Determine Profit Maximization|Business Finance – Economics
One of the proclaimed benefits of free market capitalism relative to other economic systems or government production is that a profit incentive gives producers the incentive to use resources efficiently in order to produce at the lowest cost. Is profit maximization consistent with the self-interest of corporate owners, corporate managers, and employees? How well do you think the assumption that firms are “profit-maximizers” works in reality?
What a perfectly competitive market is and the characteristics of a perfectly competitive industry
How a price-taking producer determines its profit – maximizing quantity of output
How to assess whether or not a producer is profitable and why an unprofitable producer may continue to operate in the short run
Why industries behave differently in the short run and the long run
What determines the industry supply curve in both the short run and the long run
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What you will learn in this chapter
1
PERFECT COMPETITION: KEY CHARACTERISTICS
1. There are many buyers and sellers, each with a small market share.
Market share: the fraction of the total industry output accounted for by that producer’s output.
This means both sellers and buyers are price- takers; their actions have no effect on price.
Each participant is a drop in the bucket.
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2
Which of the following markets is likely to be the most competitive?
Cable television
Automobiles and trucks
Oil refining
Farm commodities
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3
PERFECT COMPETITION: KEY CHARACTERISTICS
2. The product is standardized across sellers.
Standardized product (aka “commodity”): Consumers regard different sellers’ products as equivalent.
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4
PERFECT COMPETITION: KEY CHARACTERISTICS
A third likely feature:
3. Free entry and exit
Free entry and exit: New producers can easily enter into an industry and existing producers can easily leave that industry.
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5
PRODUCTION AND PROFITS
Since each firm is a price-taker, each firm’s
total revenue will be equal to price × quantity sold, or
TR = P × Q
And Profit = total revenue – total cost, or
Profit = TR – TC
But there is another way to think about it…
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6
USING MARGINAL ANALYSIS TO MAXIMIZE PROFIT
(When market price = $18) profit is highest at Q = 50, which is also the point where marginal cost = marginal revenue.
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MARGINAL REVENUE AND THE OPTIMAL OUTPUT RULE
Marginal revenue: change in total revenue generated by an additional unit of output.
MR = ΔTR/ΔQ
For price-taking firms, MR is simply the good’s market price.
Optimal output rule: Profit is maximized by producing the quantity of output at which the marginal revenue of the last unit produced is equal to its marginal cost.
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EXPLAINING THE OPTIMAL OUTPUT RULE
Why is profit maximized where MR = MC?
Each time the firm produces another unit, there are extra costs and extra revenues.
If producing another unit adds more to revenue than cost, profit will increase.
Because if MR > MC, producing more will add to profit.
And if MR < MC, producing less will add to profit.
Since MR = P for competitive firms, the profit-maximizing rule is: Choose the quantity of output where P = MC.
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9
COSTS AND PRODUCTION IN THE SHORT RUN
As long as increasing production by one more unit creates more MR than MC, it makes sense to do it.
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10
THE SHORT RUN AND THE LONG RUN
Reminder: In the short run, plant size is fixed.
We focus here on short-run profit maximization at a given plant size.
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11
THE PRICE-TAKING FIRM’S PROFIT-MAXIMIZING QUANTITY OF OUTPUT
70
60
50
40
30
20
10
0
$24
20
18
16
12
8
6
Price, cost of tree
Quantity of trees
MC
MR
=
P
E
Profit-maximizing quantity
Optimal point
Market price
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WHAT IF MARGINAL REVENUE AND MARGINAL COST AREN’T EXACTLY EQUAL?
What do you do if there is no output level at which marginal revenue equals marginal cost?
In that case, you produce the largest quantity for which marginal revenue exceeds marginal cost.
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WHEN IS PRODUCTION PROFITABLE?
*Recall we are using economic profit, which includes implicit costs. It is normal for a firm’s economic profit to be zero.
If TR > TC, the firm is profitable.
If TR = TC, the firm breaks even.
If TR < TC, the firm incurs a loss.
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PROFITABILITY AND THE MARKET PRICE
70
60
50
40
30
20
10
0
$30
18
14
MC
ATC
MR
=
P
C
Break- even price
Minimum-cost output
Price, cost of tree
Quantity of trees
Minimum average total cost
If the price is just high enough to cover ATC and if it chooses the Q where
MR = MC, the firm will break even.
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PROFITABILITY AND THE MARKET PRICE
The farm is profitable because P > min ATC ($14).
70
60
50
40
30
20
10
0
MC
Profit
ATC
MR
=
P
C
Z
E
Market price = $18
14.00
14.40
$18.00
Price, cost of tree
Quantity of trees
Minimum average total cost
Break- even price
Optimal output
Per-unit profit = $18 – $14.40
= $3.60
Total profit = $3.60 × 5 = $18.00
The ATC of producing 5 is $14.40
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CALCULATING TOTAL COSTS AND PROFIT
Profit = TR − TC = (TR/Q − TC/Q) × Q, or
Profit = (P − ATC) × Q
Break-even price of a price-taking firm is the market price at which it earns zero profit.
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If a firm is earning positive economic profit, it must be the case that:
price is less than average cost.
price is equal to average cost.
price is equal to total cost.
price is greater than average cost.
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18
Ralph opened a small shop selling bags of trail mix. The price of the mix is $5, and the market for trail mix is very competitive. At what quantity will Ralph produce?
7
10
14
18
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19
Ralph opened a small shop selling bags of trail mix. When the price is $5, how much profit will Ralph make?
$0
$14
$52
$68
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20
PROFITABILITY AND THE MARKET PRICE
The farm’s per unit loss: $10.00 – $14.67 = –$4.67.
Total loss: 3 ×
–$4.67 = approx.
(–$14.00).
70
60
50
40
30
20
10
0
MC
Loss
ATC
MR
=
P
C
A
Y
Market price = $10
14.00
10.00
$14.67
Price, cost of tree
Quantity of trees
Minimum average total cost
Break- even price
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SHOULD I STAY OR SHOULD I GO?
Losses don’t mean immediate shutdown.
Remember, fixed costs must be paid whether or not the firm produces in the short run.
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22
SHOULD I STAY OR SHOULD I GO?
Firms will choose to produce (even at a loss) if they can cover their variable AND SOME of their fixed costs.
Shortcut: Is the price at or below the shut-down price?
Shut-down price: minimum average variable cost.
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THE SHORT-RUN PRODUCTION DECISION: A SIMPLE EXAMPLE
A firm should stay open in the short run if it can cover its variable costs.
Decision Fixed Costs Variable Costs Revenue Profit
Shutdown $100 0 0 –$100
Stay Open 100 50 75 –75
He’ll stay in business… for now.
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24
If Gnomes-R-Us (a competitive firm) produces where the marginal cost curve intersects with the average total cost curve at its minimum point, the firm will earn:
positive economic profits.
zero economic profits.
a short-run loss.
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25
Should a competitive firm keep producing even if it faces short-run losses (and is producing at a point on its MC curve that is above the minimum AVC curve)?
Yes, it is earning normal profits.
Yes, because it covers its variable costs and some fixed costs.
No, it should never incur losses.
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26
If the market price is $5, about how much will this firm produce?
0
30
60
95
100
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27
THE SHORT-RUN INDIVIDUAL SUPPLY CURVE
…but will stop producing in the short run if the market price falls below the shut-down price…
50
40
30
35
0
$18
14
12
10
MC
ATC
AVC
C
B
A
E
Minimum average variable cost
Short-run individual supply curve
Shut-down price
Price, cost of tree
Quantity of trees
A firm will produce at every price above minimum ATC where price intersects the MC curve…
…so the MC curve (above shut-down price) is the firm’s supply curve.
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SHOULD I STAY OR SHOULD I GO?
Summary:
In the short run, a firm will produce if P > shutdown price (min AVC).
A firm will NOT produce if P < min AVC.
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29
FARMERS MOVE UP THEIR SUPPLY CURVES
Increased ethanol demand raised the price of corn- so farmers are planting more and more (and buying more fertilizer, which is getting more expensive in return)
Although farmers were taking a big gamble by cutting the size of their other crops to plant more corn, their decision made good economic sense.
ECONOMICS
IN ACTION
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30
THE INDUSTRY SUPPLY CURVE
If P > break-even (min ATC), firms are profitable.
This profit attracts new entrants.
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31
THE SHORT-RUN INDUSTRY SUPPLY CURVE
The short-run industry supply curve: how the Q supplied by an industry depends on the market price (given a fixed number of producers).
7000
6000
5000
4000
3000
2000
0
$26
22
18
14
10
D
Short-run industry supply curve, S
EMKT
Shut-down price
Price, cost of tree
Quantity of trees
Market price
A higher price means more firms are willing to supply.
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THE LONG-RUN MARKET EQUILIBRIUM
A market is in long-run equilibrium when the quantity supplied equals the quantity demanded, given that sufficient time has elapsed for entry into and exit from the industry to occur.
Quantity of trees
60
50
40
45
30
0
$18.00
16.00
14.00
10,000
7500
5000
0
$18
16
14
D
E
C
D
Y
Z
MC
ATC
A
B
(a) Market
(b) Individual firm
14.40
EMKT
DMKT
CMKT
S1
S3
S2
Price, cost of tree
Quantity of trees
Price, cost of tree
Break-even price
New firms enter as long as there is economic profit (P > min ATC).
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THE EFFECT OF AN INCREASE IN DEMAND: NOW AND LATER
The LRS shows how the quantity supplied responds to the price (once producers have had time to enter or exit the industry)
D↑ P↑ profits entry S↑ P↓ back to zero profit (on LRS curve).
MC
ATC
X
Y
0
0
0
$18
14
Quantity
MC
ATC
Z
Y
Price
S1
D1
D2
S2
YMKT
XMKT
ZMKT
LRS
QX
QY
QZ
(a) Existing firm’s response to increase in demand
(b) Short-run and long-run market response to increase in demand
(a) Existing firm’s response to new entrants
Price, cost
Price, cost
Increase in output from new entrants
An increase in demand raises price and profit.
Long-run industry supply curve
Higher industry output from new entrants drive price and profit back down.
Quantity
Quantity
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COMPARING THE SHORT-RUN AND LONG-RUN INDUSTRY SUPPLY CURVES
The long-run industry supply curve is always flatter—more elastic—than the short-run industry supply curve.
Short-run industry supply curve, S
Long-run industry supply curve, LRS
Price
Quantity
This is because of entry and exit:
A higher price attracts new entrants in the long run, raising industry output and lowering price.
A fall in price induces existing producers to exit in the long run, reducing industry output and raising price.
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ECONOMIC PROFIT, AGAIN
Q: Why would a firm would want to enter an industry if the market price is only slightly
greater than the break-even price?
A: We are using economic profit as our measure, so if the market price is above the break-even level (no matter how slightly), the firm can earn more in this industry than it could elsewhere.
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36
The long-run market equilibrium in a perfectly competitive industry with identical firms results in all firms:
earning zero economic profit.
producing the quantity associated with their break-even price.
producing the profit-maximizing quantity at which MR = MC.
All of the above statements are true.
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