ECO 105 Principles of Economic Theory Chapter 7 Revenues by act50979

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									                             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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