Profit

Profit

• Total Profit= TR- TC

• Very important: TC includes fixed, variable and opportunity cost

• (i.e. payment to all the factors of production incl. the entrepreneur)

• Profit measures the return to risk when committing scarce resources to a market or industry

• Entrepreneurs take risks for which they require an adequate expected rate of return

• The higher the market risk and the longer they expect to have to wait to earn a positive return, the greater will be the minimum required return that an entrepreneur is likely to demand

Profit eg. Firm A Firm B Firm C

TR 200, 000 200, 000 200, 000

TFC 40, 000 40, 000 40, 000

TVC 80, 000 100, 000 120, 000

Opportunity Cost

60, 000 60, 000 60, 000

TC 180, 000 200, 000 220, 000

Profit or Loss?Entrepreneur expects to earn 60, 000 that is what the entrepreneur could earn if she had stayed in her old job- i.e. that is the ‘next best alternative’) If the opportunity cost is not being covered the entrepreneur will close down the firm and move onto to the next best occupation

The shut- down price

Firm D Firm E Firm F

TR 80, 000 120, 000 150, 000

TFC (incl OC) 100, 000 100, 000 100, 000

TVC 100, 000 120, 000 140, 000

TC 200, 000 220, 000 240, 000

Loss 120, 000 100, 000 90, 000

Some firms continue to operate in the short- run, even if they are making a loss. Why?When will a firm shut down production in the short run?(Remember FC need to be paid regardless of output)

Firm D- TR does not cover TVC. Loss 120, 000 if operates, only 100,000 if closesFirm E- TR covers TVC thus loss is 100, 000 if closes or notFirm F- TR covers TVC and contributes 10, 000 to TFC

Definition

• The shut- down price is the level of price that enables a firm to cover it’s variable costs in the short- run. i.e. it is the price where P= AVC. If price does not cover AVCs then the firm will shut down in the short run.

• Can occur with seasonal demand eg. Ice cream stalls

The Break- Even Price

• The price at which a firm is able to make normal profits in the long –run

• The break- even price is the price that enables a firm to cover all of it’s costs in the long- run i.e. P= ATC

Costs

Output

MCATC

Optimum Output MC= AC

AVC

P1= ATC

P= AVC

P= shut down priceP1= breakeven price

Profit Maximising Level of Output

• Usual assumption- firms aim to maximise profit

• They will produce at an output level where MC=MR

• Wherever the firm finds that MR>MC it should increase output as profits will increase as extra units are produced

Cost/ Price(£)

Output

MC

D= AR= MR

P

q1

q2

• At q1 the firm has made a loss on every unit of produced up to this level of output as MC>MR• q1-q2 firm makes a profit on every unit produced as MR>MC• q2= max profit as after this point MC>MR• q1 = profit minimising, thus usually ignore that part of MC curve

Price Taking Firm

Cost/ Price(£)

Output

MCFirm facing a downward sloping demand curve

MR

D= AR

P

q

Therefore…..

• Profit Maximising level of output Profit Maximising level of output occurs where occurs where MC= MRMC= MR

• Whether the firm makes normal, abnormal or subnormal profit depends on….

• The position of the AC curve!!!

Cost/ Price

Output

MC

AC

D= AR

MR

Pa

bc

Firm making Abnormal Profit OR Supernormal Profit

Profit maximising at output MC=MRProfit maximising at output MC=MR

At this output level AC<AR= Abnormal Profit shown by rectangle Pabc

Cost/ Price(£)

Output

MC

AC

D= AR

MR

c1= P

a

Firm making Normal Profit

Profit maximising at output MC=MRProfit maximising at output MC=MR

At this output level AC=AR= normal profit

Cost/ Price

Output

MC

D= AR

MR

Pa

AC2

c2d

Firm making Subnormal Profit OR Loss

Profit maximising at output MC=MRProfit maximising at output MC=MR

At this output level AC>AR= subnormal profit

Alternative Objectives of the Firm

• Revenue Maximisation• Sales Maximisation• Profit Satisficing• Other Stakeholder Objectives eg.

Environmental concerns• To be covered later…