Principles of Economics by Fred M Gottheil Power

Principles of Economics by Fred M Gottheil Power. Point Slides prepared by Ken Long Chapter 9: Maximizing Profit © 1999 South-Western College Publishing 1

What is Profit Maximization? The primary goal of a firm to achieve the most profit possible from its production and sales © 1999 South-Western College Publishing 2

What is Profit? Income earned by entrepreneurs © 1999 South-Western College Publishing 3

What is the accounting view of profit? Total Revenue minus total explicit costs 4

What is the economic view of profit? Total Revenue minus all cost, both explicit and implicit 5

Possible profit situations, short run • Positive economic profit • Negative economic profit (losses) • Zero economic profit (normal rate of return) 6

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At what point of production are profits maximized? MR = MC © 1999 South-Western College Publishing 8

What does the word Margin mean? The marginal unit is the last unit produced © 1999 South-Western College Publishing 9

What is Marginal Revenue? The change in total revenue generated by the sale of one additional unit of goods or services © 1999 South-Western College Publishing 10

What is Marginal Cost? The cost incurred on the last unit produced © 1999 South-Western College Publishing 11

Why are profits maximized at MR = MC? MR > MC (produce more) MR < MC (produce less) MR = MC (no $ gained or lost on the last unit) © 1999 South-Western College Publishing 12

What is a Perfectly Competitive Market? • homogeneous product • many buyers and sellers • no one has much market power • easy entry & easy exit • can sell all bring to market • perfect information © 1999 South-Western College Publishing 13

What determines Price in a Free Market? Market Demand & Supply © 1999 South-Western College Publishing 14

The Market and the firm in Perfect Competition P D S P P=MR=d The Market Individual firm 15 15

The Firm’s Demand Curve in Perfect Competition Price P=MR=d P Quantity 16 16

Why does P = MR in Perfect Competition? Because no matter how many units are brought to market, the firm can sell all of them at the market price © 1999 South-Western College Publishing 17

Why is a Perfectly Competitive firm’s demand curve horizontal at the market price? All units brought to market can be sold at the market price © 1999 South-Western College Publishing 18

What is Average Revenue? Total revenue divided by the quantity of goods or services sold, thus AR = P © 1999 South-Western College Publishing 19

Why does AR=P in all markets? Because each unit is sold for the same price at one point in time AR = TR / Q = P © 1999 South-Western College Publishing 20

Profits are maximized where P MR = MC MC P=MR Q Q 2 Q 1 Q 3 21 21

At Q 3, MC>MR, should produce less At Q 2, MC<MR, should produce more Leads to Q 1, where MC=MR as profit maximizing output 22

Measuring economic profit Need to put the ATC curve in the graph to show whether profits or losses being made 23

Understanding the graphic view of profit As long as the price, P, exceeds the average total cost, there is profit per unit, multiply by the total number of units to get total profit. 24

Understanding the graphic view of profit Can also see profit from the graph by taking the total revenue rectangle, which is price times quantity, and subtracting the total cost rectangle, which is average total cost times quantity, to get the profit rectangle 25

Economic Profit P MC MR=P ATC Profit rectangle P ATC Q 1 26 26

Economic Loss MC ATC P Loss Rectangle MR=P ATC P Q 1 27 27

Zero Profits MC ATC P P = MR P = ATC Q 1 28 28

Does the MR = MC Rule apply to minimizing losses? YES With one exception © 1999 South-Western College Publishing 29

Why should a firm stay in business if it’s losing money? Because its losses may be less than its fixed costs © 1999 South-Western College Publishing 30

In other words, stay in business in the short run as long as price covers your average variable costs, if not, shut down 31

What is a Fixed Cost? Costs that have to be paid regardless of the level of production © 1999 South-Western College Publishing 32

Are there any Fixed Costs in the Long Run? No, all costs are variable in the long run © 1999 South-Western College Publishing 33

$ Loss - Stay Open, P>AVC ATC MR=P AVC Q 1 34 Q 34

Loss - Close Down, P<AVC $ MC AVC MR=P 0 ATC Q 1 Q 35 35

What Should a Firm Do in the Short Run? Yes Is P > ATC? Continue to produce yes Continue to produce Price (P) No Is P > AVC? No Shut down 36

Do firms follow the MC=MR rule? Lester, 1940’s, argued firms do not appear to use marginal analysis 37

Machlup and Friedman disagree with Lester Firms do not have to “think” they use marginal analysis even though they are 38

Is a firm’s first priority always maximizing profits? No! Sometime there are social, political and historical factors © 1999 South-Western College Publishing 39

Other views of firm behavior Do firms maximize sales, do managers build empires rather than maximize profits? 40

Who is a Stakeholder? Someone who has a personal and consequential interest in the viability of the firm © 1999 South-Western College Publishing 41

Do Stakeholders always want to maximize profits? The preservation of the managerial class may have a higher priority © 1999 South-Western College Publishing 42

• • • What does the word Margin mean? What is Total Revenue? What is Marginal Cost? Why are profits maximized at MR = MC? • Why should a firm stay in business if it’s losing money? 43

END © 1999 South-Western College Publishing 44

Loss = Fixed Costs AC MR=P MC ATC AVC 45 45