ECO 105: Principles of Economic Theory Chapter 7: Revenues and Profit Maximization I. The firm’s objective: profit A. Definition of profit 1. Economic profit = total revenues - full opportunity costs of production 2. Total revenues = price x quantity 3. Full opportunity costs = explicit costs + implicit costs Recall from Chapter 6: explicit costs are out-of-pocket expenses such as payments for labor, raw materials, rent. Implicit costs are the opportunity costs of using resources already owned by the firm. Normal profit is one example of an implicit cost. It is the amount of payment the owner(s) of the firm could earn in their next-best alternative Note: economic profit is not the same as accounting profit, since accounting profit does not reflect implicit costs 4. An example: Ski Shop Building: $100,000 Inventory:$250,000 Energy: $50,000 Labor: $10,000 Income as computer programmer: $40,000 Total Explicit costs: _________________ Full Opp. Costs: _________________ TR = $445,000 Y Econ profit = _____________ TR = $450,000 Y Econ profit = _____________ TR = $460,000 Y Econ profit = _____________ II. The firm’s output and revenue A. Price-taking firms (farmers, stock market): Table 1 A firm is a price taker when its output decision has no effect on market price. The demand curve faced by the price-taking firm is perfectly elastic at the market price. 1. In the case of price-taking firm, P = MR = AR since the individual firm has no effect on market price B. Price-searching firms (fast food, clothing, cars): Table 2 A firm that has some degree of price-setting power is a price searcher. The demand curve faced by the price-searching firm is downward sloping. 1. In the case of the price-searching firm, P = AR > MR. MR declines as output increases since the firm faces a downward sloping demand curve. To sell additional units of output, the firm must reduce the price on all units of output sold. III. The rule for maximizing profits in the short run: Tables 1 and 2 So long as an additional unit of output adds more to total revenue than it adds to total cost, total profit will increase. This is equivalent to saying that, so long as MR > MC, producing the next unit of output will increase profit. A. Profit maximization and the price-taking firm 1. produce the level of output for which MR = MC B. Profit maximization and the price-searching firm 1. produce the level of output for which MR = MC IV. Determination of profits or losses A. Determination of short-run economic profit 1. Economic profit = total revenue - total economic costs 2. The output decision rule for maximizing economic profit: Produce the level of output at which MR = MC B. To produce or not to produce 1. Positive economic profits So long as price is greater than ATC at the profit-maximizing level of output, the firm will earn positive economic profits. 2. The breakeven point The price equals ATC at the profit-maximizing level of output, TR = TC and the firm’s economic profit is 0. This price-output combination is called the breakeven point. 3. Economic losses When price is less than ATC at the profit-maximizing level of output, the firm will incur an economic loss. However, the decision of whether to continue operating depends on the relationship between P and AVC. • So long as price is greater than AVC at the level of output at which MR = MC, the firm should continue to operate. It can cover all of its variable costs and have some money left over to pay part of its fixed costs. • When price is less than AVC at the level of output at which MR = MC, the firm should shut down. If it continues to operate, it will not be able to cover all of its variable costs, let alone any of its fixed costs. The price-output combination at which price equals AVC at the profit-maximizing level of output is called the shutdown point.
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