falling marginal revenue. Marginal costs rise as units of the variable input are
added to the firm’s fixed resource. Marginal revenue falls because it is necessary for
the firm to lower the price of its product if it wants to sell more units.
6. a. The firm calculates profit as total revenue minus total cost and selects the output
level that gives maximum profit. Graphically, the firm produces output where the
vertical distance between the total revenue and total cost curve is greatest and
where the total revenue curve lies above the total cost curve.
b. The firm increases output when marginal revenue is above marginal cost and
decreases output when marginal revenue is less than marginal cost. Graphically,
the firm produces the level of output closest to where the marginal cost and
marginal revenue curves intersect.
PROBLEM SET
1. Explicit cost: $30 for gas, motel, lift tickets, and miscellaneous expenses
Implicit cost: $30 for Saturday wages
$30 for Sunday wages
Total cost:
$90
2. a. Annual explicit costs:
cost of office equipment:
programmer’s salary:
heat and light:
total explicit costs:
$50 × 12 =
b. Annual implicit costs:
salary foregone:
investment income
foregone:
$10,000 × .05 =
rent foregone:
$250 × 12 =
total explicit costs:
$3,600
25,000
600
$29,200
$35,000
500
3,000
$38,500
c. Congratulations are not in order since economic profit for the year is
$55,000 – ($29,200 + $38,500) = –$12,700.
3. To answer this question, it helps to first construct the following table:
Quantity
0
Total
Revenue
0
Marginal
Revenue
Total
Cost
$200,000
$225,000
1
$225,000
2
$350,000
3
$450,000
4
$500,000
$250,000
–$25,000
$25,000
$275,000
$100,000
$75,000
$50,000
$325,000
$50,000
$125,000
$75,000
$400,000
–$50,000
$450,000
Total
Profit
–$200,000
$50,000
$125,000
5
Marginal
Cost
$100,000
$100,000
$500,000
–$50,000
a. From the table, marginal revenue of increasing output from 2 to 3 units is
$100,000; marginal cost of the fifth unit produced is $100,000.
b. To maximize total revenue, Titan should produce 4 units of output. To maximize
total profit, Titan should produce 3 units of output.
c. Titan’s fixed cost is $200,000. Marginal cost first declines and then increases as
output increases.
4. The profit-maximizing level of output is either 13 or 14, since the marginal revenue
associated with the 14th unit equals the marginal cost of that unit ($25). When output
rises from 14 to 15, the marginal revenue of the 15th unit ($23) is less than MC of that
unit ($27).
5.
Firm A
Quantity
Total
Revenue
Marginal
Revenue
Total
Cost
Marginal
Cost
Total
Variable
Cost
0
0
1
$125
$250
$125
$150
$400
$75
2
$200
$500
$225
$550
$200
$300
$50
$600
–$75
5
$250
$50
–$25
4
$150
$100
$25
3
0
$125
$350
$100
$700
$450
In the short run, this firm should not produce since its marginal cost exceeds its
marginal revenue at all levels of output. ALTERNATIVELY, it should shut down
since total variable cost exceeds total revenue at EVERY level of output.
Firm B
Quantity
0
Total
Revenue
0
Marginal
Revenue
Total
Cost
$500
$500
1
$500
2
$800
$200
$700
$300
$200
$900
$1100
$800
$500
$600
$200
$1300
–$300
5
$400
$200
–$100
4
$200
$900
$100
3
Marginal
Cost
Total
Variable
Cost
0
$800
$200
$1500
$1000
In the short run, the firm should produce 2 units of output, since its marginal revenue
exceeds its marginal cost as it moves from 0 to 1 and 1 to 2 units of output. When
output rises from 2 to 3 units, the marginal revenue of the 3rd unit ($100) is less than
the marginal cost of that unit ($200).
6. a. If the firm’s fixed costs are $3,000 per day, then its variable costs are $7,000 $3,000 = $4,000 per day. Since its total revenue is less than this amount, this firm
should shut down in the short run.
b. Since the firm is earning enough total revenue to cover these variable costs, it
should continue to operate in the short run.
7. a. Your foregone labor income and your foregone interest are implicit costs. The
other costs are all explicit costs.
b. It depends on the change in your electric bill, which presumably varies according
to usage. If your electric bill will increase by less than $800, then you should rent
out your restaurant to The Breakfast Club.
8. a. The tax hike does not affect Ned’s MC and MR curves.
b. Ned should continue to produce 5 beds in the short run.
c. Since the best that Ned can do is to earn a -$100 profit if he continues to operate,
he should shut down and produce 0 beds in the long run.
9.
a. The new MR curve will be flat.
b. Each MR figure will now be $275.
c. Ned should now sell 6 beds.
MORE CHALLENGING QUESTIONS
10. a.
Output
0
Total
Profit
-$300
Marginal
Profit
$250
1
-$50
$350
2
$300
$350
3
$650
$200
4
$850
$50
5
$900
6
$800
7
$550
8
$150
9
-$400
10
-$1,100
-$100
-$350
-$400
-$550
-$700
b. Since we can define marginal profit as MP = MR - MC, then the rule for finding
the profit-maximizing output in terms of marginal profit will say that the firm
should increase output whenever MP > 0 and decrease output when MP < 0.
11. To answer this question, we need to compare the marginal revenue and marginal cost
of the action. Marginal cost can be computed from average total cost by first
computing total cost.
Unit
74
ATC
$10,000
TC
$740,000
75
$12,000
$900,000
MC
$160,000
$164,000
76
$14,000
$1,064,000
The marginal cost for the 76th unit is $164,000. Marginal revenue of the 76th unit is
what Backus Electronics is offering to pay for it, or $150,000. Howell should not
accept the offer since marginal cost exceeds marginal revenue.