economics 101 – section 5 lecture #16 – march 11, 2004 chapter 7 how firms make decisions -...
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Economics 101 – Section 5Lecture #16 – March 11, 2004
Chapter 7How firms make decisions
- profit maximization
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Lecture overview Recap of profit maximization from last day
The firms constraints Profit maximizing level of output Marginal decision making Graphical Analysis
What happens when you are losing $ - should you shut the firm down or not?
When to shut down and when not to
Goals of the firm versus those of the workers Principal-Agent problem
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Profit Maximization The demand curve facing the firm shows us
the maximum price the firm can charge to sell any given amount of output.
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Figure 1 The Demand Curve Facing the Firm
1
D em and C urve Facing
N ed’s Beds
Number of Bed Frames per Day
Price per Bed
$600
450
2 3 4 5 6 7 8 9 10
200
(3) (4) (1) (2) T otal T otal (5)
Price Output Revenue Cost Profit
$650 0 0 $ 300 $ 300 $650 1 $ 650 $ 700 $ 50 $600 2 $1,200 $ 900 $ 300 $550 3 $1,650 $1,000 $ 650 $500 4 $2,000 $1,150 $ 850 $45 0 5 $2,250 $1,350 $ 900 $400 6 $2,400 $1,600 $ 800 $350 7 $2,450 $1,900 $ 550 $300 8 $2,400 $2,250 $ 150 $2 9 $2,250 $2,650 $ 400 $200 1 0 $2,000 $3,100 $1,100
5 0
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Profit Maximization Total revenue
- is the total inflow of receipts from selling a given amount of output
This is computed as the quantity sold multiplied by the accompanying price on the demand curve
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Profit Maximization The cost constraint
For each level of production the firm must determine the cheapest method to produce that quantity – i.e. determine the least cost method
At any level of output the firm may produce at it must incur the cost associated with “least cost method”
This is largely determined by the firms production technology
How many inputs are used to produce any given level of output
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The profit-maximizing level of output We can use 2 methods to determine what is
the profit maximizing level of output 1) the total revenue and total cost approach 2) The marginal revenue and marginal cost
approach Both methods will give exactly the same
result
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The profit-maximizing level of output
1
D em and C urve Facing
N ed’s Beds
Number of Bed Frames per Day
Price per Bed
$600
450
2 3 4 5 6 7 8 9 10
200
(3) (4) (1) (2) T otal T otal (5)
Price Output Revenue Cost Profit
$650 0 0 $ 300 $ 300 $650 1 $ 650 $ 700 $ 50 $600 2 $1,200 $ 900 $ 300 $550 3 $1,650 $1,000 $ 650 $500 4 $2,000 $1,150 $ 850 $45 0 5 $2,250 $1,350 $ 900 $400 6 $2,400 $1,600 $ 800 $350 7 $2,450 $1,900 $ 550 $300 8 $2,400 $2,250 $ 150 $2 9 $2,250 $2,650 $ 400 $200 1 0 $2,000 $3,100 $1,100
5 0
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The profit-maximizing level of output The marginal revenue and marginal cost
approach This method may seem less intuitive but gives
much more insight into the firms and managers decision making process
In other economics courses this is the primary method used since it is much more insightful in understanding behavior
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The profit-maximizing level of output Marginal revenue (MR)
Is the change in total revenue (TR) from producing on more unit of output (Q).
TRMR
Q
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The profit-maximizing level of output Recall the definition of marginal cost from
previous lectures Marginal cost
Is the increase in total cost from producing one more unit of output
TCMC
Q
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The profit-maximizing level of output When a firm faces a downward sloping
demand curve there will be two forces acting on revenue 1) revenue gain – from selling additional output
at the new price 2) revenue loss – from selling all the previous
units out output at a lower price Example – going from 2 to 5 bed frames – selling 3
more frames but the instead of getting $600 for the first two, you now only get $450
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The profit-maximizing level of output Using MC and MR to maximize profits
An increase in output will always raise profits as long as MR>MC
An increase in output will always decrease profit when MR<MC
Following from above, profit will be maximized where MR is as close to MC as possible
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Figure 2 Profit Maximization
Total Fixed Cost
$3,500
3,000
2,500
2,000
1,500
1,000
500
TC
TR
Output
TR from producing 2nd unit
TR from producing 1st unit
Profit at 3 Units
Profit at 5 Units
Profit at 7 Units
(a)
$700
600
500
400
300
200
100
0
–100
–200
MC
MR
Output
(b)
Dollars Dollars
1 210 3 4 5 6 7 8 9 10 1 2 3 4 5 6 7 8 9 10
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New Material Profit maximizing using marginal cost and
marginal revenue revisited The profit maximizing level of output is always
found where MC intersects MR from below
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Dollars
Q1 Q* Output
AMC
B
MR
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Profit Maximization Why is our marginal approach to maximizing
profit reasonable? This idea of having marginal cost and
marginal revenue as close as possible to marginal cost means the amount of money coming in (MR) for each additional unit of output is just equal to the amount of money going out (MC) to pay for the additional output
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Profit Maximization The text refers to this as the “marginal
approach to profit” This notion can be applied to other ideas as
well Example with advertising
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5 10 15 20 25 30
$10 Additional Cost
Advertising Space (Square Inches)
Dollars per Square
Inch
Additional Revenue
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When to shut down What happens if you are losing money in the
short run? Should you always shut down?
Answer depends on how much you are losing.
The shut down rule in the short run (SR) is to stop production if it cannot cover its variable costs
If it can cover all its variable costs but not all the fixed costs, then it should still keep producing in the SR
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Figure 5 Loss Minimization
Q*
TCDollars
TR
TVC
TFC
Output
Loss at Q*
MC
Dollars
MROutput
TFC
Q*
(a) (b)
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Q*
TCDollars
TR
TVC
Output
TFC
TFC
Loss at Q*
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When to shut down in the SR If we are already at the output level where Q*
is the point where MR=MC then: If TR>TVC at Q*, the firm should keep
producing If TR<TVC at Q*, then the firm should shut
down If TR=TVC at Q*, then the firm does not care if it
shuts down or not
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What happens in the LR? In the LR all inputs are variable so the firm
would shut down or exit the industry if there is any loss at all No matter how small the loss is, in the LR the
firm should exit
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The principal-agent problem Do the firms manager(s) and the workers have
the same objectives? Usually not! Firms want to make profits and earn $ for the
shareholders Workers usually want to maximize their benefit
from working (i.e. their wage less the time and effort required to get that wage)
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The principal-agent problem The difference between the firm managers
goals and those of the workers or employees creates what is called a principal-agent problem