The Goal Of Profit Maximization

What is the firms goal?

A firms 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
Hall & Leiberman;
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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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Economics: Princi

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
productionboth explicit and implicit costs

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Economics: Princi

Why Are There Profits?

Economists view profit as a payment for
Risk-taking
Someonethe ownerhad 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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Economics: Princi

The Firms 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

Hall & Leiberman;

Economics: Princi

Figure 1: The Demand Curve

Facing The Firm

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Economics: Princi

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

Hall & Leiberman;

Economics: Princi

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

Hall & Leiberman;

Economics: Princi

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 profitwhen 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
Hall & Leiberman;
Economics: Princi

The Marginal Revenue and

Marginal Cost Approach
Marginal revenue
Change in total revenue from
producing one more unit of output
MR = TR / Q

Tells us how much revenue rises

per unit increase in output
Hall & Leiberman;
Economics: Princi

10

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
Hall & Leiberman;
Economics: Princi

11

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?
Hall & Leiberman;
Economics: Princi

12

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?

Hall & Leiberman;

Economics: Princi

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Figure 2a: Profit Maximization

Dollars
$3,500

TC

3,000
2,500
2,000

Profit at 3
Units

1,500
1,000

Profit at 5
Units

TR

TR from producing 2nd unit

500
Total Fixed
Cost

Profit at 7
Units

TR from producing 1st unit

0

Hall & Leiberman;

Economics: Princi

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Output
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Figure 2b: Profit Maximization

Dollars
600
MC

500
400
300
200
100
0
100
200
Hall & Leiberman;
Economics: Princi

profit rises

profit falls

Output
MR
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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

Hall & Leiberman;

Economics: Princi

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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 usefulallows us to look at a

diagram of MC and MR curves and immediately
identify profit-maximizing output level

Hall & Leiberman;

Economics: Princi

17

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????

Hall & Leiberman;

Economics: Princi

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