AE 11 (MANAGERIAL ECONOMICS)

Module 5: Profit Maximization by Firms

Activity Description Time to Complete

1. Formative Firms are profit oriented organizations 30 Minutes

Activity that purchase inputs and input services
and sell goods and services. Production
frequently requires the coordinated efforts
of many persons.

Section 1. Firms 240 Minutes

2. Lesson Proper a. Goals of Firms
b. Economic Profits

Section 2. Profit Maximization

a. Choice of Plant Size

Section 3. Market Structures and

Decision.

3. Summative Application of knowledge on production 45 Minutes

Assessment costs.

4. Reinforcement Reinforcement on Students’ 45 Minutes

Discussion understanding on profit maximization

Total: 360 minutes

2020-2021 Module Packet for Managerial Economics (AE 12) College of Liberal Arts, Sciences, and Education, University of San Agustin Iloilo
City, Philippines
Overview of Module 5
The discussion in this section teaches us to be cautious before rejecting the profit-maximization
assumption, for two reasons. First, we cannot accept statements of objectives by business
executives and managers at face value. Second, and more generally, an economic theory like
the profit-maximization assumption can only really be tested by empirical study, not by
theoretical objections like those raised earlier. Another example can illustrate this. An objection
to the profit-maximization assumption discussed earlier was that managers do not have access
to accurate and detailed up-to-date information regarding costs and revenue functions, and
certainly have difficulty with forecasting. It was suggested that this would lead to satisficing
behavior. However, a couple of studies have shown that such information, to a large extent, is
not necessary for managers to achieve profit maximization. Day introduced a simple learning
model wherein managers adjust output from one period to the next on the basis of changes in
output and profit in the previous period. He demonstrated that profit-maximizing behavior can
emerge in this situation, even without a knowledge of cost and revenue functions. Thus,
satisficing can in practice closely approximate to maximizing. An analogy can be drawn here: a
bird does not need to know the laws of aerodynamics in order to be able to fly. A more general
analogy can be made with the Darwinian law of natural selection, or ‘survival of the fittest’ as it
is often called. Dawkins46 has dubbed this process of nature ‘the blind watchmaker’; similarly,
managers can be blind to cost and revenue information but the forces The theory of the firm 65
of competition may force them to maximize profit regardless, while managers who make bad
decisions will ultimately force their firms out of business. Therefore, we can conclude that,
whatever the theoretical objections to the profit-maximization assumption, provided that it can
make reasonably accurate predictions of the behavior of firms and managers, it is still a useful
and sensible theory with which to work. Thus, the neoclassical approach can be vindicated.

Learning Objectives

Dear students, what will you learn from this module?

At the end of the module, learners are expected to:
 Explain why firms are created.
 Elucidate why firms are assumed to be profit-maximizing.
 Describe why equilibrium may require that economic profits equal zero.
 Justify how to find profit-maximizing outputs from total revenue and total cost curves.
 Justify how to find profit-maximizing outputs from marginal revenue and marginal cost
curves.
 Rationalize why a firm should shut down if price is less than average variable cost.

Firms
 Firms are profit oriented organizations that purchase inputs and input services and sell
goods and services. Production frequently requires the coordinated efforts of many
persons.
 Firms are means of achieving the required coordination. Market may be used to
coordinate activities, but there are may be significant transaction costs involved.
Transaction that occur within a firm may avoid some of these costs.

2020-2021 Module Packet for Managerial Economics (AE 12) College of Liberal Arts, Sciences, and Education, University of San Agustin Iloilo
City, Philippines
  Firms are created when it is more efficient to organize productive activity on a
contractual basis than to use markets. (Not all producers are firms, for example, the
Department of National Defense, public schools, and nonprofit hospitals.)

A. Firms have workers and entrepreneurs

 There are two types of participants in a firm: workers and entrepreneurs.
 Workers provide labor inputs; their services are usually compensated on a contractual
basis, usually at a specified daily or weekly rate.
 Entrepreneurs are the organizers and risk-bearers in the production process. They are
usually “residual claimants.” Entrepreneurs receive compensation only after all other
claims against the firm have been settled.

https://www.youtube.com/watch?v=VjER5cOpHLs

B. Entrepreneurial functions are divided in

corporations.
 The entrepreneurial function is divided in corporations between management and
stockholders. Management organizes production. The stockholders provide the financial
resources for the corporation and bear the risks. The stockholders are technically the
residual claimants. However, the stockholders’ liability for the debts of the corporation is
limited to their initial investments (limited liability.)
Goals of Firms
 Firms are assumed to be profit-maximizing or profit oriented. Their decisions on prices,
outputs, inputs, and other factors consistently reflect a striving for higher profits. While
any theory of the firm must be judged on the accuracy of its predictions, there are a priori
reasons to assume profit maximization.

https://www.youtube.com/watch?v=yXcVf_4Gf_w

A. Profit maximizers are likely to survive.

 Economist George Stigler has proposed a “survivorship principle.” According to this
principle, firms that survive over time are likely to be those whose decisions product the
highest profits. Commercial entities that do not orient their behavior towards profits will
be driven out of business by the more efficient profit maximizers.

B. Low profits invite corporate takeovers.

 Corporations that do not generate adequate corporate profits may be taken over and the
management replaced. The price of stock in the corporation will probably decline if
management is not efficient. Low stock prices may attract a new group of stockholders.

2020-2021 Module Packet for Managerial Economics (AE 12) College of Liberal Arts, Sciences, and Education, University of San Agustin Iloilo
City, Philippines
 The new stockholders will replace the management in hope of realizing a gain from
higher stock prices when profits improve.

C. Firms may have alternative goals.

 Economic models have been constructed that assume other goals for firms. Firms may
be assumed to be maximizing sales, growth, or management’s utility. J.K. Galbraith
contends that the “technostructure” running the modern corporations is seeking growth
and stability. Still other models, based on the work of Herbert Simon, assume that firms
pursue “satisficing,” rather than maximizing behavior. Simon argues that the complexity
of modern firms precluded their focusing on a single objective, such as profits. Instead,
forms seek to meet a variety of objective.

Economic Profits
 Economic profits are defined as revenues minus private production costs:
profits = revenues – production costs
Production cost is defined to include both explicit and implicit costs. Given the unique definition
of costs, the definition of profits will also differ from that commonly used. Economic profits and
accounting profits differ in concepts.
Example: Assume that the firm has revenue of P 540,000 and the cost of P530,000. Profits will
equal P10,000
Profits = revenues – costs
10,000 = 540,000 – 530,000

https://www.youtube.com/watch?v=BE5MBKtSA6w

A. Equilibrium may require that economic profits

equal zero.
 Economic profits equal to zero may be a condition for equilibrium in the market.
Production costs include implicit costs valued at what they can earn in their best use. A
zero economic profit means that inputs are earning as much in their present use as they
could in their next best alternative. When profits are zero, there is no incentive for a firm
to reallocate its inputs. New firms have no special incentive to begin production goods if
they expect to earn zero profits. When profits are positive in some market, other firms
have the incentive to enter the market.

B. Profits may be represented graphically by distance

or area.
 Profits may be represented graphically in two ways. Total profits may be shown as the
vertical distance between the total revenue and the total cost.

https://www.youtube.com/watch?v=92tfFyrISxk

2020-2021 Module Packet for Managerial Economics (AE 12) College of Liberal Arts, Sciences, and Education, University of San Agustin Iloilo
City, Philippines
B. Profits may be represented graphically by distance
or area.
 Average profits or profits per unit of output may be shown as the vertical distance
between price (price=average revenue) and average cost. Total profits are then
represented by the area PABC below.

2020-2021 Module Packet for Managerial Economics (AE 12) College of Liberal Arts, Sciences, and Education, University of San Agustin Iloilo
City, Philippines
Profit Maximization
 Firms will set quantities and prices such that economic profits are maximized. Profits
may be optimized by applying differential calculus or other mathematical programming
techniques to a profit function. Following the rules can be applied to maximize profits:
 Short-run rules
 If the firm produces, it should produce where marginal cost rises to equal
marginal revenue.
 The firm should produce in the short run if the price equals or exceeds average
variable cost.
 Firms will set quantities and prices such that economic profits are maximized. Profits
may be optimized by applying differential calculus or other mathematical programming
techniques to a profit function. Following the rules can be applied to maximize profits:
 Long rules
 The firm should select a plant size that will minimize the cost of
production.
 The firm should produce in the long run if profits are greater than or equal
to zero.

https://www.youtube.com/watch?v=cc07x5tCrNc

A. Maximize distance between revenue and cost

curves.
Total profits will be maximized when the total revenue curve exceeds the total cost curve
by the maximum vertical distance. This will occur at the output where the two curves have the
same slope. A tangent to the total revenue curve will be parallel to a tangent to the total cost
curve at the profit maximizing output.

2020-2021 Module Packet for Managerial Economics (AE 12) College of Liberal Arts, Sciences, and Education, University of San Agustin Iloilo
City, Philippines
B. Equate marginal revenue to marginal cost.
 The profit-maximizing output level will occur where marginal cost rises to equal marginal
revenue:
Marginal revenue = Marginal cost
 Marginal cost is the change in total cost for a one-unit change in quantity. Marginal
revenue is the change in total revenue for a one-unit change in quantity. Marginal cost
corresponds to the slope of a tangent to the total cost curve (ΔTC/ΔQ). Marginal revenue
corresponds to the slope of a tangent to the total revenue curve (ΔTR/ΔQ). The
maximum vertical distance between total revenue and total cost curves occurs where a
tangent to the total revenue curve is parallel to a tangent to the total cost curve. Thus
profits will be maximized where marginal revenue equal marginal cost.

https://www.youtube.com/watch?v=iViIC3A3rr8

Profits will be maximum where the marginal cost (MC) curve rises to intersect the
marginal revenue (MR) or price curve.

2020-2021 Module Packet for Managerial Economics (AE 12) College of Liberal Arts, Sciences, and Education, University of San Agustin Iloilo
City, Philippines
C. Short run: Shut down if price is less than average
variable cost.
 The maximum profit attainable by a firm may be negative. If the price of the good were
decreased, any output level selected by the firm would yield negative profits. The form
can minimize its losses by shutting down if the price is less than the average variable
cost. A firm must lose no more than its fixed costs over one fixed period. The firm can
avoid all other costs in the short run by ceasing production. If the price is less than the
average variable costs of production, then losses will be greater than fixed costs.
Therefore, the firm should shut down production.

2020-2021 Module Packet for Managerial Economics (AE 12) College of Liberal Arts, Sciences, and Education, University of San Agustin Iloilo
City, Philippines
A firm would produce in the short run in price (P) equals or exceeds
average variable cost (AVC).

D. Long-run: Shut down if profits are negative.

 In the long run the plant should shut down if economic profits are less than zero. There
are no fixed costs in the long run. Therefore, the firm will increase production if revenues
are not sufficient to cover all private production costs.

2020-2021 Module Packet for Managerial Economics (AE 12) College of Liberal Arts, Sciences, and Education, University of San Agustin Iloilo
City, Philippines
Choice of Plant Size
 Firms will select a plant capacity to minimize the cost of producing the desired output
level in the long run. This means that the firm must choose a plant size corresponding to
an average cost shown on the LRAC (planning curve.
 Example: If Q* is the desired output level in the long run, then the firm will select the
plant capacity corresponding to Q*.
 Watch this: https://www.youtube.com/watch?v=6kIIAbb6hZg

Market Structures and Decisions

 The number and types of decisions made by a firm depend on the type of the product produced
and the structure of the market in which the product is sold. All firms must decide output levels.
Firms in market structures such as monopoly or monopolistic competition must determine prices
for their products. Firms that sell heterogenous goods such as cars, perfumes, and other luxury
goods must also decide upon the characteristics of their particular product.

2020-2021 Module Packet for Managerial Economics (AE 12) College of Liberal Arts, Sciences, and Education, University of San Agustin Iloilo
City, Philippines
Market Structures and Decisions

 The number and types of decisions made by a firm depend on the type of the product
produced and the structure of the market in which the product is sold. All firms must
decide output levels. Firms in market structures such as monopoly or monopolistic
competition must determine prices for their products. Firms that sell heterogenous goods
such as cars, perfumes, and other luxury goods must also decide upon the
characteristics of their particular product.

Market Structures and Decisions

Market Structure Decision

Perfect Output
competition
Monopoly Output, price

Monopolistic Output, price, product differentiation

competition
Oligopoly Output, price, product differentiation

References

Hirschey, M., Managerial Economics 12th ed. Pasig City: Cengage Learning Asia Pte Ltd. 2012.

Samuelson, W., Marks, S. Managerial Economics. John Wiley and Sons Inc. 2016

Thomas, C, Maurice, C., Manager Economics, Foundations of Business Analysis and Strategy 12th ed
International Edition. Mc Graw Hill 2016

Wikenson, N. Managerial Economics: A Problem Solving Approach. Harvard, Cambridge University

Press 2015

2020-2021 Module Packet for Managerial Economics (AE 12) College of Liberal Arts, Sciences, and Education, University of San Agustin Iloilo
City, Philippines