Download Topic 3.3.4 Profit student version

Syllabus
Candidates should be able to:
 Define normal profit, supernormal profit and loss
 Analyse the conditions for profit maximisation
 Explain and illustrate the concept of profit
maximisation using marginal cost and marginal
revenue
 Explain the short-run and long-run shut-down
points and show diagrammatically
Definitions
What is profit?
What is break even?
Remember that economic cost is the total o_________
cost of production.
Economic cost = money cost + imputed cost
OR Economic cost = explicit cost + implicit cost
Definitions: accounting versus normal profit
Accounting profit = TR – explicit costs
Normal profit is the level of profit which is sufficient to
keep the resources employed (rather than transfer them
to something else).
It includes the opportunity cost.
E.g. running your own business may earn you £20,000
but you may have given up a job paying you £25,000.
So you have given up £_______ for £________
Normal profit =
i.e. you are _____________ running your own business
Definitions: supernormal profit = economic profit
Supernormal profit = economic profit
Supernormal profit = TR – explicit cost – implicit cost
If economic profit = 0 this is known as normal profit as
the revenues are ____________ to cover all costs
(explicit and implicit)
Firms earn normal profit when TR = TC or AR = AC
Supernormal profit is the profit which is ____________
than normal profit. It is also known as abnormal profit
Firms earn supernormal profit when TR > TC or
AR > AC
Profit example
For example, say you invest £100,000 to start a
business, and in that year you earn £120,000 in profits.
Your accounting profit would be £___________
However, say that same year you could have earned
an income of £45,000 had you been employed.
Normal profit
=
=
Therefore, you have an economic loss of £________
What happens…
What would happen if a firm failed to earn normal
profits?
What happens if a firm earns supernormal profit?
Examples of objectives (see topic 3.2.1): profit maximisation
Firms may have an objective of profit maximisation.
What does profit maximisation mean? When does it
occur?
Profit maximisation: aim for
Profit = __________ so firms try to maximise this.
It occurs when marginal ________ = marginal cost,
_______ = MC
QU. diagram of normal profit when price is constant
Plot a graph showing constant price (P = MR = AR = D)
Mark on AC just touching AR
Where is MC?
What type of profit is this?
QU. diagram of supernormal profit when price is constant
Plot a graph showing constant price (P = MR = AR = D)
Where must AC occur for the firm to make supernormal
profit?
Where is MC?
What type of profit is this?
Diagrams: which point is quantity? Which point is price? Cost?
If a firm is profit maximising it will operate when _____
Therefore to find the quantity you should look where
MR = MC and then draw a vertical line to meet the xaxis, this is the quantity.
Once you have the quantity you need to find the price.
The price is AR so simply use the quantity and then
read across to the y-axis
The cost is AC so again just read across:
Diagram of normal profit when price falls
Assume a firm must lower the price to sell more. Plot AR
and MR
AR and MR slope _______, MR is _______ as steep
Assume the firm is profit maximising and makes normal
profit. Plot AC and MC
Diagram of supernormal profit when price falls
Normal profit occurs when TR = TC or AR = AC
Supernormal profit occurs when TR > TC or AR > AC
Repeat diagram showing supernormal profit
Profit maximising diagrams: constant price
Draw:
(1) TC and TR on one graph
(2) On a new diagram directly below draw MC & MR
(3) Where is max profit?
Profit maximising diagrams: falling price
Draw:
(1) TC and TR on one
graph
(2) On a new diagram draw
MC & MR
(3) Where is max profit?
(4) Can you add another
graph showing profit?
Profit maximising: the rule MC = MR explanation
Marginal cost is the ______ of making ____ more unit,
and marginal revenue is the income from this extra
unit.
MR – MC gives the extra profit from the additional unit.
As long as the firm can make additional profit by
producing an additional unit it will continue to
____________ production.
It will stop production when the additional unit makes a
_________
Thus profits will be maximised when MC = MR
Recap of profit maximising: diagrams for MC = MR
If demand is perfectly price elastic then the TR curve
will be a _________ line and MR (=AR=D) will be
__________
At Q = 88 the gap is __________ between TC and TR.
Also when Q = 88, MC = MR
Note: sometimes there
are two points where
MC = MR, if this is the
case then the first point
MC
is NOT the profit
maximisation point
since we need MC to be
rising as well.
Shift in cost curves
If costs for raw materials decrease then what will
happen to the marginal cost of production?
MC will be _________ and so the MC curve will shift
___________ MC1-> MC2
Draw a diagram showing this for constant price and
then another diagram for falling AR (just mark on MR,
AR and MC1 and MC2)
Shift in revenue curves
What will happen to AR and MR if a good becomes
fashionable? Draw this. What happened to output?
Losses
Firms may not make a profit.
Sketch two diagrams showing a firm making a loss
(in the first assume that the price is constant)
Shut down point in the short run: constant price
Firms may not make a profit. But, in the short run, if
they are covering ________ costs, it may be best to
continue production since they may be able to
contribute towards ________ costs.
In the ______ run all costs must be covered.
Short run profit maximisation means that a firm will
shut down only once its total revenue does not cover
total variable costs
Shut down point in the short run: falling price
Short run profit maximisation means that a firm will
shut down only once its total revenue does not cover
total variable costs. Draw a diagram where the firm is
more than covering variable costs:
Short-run loss: falling price
Short run profit maximisation means that a firm will
shut down only once its total revenue does not cover
total variable costs. Draw this
Short-run loss diagram with industry and individual firm
Sometimes the industry diagram and an individual
firm diagram is required:
Long-run shut down point: constant price
In the long run all costs must be covered. But also in
the long run all costs are variable.
The long run shut down point is when ATC = AR
Draw a diagram showing shut down in the short-run
(price P) and then shut down in the long-run (price
P2)