The Goal Of Profit Maximization

Hall & Leiberman; Economics: Principles And Applications, 2004

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The Goal Of Profit Maximization• What is the firm’s goal?

• A firm’s owners will want the firm to earn as much profit as possible

• Why?– Managers who deviate from profit-maximizing

for too long are typically replaced either by• Current owners or • Other firms who acquire the underperforming firm

and then replace management team with their own


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Two Definitions of Profit

• Profit = sales revenue minus costs of production

• Accounting profit = Total revenue – Accounting costs

• Economic profit = Total revenue – All costs of production = Total revenue – (Explicit costs + Implicit costs)

• This last term is the opportunity cost of production


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Two Definitions of Profit

• Proper measure of profit for understanding and predicting firm behavior is economic profit– Unlike accounting profit, economic profit

recognizes all the opportunity costs of production—both explicit and implicit costs


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Why Are There Profits?• Economists view profit as a payment for

• Risk-taking– Someone—the owner—had to be willing to

take the initiative to set up the business• This individual assumed the risk that business

might fail and the initial investment be lost

– Innovation• In almost any business you will find that some sort

of innovation was needed to get things started


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The Firm’s Constraints: Demand • Demand curve facing firm is a profit constraint

– Curve that indicates for different prices, quantity of output customers will purchase from a particular firm

• Can flip demand relationship around– Once firm has selected an output level, it has also

determined the maximum price it can charge

• Leads to an alternative definition– Shows maximum price firm can charge to sell any

given amount of output


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Figure 1: The Demand Curve Facing The Firm


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Total Revenue

• The total inflow of receipts from selling a given amount of output

• Each time the firm chooses a level of output, it also determines its total revenue– Why?

• Total revenue— PxQ


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The Cost Constraint• Every firm wants to reduce costs, but there

is a limit to how low costs can go

• 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


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Total Revenue and Total Cost Approach

• At any given output level, we know– How much revenue the firm will earn– Its cost of production

• Loss– A negative profit—when total cost exceeds total

revenue

• In the total revenue and total cost approach, the firm calculates Profit = TR – TC at each output level – Selects output level where profit is greatest


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The Marginal Revenue and Marginal Cost Approach

• Marginal revenue–Change in total revenue from

producing one more unit of output• MR = ΔTR / ΔQ

• Tells us how much revenue rises per unit increase in output


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The Marginal Revenue and Marginal Cost Approach

• What does it mean when MR is positive?

• When a firm faces a downward sloping demand curve, each increase in output causes – Revenue gain

• From selling additional output at the new price

– Revenue loss• From having to lower the price on all previous units of output

– Marginal revenue is therefore less than the price of the last unit of output


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Using MR and MC to Maximize Profits

• Marginal revenue and marginal cost can be used to find the profit-maximizing output level– Logic behind MC and MR approach

• An increase in output will always raise profit as long as marginal revenue is _____ than marginal cost (MR __ MC)

– Converse of this statement is also true• An increase in output will lower profit whenever marginal

revenue is ___ than marginal cost (MR ___ MC)

What should the firm do when MC>MR?

What should the firm do when MC<MR?


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Profit Maximization Using Graphs• How is the marginal revenue curve related

to the total revenue curve

• Total revenue (TR) is plotted one the vertical axis, and quantity (Q) on the horizontal axis

• So what is the marginal revenue?


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Figure 2a: 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

$3,500

3,000

2,500

2,000

1,500

1,000

500

Output

Dollars

1 210 3 4 5 6 7 8 9 10

Profit at 7 Units


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Figure 2b: 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


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The TR and TC Approach Using Graphs

• To maximize profit, firm should – Produce quantity of output where vertical

distance between TR and TC curves is greatest and

– TR curve lies above TC curve


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The MR and MC Approach Using Graphs

• Figure 2 also illustrates the MR and MC approach to maximizing profits

• To maximize profits the firm should produce level of output closest to point where MC = MR

• Level of output at which the MC and MR curves intersect

• This rule is very useful—allows us to look at a diagram of MC and MR curves and immediately identify profit-maximizing output level


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An Important Proviso

• Important exception to this rule– Sometimes MC and MR curves cross at two

different points– In this case, profit-maximizing output level is

the one at which MC curve crosses MR curve from below

– Why????

The Goal Of Profit Maximization

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