How Firms Make Decisions:

Profit Maximization

COLETO, NEIL ROCA, JOANNA

REDONDO, ALLYSA SARARANA, JANDENVER
ROBLES, KURT VINCENT TIBUNSAY, MIKHAELL
FIRM
A commercial organization
that operates on a for-profit
basis and participates in
selling goods or services to
consumers. The management
of a business firm will typically
develop a set of
organizational objectives and
a strategy for meeting those
goals to help employees
understand where the
company is headed and how
it intends to get there.
THE GOAL OF PROFIT MAXIMIZATION

 To analyze decision making at the firm, let’s start with a very

basic question
What is the firm trying to maximize?
 A firm’s owners will usually want the firm to earn as much profit as
possible
 We will view the firm as a single economic decision maker whose
goal is to maximize its owners’ profit
THE GOAL OF PROFIT MAXIMIZATION
 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
Many managers are well trained in tools of profit-
maximization
UNDERSTANDING PROFIT
In general, profit is the difference between costs and revenue, but
there is a difference between accounting profit and economic
profit.
Accounting Profit Economic Profit
 Accounting profit is the  Economic profit is the
difference between total difference between total
monetary revenue and total monetary revenue and total
monetary costs, and is costs, but total costs include
computed by using generally both explicit and implicit
accepted accounting costs.
principles (GAAP).
UNDERSTANDING PROFIT

Difference between Economic and Accounting Profit

Economic profit consists of revenue minus implicit
(opportunity) and explicit (monetary) costs;
accounting profit consists of revenue minus explicit
costs.
THE FIRM’S CONSTRAINTS

 Demand curve facing the firm

Tells us, for different prices
The quantity of output that customers will purchase from a
particular firm
Shows us the maximum price the firm can charge to sell any
given amount of output
One firm; All buyers (potential customers)
THE FIRM’S CONSTRAINTS

 Total revenue, TR –The total inflow of receipts from selling a given

amount of output
 Demand and total revenue –Each time the firm chooses a level
of output, it also determines its total revenue
 Total Revenue and Elasticity–Lower price: sell more output
If ED > 1 (elastic demand): total revenue will rise
If ED < 1 (inelastic demand): total revenue will fall
THE FIRM’S CONSTRAINTS

 Supply Costs
The inability to purchase supplies and products at a relatively
low price is a major constraint to economic profit.
 Production Processes
Constraints in production include the costs of labor impacted by
the supply of skilled labor and the capacity of available
equipment. Optimized production systems and workflows also
contribute.
THE FIRM’S CONSTRAINTS
 Market Size
Larger customer markets typically lead to opportunities for
greater sales volume and more revenue. While you can select
markets to go after, the strengths of your offering and the level
of competition you face constrain your ability to enter certain
markets.
 Demand
If your market has a number of strong competitors, your ability to
attract a significant number of customers to dictate high prices
and revenues is constrained.
THE PROFIT-MAXIMIZING OUTPUT LEVEL
DEALING WITH LOSSES: THE SHORT
RUN & THE SHUTDOWN RULE
 You might think that a loss-making firm should always shut
down its operation in the short run
However, it makes sense for some unprofitable firms to
continue operating
 The question is
Should this firm produce at Q* and suffer a loss?
The answer is yes—if the firm would lose even more if it
stopped producing and shut down its operation
DEALING WITH LOSSES: THE SHORT
RUN & THE SHUTDOWN RULE

 If, by staying open, a firm can earn more than enough revenue
to cover its operating costs, then it is making an operating profit
(TR > 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
DEALING WITH LOSSES: THE SHORT
RUN & 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 > Q* firm should keep producing
If TR < Q* firm should shut down
If TR = 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
DEALING WITH LOSSES: THE SHORT
RUN & THE SHUTDOWN RULE

LOSS MINIMIZATION
DEALING WITH LOSSES: THE SHORT
RUN & THE SHUTDOWN RULE

LOSS MINIMIZATION
DEALING WITH LOSSES: THE SHORT
RUN & THE SHUTDOWN RULE

SHUTDOWN
THE LONG RUN: 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
THE PROFIT-MAXIMIZING OUTPUT LEVEL

Profit Maximization
The monopolist's profit maximizing level of output is found by equating
its marginal revenue with its marginal cost, which is the same profit
maximizing condition that a perfectly competitive firm uses to
determine its equilibrium level of output.
THE PROFIT-MAXIMIZING OUTPUT LEVEL