Download profit theory

PROFIT THEORY
IB ECONOMICS –
A COURSE COMPANION
(Blink & Dorton, 2007/2012)
PROFIT THEORY
• How economist’s measure profit is different to
accountants, because of the issue of opportunity
cost.
• For example, a person might be making $80,000 a
year profit from running their business, but they
were making $80,000 a year as marketing
manager before they started to run their own
business. Running a business may involve more
stress, and higher levels of uncertainty.
PROFIT THEORY
How do economists measure profit?
Total Profit = Total revenue – total cost
(fixed, variable and
opportunity cost)
PROFIT THEORY
Normal Profit
• If total revenue is equal to total cost, the firm is
making normal profit.
Abnormal Profit or Economic Profit
• If total revenue is greater than the total cost, the
firm is making abnormal profit.
Losses
• If total revenue is less than total cost, then the
firm is making losses.
PROFIT THEORY – EXAMPLES
Total Revenue ($)
Total Fixed Cost ($)
Total Variable Cost ($)
Opportunity Cost ($)
Total Cost ($)
Firm A
Firm B
Firm C
(ABNORMAL
PROFIT)
(NORMAL
PROFIT)
(LOSSES)
200,000
40,000
80,000
60,000
180,000
200,000
40,000
100,000
60,000
200,000
200,000
40,000
120,000
60,000
220,000
Table Analysis – Firm A
• A firm is making an abnormal profit of
$20,000.
• This means that the revenue earned by the
firm is not only covering all the costs, but it is
in fact $20,000 more.
• This will make the entrepreneur happy, as
he/she was expecting to cover her
opportunity cost of $60,000 and in fact gets
$80,000.
Table Analysis – Firm B
• Firm B is making normal profit.
• The revenue earned by the firm exactly covers
all the costs.
• The entrepreneur will be satisfied.
Table Analysis – Firm C
• Firm C is making losses.
• Although an accountant would say that the
firm is making a profit of $40,000 ($200,000$160,000) the entrepreneur will not be happy.
• Fixed and variable costs are covered, but
opportunity cost is not covered.
• The entrepreneur should close down the firm,
moving to the entrepreneur’s next best
occupation.
Which one of the following firms is making
abnormal profit, normal profits and losses?
Total Revenue ($)
Total Fixed Cost ($)
Total Variable Cost ($)
Opportunity Cost ($)
Total Costs
TYPE OF PROFIT/LOSS
Firm A
Firm B
Firm C
199,345
60,275
101,000
40,000
210,000
42,500
100,000
63,000
200,000
20,000
120,000
60,000
PROFIT THEORY
Beyond the issue of opportunity cost, firms
must also consider the following:
1.The shut-down price.
2.The break-even price.
3.The profit-maximising
level of output.
Shut Down Price
• It is not unusual to see firms
continue to operate, in the short run,
even if they are making a loss.
• It is also not unusual to see firms
shut down for a short period of time
and then open up again.
Shut Down Price
Temporary Shut Down
• The firm may close down temporarily in the
short run and produce nothing.
• It will only lose its total fixed costs – the costs
that are unavoidable such as rent or the
interest payments on loans.
• Temporarily closing may be better than
producing and not getting enough revenue to
cover the variable costs.
Shut Down Price: Example – 3 Firms
Archie
Total Revenue
Total Fixed Cost
(including opportunity
cost)
Total Variable Cost
Total Costs
LOSS
Batcat
Charlie
80,000 120,000 150,000
100,000 100,000 100,000
100,000 120,000 140,000
200,000 220,000 240,000
120,000 100,000 90,000
Shut Down Price Example: Archie
• Archie would be better not producing at all in
the short turn and closing down temporarily.
• Revenue gained has failed to cover all the
variable costs.
• By producing, Archie has costs of $120,000
not covered by revenue, but he only loses
$100,000 of fixed costs if he did not produce.
Shut Down Price Example: Batcat
• Total revenue of $120,000 means the variable
costs of $120,000 are just covered.
• They will lose $100,000 of fixed cost whether
they produce or not produce.
• In this situation it is likely that Batcat will
continue to produce in order to maintain the
continuity of production, thus pleasing customers
and to maintain the employment of workers and
the usage of inputs. This will please unions and
suppliers.
Shut Down Price Example: Charlie
• Charlie loses $90,000 by producing, since their
total revenue covers their variable costs and
also contributes $10,000 towards their fixed
costs.
• If they did not produce then Charlie would
lose their fixed costs of $100,000.
• Therefore Charlie will produce in the short
run.
Short Run Losses
• Firms making losses in the short run cannot do
this forever.
• Whether they produce or not in the short run,
the firms need to plan ahead in the long run in
order to change their combination of factors
and to devise a situation where they are able
to cover all their costs and make normal
profits. If they cannot do this, they will have
to close permanently.
Shut Down Price – Definition.
• The Shut Down price is the level of price
(revenue) that enables a firm to cover its variable
costs in the short run
• It is the price where price = the average variable
costs in the short run.
• If price (revenue) does not cover average variable
costs, then the firm will shut down in the short
run.
SHUT DOWN PRICE
atc
avc
In this diagram the
minimum price before
shutdown is P.
At this price the firm is
able to cover its
variable costs in the
short run, because
P = avc and so is only
losing its fixed costs.
At any price below P
the firm will shut
down in the short run.
Real World Examples –
Shut Down Price
• Many businesses open and close on a
seasonable basis in very hot and cold climates.
• For example an ice cream in store in Vienna
shuts down in October and re opens again in
April.
• The act of temporarily closing down, because
it cannot cover its variable costs is a good
example of a firm that is not reaching its shut
down price in the short run.
THE BREAK EVEN PRICE
• The break-even price is the price at which a firm
is able to make normal profit in the long run.
• This means that it will break even, covering all of
its costs, including opportunity cost.
• The break even price is the level of price that
enables a firm to cover all its costs in the long
run: - the price where price = average total costs.
• If the price does not cover average total costs in
the long run, then the firm will shut down for
good.
BREAK EVEN PRICE
atc
avc
The break even
price is P1. At this
price the firm is
able to cover its
total costs,
because P1 = atc,
and so all costs are
covered.
THE PROFIT MAXIMISING LEVEL OF OUTPUT
Why does average revenue (AR)
equal marginal revenue in this
case??
The graph opposite shows the marginal costs
and marginal revenue situation for a firm with
a perfectly elastic demand curve. The MC
curve cuts the MR curve at two points. The
first point where MC=MR, q1, is the point of
profit minimisation (loss maximisation). The
firm has made a loss on every unit produced
up to this level of output, because MC is
greater than MR. From q1 to q2 the firm makes
a a profit on every extra unit produced,
because the MR is greater than MC. As long
as the profit made between q1 and q2 is
greater than the loss made on the first q1
units, then the firm will be making abnormal
profits. Any unit that is produced beyond q2
will make a loss because MC would again be
above MR. If the firm produces more than q2
the level of abnormal profit will begin to fall. It
is at q2 where profits are maximised.
The Profit Maximizing Level of Output
A more common modified graph.
Profit minimisation is not what a firm
would want. To avoid confusion, the left
hand part of the MC curve is normally
omitted in diagrams. This means that
only the profit maximising output q2 is
shown.
As a general rule we can say that:
If a firm wishes to
maximise it profits, it
should produce at the
level of output where the
Marginal Cost (MC) cuts
Marginal Revenue (MR)
from below.
PROFIT MAXIMIZING OUTPUT
FOR A NORMAL DEMAND & MR
CURVE
Profit is maximised by
producing where MC =
MR, at a level of output
of q. The find the price
we look at what
consumers are willing
to pay for this quantity.
This is shown on the
demand curve. It is
found by going from q
up to the demand
curve and then across
the y-axis.
GRAPHING ABNORMAL
PROFITS
In order to show a
measureable amount of
profit on a diagram (eg:
simple shape like a
diagram), the average cost
curve can be added to the
diagram. You must check
that the MC curve cuts the
AC curve at the lowest point
in the AC curve. The profitmaximizing output is q and
the price is p. The profit per
unit of producing q is the
difference between AR and
AC. Thus the profit per unit
is a – b. Since q units are
produced, the total
abnormal profit is the
shaded area, ab x OQ.
ABNORMAL PROFIT, NORMAL
PROFIT AND LOSSES
Whether an abnormal profit
is made will depend upon
the position of the AC curve.
The AC curve can be moved
around to show what we
want – abnormal profit,
normal or losses. If the
average cost curve is at AC,
then the diagram shows an
abnormal profit of pabc. If
the average cost is
represented by AC1 then
normal profits is being
made, because p = c1 . If
average cost is shown by
AC2, then a loss is being
made.
Using the following info, draw an appropriate graph to model
different profit and loss situations.
Output
(Machines)
Total Cost $
(thousands)
Average
Cost $
(thousands)
0
0
0
1
3000
3000
2
7000
3500
3
12000
4000
4
20000
5000
5
32000
6400
Marginal
Cost $
(thousands)
3000
4000
5000
8000
12000
Price
Quantity
Demanded
Total Revenue Marginal
Revenue
6000
0
0
5000
1
5000
4500
2
9000
4000
3
12000
3500
4
14000
5000
4000
3000
2000