Firms’ Decisions
• The goal of profit maximization
• Two definitions of profit
• The firm’s constraints
• The total revenue and total cost approach
• The marginal revenue and marginal cost
approach
• short-run: shut down rule
• Long-run: exit rule
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The Goal Of Profit Maximization
• What is the firm trying to maximize?
• A firm’s owners will usually want the firm to
earn as much _____ as possible
• We will view the firm as a single economic
decision maker whose goal is
to_______________
• Why?
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Understanding Profit: Two
Definitions of Profit
• Profit is defined as the firm’s sales revenue minus its costs
of production
• If we deduct only costs recognized by accountants, we get
one definition of profit
– ____________ = Total revenue – Accounting costs
• A broader conception of costs (opportunity costs) leads to
a second definition of profit
– ____________= Total revenue – All costs of production
– Or Total revenue – (Explicit costs + Implicit costs)
• Proper measure of profit for understanding and predicting
firm behavior is economic profit
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Why Are There Profits?
• Economists view profit as a payment for two
necessary contributions
• 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: The
Demand Constraint
• 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 ________ price it can charge
• Leads to an alternative definition
– Shows __________ 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—which is the number of units
of output times the price per unit—follows
automatically
TR=P*Q
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The Cost Constraint
• Every firm struggles to reduce costs, but there is a
limit to how low costs can go
– These limits impose a second constraint on the firm
• 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
• For any level of output the firm might want to
produce
– It must pay the cost of the ―__________‖ of production
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The 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 Cost
Change in total cost from producing one
more unit of output
• MR = ________
• Marginal revenue
– Change in total revenue from producing one
more unit of output
• MR = _________
• MR tells us how much revenue rises per
unit increase in output
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The Marginal Revenue and Marginal
Cost Approach
• Important things to notice about marginal revenue
– When MR is ____, an increase in output causes total revenue to rise
– Each time output increases, MR is ______ than the price the firm
charges at the new output level
• 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 greater than marginal cost (MR > MC)
– Converse of this statement is also true
• An increase in output will lower profit whenever marginal
revenue is less than marginal cost (MR MC, and decrease
output when MR
TVC)
– Should not shut down because operating profit can be used to help pay
fixed costs
– But if the firm cannot even cover its operating costs when it stays open, it
should shut down
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Dealing With Losses: The Short-
Run and the Shutdown Rule
• Guideline—called the shutdown rule—for a loss-
making firm
– Let Q* be output level at which MR = MC
– Then in the short-run
• If TR >TVC at Q* firm should keep producing
• If TR < TVC at Q* firm should shut down
• If TR = TVC at Q* firm should be indifferent between shutting
down and producing
• The shutdown rule is a powerful predictor of firms’
decisions to stay open or cease production in
short-run
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Figure 4: Loss Minimization
Dollars
MC
Q* MR Output
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Figure 5: Shut Down
Dollars TC
Loss at Q* TVC
TFC
TR
TFC
Q* Output
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The Long Run: The Exit Decision
• We only use term shut down when referring
to short-run
• If a firm stops production in the long-run it is
termed an exit
• A firm should exit the industry in long- run
– When—at its best possible output level—it has
any loss at all
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