1

Profit

The word profit in economics really means economic

profit. Let’s see what this means.

2

Market types

Firms may operate in industries, or markets, that are called perfect competition, monopoly, oligopoly, and monopolistic competition.

No matter what type of market, we assume firms attempt to maximize profit.

3

Economic Costs

Costs are accounting for the fact that when one thing is produced alternative goods and services are forgone.

This is the idea of opportunity cost. When one thing is chosen, the opportunity to do the next best thing is forgone.

4

Example where revenue is 72,000

Explicit costs 12,000 hired

labor 5,000 rent 20,000 materials 37,000 total

Implicit costs 15,000 owner’s

labor 3,000 entrepre. cost 4,000 inter. forgone 22,000 total

•Accounting profit = 72,000-37,000 = 35,000•Economic profit = 72,000-37,000-22,000 = 13,000

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Explicit cost

In the example, the labor hired to make pottery would then not be used to make something else - an opportunity cost.

These explicit costs represent payments to nonowners of the firm.

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Implicit cost

Costs of using owner supplied resources.

The implicit costs represent money payments owner supplied resources could have earned in their next best use.

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Profit

Accounting profit = Revenue - explicit cost.

Economic profit = Revenue - explicit cost - implicit cost.

Profit will be used in general and this will mean economic profit. Implicit costs are incorporated into an economic analysis.

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Profit

One last point. Since implicit costs are what owner supplied resources would have earned in their next best usage, we might call these costs normal profit.

SO, Economic profit = accounting profit – normal profit,

Or

Accounting profit = normal profit + economic profit.

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Perfect Competition in the

Short Run

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Perfect competition Perfect competition is a type of market defined by:

1) All firms selling essentially the same product. The product of one firm would be a perfect substitute for the product of another firm.

2) All firms are price takers. No individual firm can have an influence on the market price based on how much the one firm produces. This usually occurs when there are a large number of firms in a market (or industry), but may happen with relatively few firms.

(two more conditions)

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Perfect competition

3) Factors of production are perfectly mobile in the long run. This means in the long run a firm can get rid of all its inputs are add to what it currently has. Labor would be equally mobile. Note: remember the short run is when at least one input is fixed in amount for the firm.

4) Firms and consumers have perfect information. Essentially this means if there is knowledge out there these folks know about it.

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Supply and demand

The model of supply and demand we have already seen is really the model of perfect competition. We will expand on that idea and focus our attention on a typical firm in that environment.

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Firm in SR

The firm in the short run has some inputs that are fixed and some that are variable. The firm just accepts the market price.

With this in mind the firms has to decide how much output to sell to maximize profit.

Example: You can probably buy a 20 Mt. Dew at 10 places or so in Wayne and the price is basically 1.25, right? So the market for Mt. Dew is roughly perfectly competitive and each store has to decide how much to sell (which means they have to decide how much to stock on any given day).

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Totals in a graphTR

TC$

QQ*

Profit

QQ*

If you plot the TR and TC curves the Q that gives the greatest distance between TR and TC is the profit max level of output, here Q*.

Next let’s turn to unit cost and price concepts.

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Revenue potentialThe market demand curve is downward sloping - in the whole market consumers will buy more at lower prices.

But, let’s say for any one firm the demand curve for the firm’s output is horizontal. Why? Any one seller is small relative to the market. 1) If the seller tries to charge a price higher than the market price no one will buy from them(because there are enough other places to buy), and2) The seller will not charge a lower price because they can sell all they want at the going price. The reason for this is because they are a small part of the market and already sell all they want at the going price.

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Revenue potential

The ideas on the previous screen have the graphical interpretation shown here. The demand curve for the firm’s output is a horizontal line at the price that occurs in the market(assumed here to be P1).

P

Q

D

market

P

QFirm

d = PP1

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Revenue potential

Since the firm in a competitive environment can not influence the market price on its own, the firm is said to be a price taker and this has implications for the revenue the firm can generate from sales of units of output.

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Revenue potentialTotal Revenue = TR = P times Q. For the firm here, P is a given value.As an example say P = 2.Units TR of output Notice the change in TR as 0 0 output changes is 2. This is 1 2 called the marginal revenue. 2 4 3 6 So the MR = P = firm demand 4 8 for a competitive firm.

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Revenue potentialAs another example say P = 5.Units TR of output Notice the change in TR as 0 0 output changes is 5. Thus 1 5 marginal revenue = 5. 2 10 3 15 So the MR = P = firm demand 4 20 for a competitive firm.

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review cost concepts$/unit

Q or units

MCAC

AVC

30

b

a

The cost curves look this way in the short run due to diminishing returns.

I picked Q = 30 arbitrarily. At this Q the height of the

MC curve is the MC of this output and the height of the AVC and AC curves have similar interpretations. AC minus AVC equals AFC. Area a = TVC, a + b = TC

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production rule$/unit

Q or units

MCThe profit maximizing firm will choose to produce the quantity of output where MR = MC(Q2 in graph).If the firm stops short of the rule, like at Q1, then the firmsacrifices units of output where MR > MC. In other

words, some units after Q1 add more to revenue than to cost. A profit max. firm wouldn’t pass up this opportunity.

Q1 Q2 Q3

P = MR

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production ruleIf the firm produces beyond Q2, MC > MR and the firm would thus add more to cost than to revenue on these units. A profit maximizing firm would not want to do this.

Now, since P = MR for the firm and since the firm goes to the Q where MR = MC, the firm in a competitive environment really produces where P = MC

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operating ruleThe operating rule is a qualification to the production rule. If operating is worth it at all, follow the production rule. Otherwise, shutdown. Now, in the short run there are fixed costs and variable costs. The fixed costs must be paid whether production is 0 or 1,000,000 or whatever. Variable costs must be paid only if variable inputs are employed. It is useful to think of hiring variable inputs only if they generate enough revenue to pay for themselves plus pay for some of the fixed costs.On the next few screens I want to present cases to see what the firm should do: operate or shutdown.

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operating rule case 1$/unit

Q or units

MCAC

AVCb

c

The firm is a price taker - say it takes P

If firm operates if it shuts downTR = a + b + c TR = 0TC = b + c TC = TFC = bprofit = a profit = -b.

P MRa

Q1

This firm should operate where MR = MC and makea positive profit

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operating rule case 2$/unit

Q or units

MCAC

AVC

d

The firm is a price taker - say it takes P

If firm operates if it shuts downTR = e + f TR = 0TC = d + e + f TC = TFC = d + eprofit = -d profit = -d -e.

P MR

Q1

This firm should operate where MR = MC and have a loss, but not as big as if it shutdown.

e

f

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operating rule case 3$/unit

Q or units

MCAC

AVC

g

The firm is a price taker - say it takes P

If firm operates if it shuts downTR = i TR = 0TC = g + h +i TC = TFC = gprofit = -g -h profit = -g.

P MR

Q1

This firm should shutdown. Where MR = MC there is too big a loss, more than if the firm should shutdown.

h

i

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operating ruleFrom these examples we can see that if the price is everywhere below the AVC curve the firm should shutdown. The firm will still have fixed costs to pay, but in this case revenue not only does not pay all fixed costs, it covers only some of variable costs. It is better to shutdown in this case.

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firm short run supply curve

A supply curve is a curve that shows combinations of price and quantity the firm is willing to supply. In other words, we see the quantity the firm is willing to make available for sale at each price.

The short run supply curve is the segment of the MC curve that is above the AVC curve.

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firm short run supply curve$/unit

Q or units

MCAC

AVC

If the price the firm accepts is above the AVC, then the MC curve acts as the line that shows the price, quantity relations we previously mentioned. The MC curve above the AVC is the supply curve of the firm.

P

30

Summary

A competitive firm will produce the Q where MR = MC, or, what is the same thing, P = MC, so long as at this Q the P > AVC.

The supply curve for the firm in this environment is the part of the MC curve above the AVC curve.