Chapter 7
How Firms Make Decisions:
Profit Maximization
ECONOMICS: Principles and Applications, 4e
HALL & LIEBERMAN, © 2008 Thomson South-Western
The Goal Of Profit Maximization
• The firm
– A single economic decision maker
– Goal: to maximize its owners’ profit
• Profit
– Sales revenue minus costs of production
2
Two Definitions of Profit
• Accounting profit
– Total revenue minus accounting costs
• Economic profit
– Total revenue minus all costs of
production
– Recognizes all the opportunity costs of
production - both explicit costs and
implicit costs
3
The Firm’s Constraints
• Demand curve facing the firm
– A curve that indicates, for different
prices, the quantity of output that
customers will purchase from a particular
firm.
– Maximum price the firm can charge to
sell any given amount of output
• Total revenue
– The total inflow of receipts from selling a
given amount of output
4
Demand and Total Revenue
• Figure 1 The Demand Curve Facing the Firm
5
Demand and Total Revenue
• Figure 1 The Demand Curve Facing the Firm
Price
Per Bed
$600
450
Demand Curve
Facing Ned’s Beds
2
5
Number of Bed
Frames per Day
6
The Cost Constraint
• For any level of output the firm might
want to produce, it must pay the cost of
the “least cost method” of production
– Production function
– Prices of inputs
• Total cost – implicit and explicit costs
7
The Profit-Maximizing Output Level
• Profit
– Total revenue (TR) minus total cost (TC)
at each output level
– The firm chooses the output level where
profit is greatest
• Loss
– Total cost (TC) minus total revenue (TR),
when TC > TR
8
Profit Maximization: TR-TC
• Figure 2 Profit Maximization
Maximize Profit = TR-TC
-greatest vertical distance between TR and TC curves
-TR curve above the TC curve.
Dollars
$3,500
3,000
Profit at 7
Units
2,500
Profit at 5
Units
2,000
Profit at 3
Units
1,500
1,000
TR
DTR from producing 2nd unit
500
Total Fixed
Cost
TC
DTR from producing 1st unit
0
1
2
3
4
5
6
7
8
9
10
Output
9
The Profit-Maximizing Output Level
• Marginal revenue
– The change in total revenue from
producing one more unit of output
MR=ΔTR/ΔQ
– how much revenue rises per unit
increase in output
• Increase in output
• revenue gain - from selling additional output
• revenue loss - lower the price on all output
10
Using MR and MC to Maximize Profits
• Increase output whenever MR > MC
– An increase in output will raise profit if
MR > MC
• Decrease output when MR < MC
– An increase in output will lower profit if
MR < MC
• Average costs (ATC, AVC, AFC)
– Irrelevant to profit maximization
11
Profit Maximization: MR=MC
• Figure 2 Profit Maximization
Dollars
Maximize profit: MR=MC
- MC and MR curves intersect.
$700
600
MC
500
400
300
200
100
0
–100
–200
1
2
3
profit rises
4
5
6
7
profit falls
8
9
10 Output
MR
12
Profit Maximization: MR=MC
• Figure 3 Two Points of Intersection
Dollars
Profit-maximizing output level
-MC curve crosses MR curve from below
MC
A
B
MR
Q1
Q*
Output
13