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CChapter 9hapter 9Maximizing ProfitMaximizing Profit

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Gottheil - Principles of Economics, 4e

Economic PrinciplesEconomic PrinciplesEntrepreneurial behaviorTotal revenue, average revenue,and marginal revenueProfit maximization

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Economic PrinciplesEconomic PrinciplesLoss minimizationThe application of the MR = MC ruleCorporate empire building

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Profit MaximizationProfit Maximization

Profit maximization

• The primary goal of a firm: To achieve the most profit possible from its production and sale of goods or services.

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Entrepreneurs and Entrepreneurs and Profit MakingProfit Making

Entrepreneurs must make production decisions that require some degree of expertise in both the mechanics of production and in accounting.

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Entrepreneurs and Entrepreneurs and Profit MakingProfit Making

How do entrepreneurs anticipate what prices will be in the future?• Entrepreneurs rely on their best judgment, sometimes on a sixth sense.

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ProfitProfit

Profit

• Income earned by entrepreneurs.

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EXHIBIT 1 AVERAGE TOTAL COST AND MARGINAL COST OF PRODUCING FISH PER FISHING RUN ($ PER FISH)

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Exhibit 1: Average Total Cost Exhibit 1: Average Total Cost and Marginal Cost of and Marginal Cost of

Producing Fish Per Fishing RunProducing Fish Per Fishing Run1. If 11,000 fish are for sale at a price of $0.75, then (using the cost data in Exhibit 1) what is the profit per fish?

• Profit per fish is (P - ATC).

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1. If 11,000 fish are for sale at a price of $0.75, then (using the cost data in Exhibit 1) what is the profit per fish?

• Profit/fish = $(0.75 - 0.68) = $0.07.

Exhibit 1: Average Total Exhibit 1: Average Total Cost and Marginal Cost of Cost and Marginal Cost of

Producing Fish Per Producing Fish Per Fishing RunFishing Run

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2. What is the total profit from selling 11,000 fish?

• Total profit is (P - ATC) × Q.



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2. What is the total profit from selling 11,000 fish?

• Total profit = (0.75 - 0.68) × 11,000 = $770.



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3. What happens to profit if price rises to $0.80, and 11,000 fish are to be sold?

• Total profit at an output level of 11,000 equals (0.80 - 0.68) × 11,000 = $1,320.



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4. If price rises to $0.80, are fishers better off to increase catch to 12,000 fish?

• No. Total profit at an output level of 12,000 equals (0.80 - 0.73) × 12,000 = $840.



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4. If price rises to $0.80, are fishers better off to increase catch to 12,000 fish?• As output increases, average total cost rises from $0.68 to $0.73. Therefore even though output rises, total profit falls.



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The The MRMR = = MCMC Rule Rule

There are two ways to find the most profitable level of production:

• Calculate total profit for each and every output level.

• Calculate whether the last unit produced adds to or subtracts from total profit.

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Total revenue (TR)

• The price of a good multiplied by the number of units sold.

TR = P × Q

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Average revenue (AR)

• Total revenue divided by the quantity of goods or services sold.

AR = TR/Q

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If TR = $22,600, and Q = 200, what is AR?

• AR = ($22,600/200) = $113.

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Marginal revenue (MR)

• The change in total revenue generated by the sale of one additional unit of goods or services.

MR = (change in TR)/(change in Q)

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If TR rises by $10 when output rises by one unit, what is MR?

• MR = $10/1 = $10.

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EXHIBIT 2A TOTAL AND MARGINAL REVENUE CURVES DERIVED FROM SELLING FISH WHEN P = $0.90

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EXHIBIT 2B TOTAL AND MARGINAL REVENUE CURVES DERIVED FROM SELLING FISH WHEN P = $0.90

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EXHIBIT 2C TOTAL AND MARGINAL REVENUE CURVES DERIVED FROM SELLING FISH WHEN P = $0.90

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Exhibit 2: Total and Marginal Exhibit 2: Total and Marginal Revenue Curves Derived Revenue Curves Derived

from Selling Fish When from Selling Fish When PP = = $0.90$0.901. Why is marginal revenue equal

to price in Exhibit 2?• TR = P × Q. Since MR = (change in TR)/(change in Q), then when Q increases by one unit, TR increases by an amount equal to price.

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1. Why is marginal revenue equal to price in Exhibit 2?• For example, if quantity increases from 2 to 3, and if price is $0.90, then the change in TR is $(2.70 - 1.80) = $0.90. The change in Q is 1. Therefore, MR = $0.90/1 = $0.90.

Exhibit 2: Total and Exhibit 2: Total and Marginal Revenue Curves Marginal Revenue Curves Derived from Selling Fish Derived from Selling Fish

When When PP = $0.90 = $0.90

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1. Why is marginal revenue equal to price in Exhibit 2?• As a result, MR = price. The marginal revenue curve is a horizontal line at the prevailing price.


When When PP = $0.90 = $0.90

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2. Why is the TR curve in panel a an upward-sloping straight line?• The TR curve is upward-sloping because as output increases, TR increases, since TR = P × Q.


When When PP = $0.90 = $0.90

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2. Why is the TR curve in panel a an upward-sloping straight line?• The TR curve is a straight line because its slope is equal to price, which does not change.


When When PP = $0.90 = $0.90

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3. What is the difference between TR and TR′ at an output level of 11,000?• TR at a quantity of 11,000 is $9,900.

Exhibit 2: Total and Marginal Exhibit 2: Total and Marginal Revenue Curves Derived Revenue Curves Derived

from Selling Fish When from Selling Fish When PP = = $0.90$0.90

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• TR′ at a quantity of 11,000 is $5,500.

3. What is the difference between TR and TR′ at an output level of 11,000?


When When PP = $0.90 = $0.90

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• (TR - TR′) = $4,400.

3. What is the difference between TR and TR′ at an output level of 11,000?

Exhibit 2: Total and Marginal Exhibit 2: Total and Marginal Revenue Curves Derived from Revenue Curves Derived from Selling Fish When Selling Fish When PP = $0.90 = $0.90

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Applying the Applying the MRMR = = MCMC Rule Rule

MR = MC rule

• The guideline used by a firm to achieve profit maximization.

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Applying the Applying the MRMR = = MCMC Rule Rule

The profit maximization guideline is to keep adding to production as long as the marginal revenue gained from adding production is greater than the marginal cost incurred from adding it.• When MR > MC, increase production.

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EXHIBIT 3 KEY DATA ON PROFIT MAXIMIZATION

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Exhibit 3: Key Data Exhibit 3: Key Data on Profit on Profit

MaximizationMaximization1. If quantity is 6,000 in Exhibit 3, what should a firm do?• Increase quantity

• Keep quantity the same

• Reduce quantity

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• Reduce quantity

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• Reduce quantity

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• Reduce quantity

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EXHIBIT 4 APPLYING THE MR = MC RULE

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Exhibit 4: Applying the Exhibit 4: Applying the MRMR = = MCMC Rule Rule

If quantity is 13,000 in Exhibit 4, is profit maximized?• No. Since the MC curve is above MR curve, profit is smaller at 13,000 than if output is set at 10,000.

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Maximizing Profit on Maximizing Profit on Israel’s KibbutzimIsrael’s Kibbutzim

According to Professors Levhari and Barkai, does a kibbutz behave as if it were a profit-maximizing firm?• Yes. While the trademark of the kibbutz is universal equality, this goal does not interfere with maximizing profit from the kibbutz’s agricultural and manufacturing activities.

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Maximizing Profit on Maximizing Profit on Israel’s KibbutzimIsrael’s Kibbutzim

• Evidence for profit-maximizing behavior includes a kibbutz switching from one crop to another based on relative prices.

According to Professors Levhari and Barkai, does a kibbutz behave as if it were a profit-maximizing firm?

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Determining Determining Maximum ProfitMaximum Profit

The formula for determining maximum profit is:• (P - ATC) × Qmax.

Note that Qmax is the profit-maximizing output level.

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EXHIBIT 5 MEASURING PROFIT MAXIMIZATION

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Exhibit 5: Measuring Exhibit 5: Measuring Profit MaximizationProfit Maximization

Using the information in Exhibit 5, what is total profit when output is 10,000, price is $0.90, and ATC is $0.645?

• Profit is $2,550.

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Using the information in Exhibit 5, what is total profit when output is 10,000, price is $0.90, and ATC is $0.645?

• $2,550 = $(0.90-0.645) × 10,000.

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Using the information in Exhibit 5, what is total profit when output is 10,000, price is $0.90, and ATC is $0.645?• Total profit of $2,550 is represented graphically as the area of the shaded rectangle in Exhibit 5.

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Maximizing Profit and Maximizing Profit and Minimizing LossMinimizing Loss

Loss minimization

• Faced with the certainty of incurring losses, the firm’s goal is to incur the lowest loss possible from its production and sale of goods and services.

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If price is less than ATC, but greater than AVC, the firm is better off to produce where MR = MC in the short run, even though profit is negative.

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The reason is that if price is less than ATC, but greater than AVC, all variable costs are being paid with revenue, and there is a bit left over to apply toward fixed cost.

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If instead the firm shut down when ATC > P > AVC, then the firm would have no revenue to apply toward fixed cost.

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Example: Suppose that price is $0.45, AVC = $0.31, output is 7,000, and TFC = $2,000. Should the firm produce or shut down?• If the firm produces, then ignoring TFC, the firm clears $(0.45 - 0.31) × 7,000 = $980.

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Example: Suppose that price is $0.45, AVC = $0.31, output is 7,000, and TFC = $2,000. Should the firm produce or shut down?

• This $980 can be applied to paying off part of the $2,000 TFC.

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Example: Suppose that price is $0.45, AVC = $0.31, output is 7,000, and TFC = $2,000. Should the firm produce or shut down?• If instead the firm were to shut down, there would be no revenue to apply toward paying the $2,000 fixed cost.

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Shutdown

• The cessation of the firm’s activity. The firm’s loss minimization occurs at zero output.

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If price is less than both ATC and AVC, the firm is better off to shut down rather than produce.

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If price is less than AVC then total revenue is less than total variable cost. Since the entire total variable cost can be avoided by shutting down, the firm is better off to shut down.

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If instead the firm were to produce rather than shut down when P < AVC, then the loss would be TFC + (AVC - P) × Q. The firm is better off to shut down and incur a loss of TFC.

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EXHIBIT 6 MINIMIZING LOSS

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Exhibit 6: Minimizing Exhibit 6: Minimizing LossLoss

1. Using the data in Exhibit 6, what output level should the firm produce if price is $0.45?• Loss is minimized when the firm produces a quantity of 7,000.

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• MR = MC at a quantity of 7,000, and the loss is $(0.45 - 0.60) × 7,000 = -$1,050.

1. Using the data in Exhibit 6, what output level should the firm produce if price is $0.45?

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2. Using the data in Exhibit 6, what output level should the firm produce if price is $0.26?• Loss is minimized when the firm shuts down.

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• While MR = MC at a quantity of 5,000, AVC is $0.28. Total revenue is $1,300, while TVC = $1,400, and so total revenue falls short of TVC by $100.

2. Using the data in Exhibit 6, what output level should the firm produce if price is $0.26?

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Do Firms Really Behave Do Firms Really Behave This Way?This Way?

What is the Lester-Machlup controversy?• Princeton’s Richard Lester challenged the idea that entrepreneurs look to the margin for production signals.

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What is the Lester-Machlup controversy?• In a survey conducted by Lester, entrepreneurs responded that they did not think in terms of marginal units.

Do Firms Really Do Firms Really Behave Behave

This Way?This Way?

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What is the Lester-Machlup controversy?• Fritz Machlup dismissed Lester’s findings on the grounds that the MR = MC theory of profit maximizing doesn’t depend on what entrepreneurs think they do.


This Way?This Way?

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• Rather, the MR = MC theory relies on what they actually do.

What is the Lester-Machlup controversy?


This Way?This Way?

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Empire BuildingEmpire Building

Another challenge to the MR = MC rule is based on the argument that decision-makers are not as one-dimensional as marginalists suggest.

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For example, stockholders typically want the firm to maximize profit. The firm’s managers, on the other hand, see the firm as more than an economic machine grinding out profit for stockholders.

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The firm has social, political, and historical dimensions that are important to the firm’s managers.

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The firm that is run by nonowning managers generally chooses to maximize sales, not profit. Success is measured by the size of the production range.

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The nonowning manager’s goal is empire building.

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In John Kenneth Galbraith’s view, the primary goal of managers is the survival of the corporation and, in particular, the survival of its managerial bureaucracy.

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StakeholderStakeholder

Stakeholder

• Someone who has a personal and consequential interest in the viability of the firm.

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According to Lester Thurow, “American government may be bureaucratic and inefficient, but American industry is just as bureaucratic an inefficient.”

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In Galbraith and Thurow’s view, the preservation of the managerial class, even at the expense of profit, is what managers seek.

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What Survives of What Survives of Marginalism?Marginalism?

In the view of many economists, the criticisms of Galbraith and Thurow are interesting and perhaps even useful in explaining some aspects of corporate behavior.

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Yet many economists also argue that these criticisms offer insufficient evidence to seriously undermine the basic postulates of the marginalist economists: Firms must be guided by the MR = MC rule to maximize profit.

What Survives of What Survives of Marginalism?Marginalism?

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C hapter 9