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Principles of Economics
by Fred M Gottheil
PowerPoint 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
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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
Find out more about
entrepreneurs and other
business owners:
http://www.entrepreneurmag.com
http://www.virtualentrepreneur.com
http://www.be-your-own-boss.com
http://www.tannedfeet.com
©1999 South-Western College Publishing
7
At what point of
production are profits
maximized?
MR = MC
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8
What does the word
Margin mean?
The marginal unit is the
last unit produced
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9
What is
Marginal Revenue?
The change in total
revenue generated by the
sale of one additional
unit of goods or services
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10
What is Marginal Cost?
The cost incurred on the
last unit produced
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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)
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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
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13
What determines
Price in a Free Market?
Market Demand & Supply
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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
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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
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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
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18
What is
Average Revenue?
Total revenue divided
by the quantity of
goods or services sold,
thus AR = P
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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
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Profits are maximized where
P
MR = MC
MC
P=MR
Q
Q2
Q1
Q3
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At Q3, MC>MR, should
produce less
At Q2, MC<MR, should
produce more
Leads to Q1, where MC=MR
as profit maximizing output
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Measuring economic
profit
Need to put the ATC
curve in the graph to
show whether profits or
losses being made
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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.
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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
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Economic Profit
MC
P
MR=P
ATC
Profit rectangle
P
ATC
Q1
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Economic Loss
MC
ATC
Loss Rectangle
P
MR=P
ATC
P
Q1
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Zero Profits
MC
ATC
P
P = MR
P = ATC
Q1
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Does the MR = MC
Rule apply to
minimizing losses?
YES
With one exception
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Why should a firm
stay in business if it’s
losing money?
Because its losses may be
less than its fixed costs
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In other words, stay in
business in the short run
as long as price covers
your average variable
costs, if not, shut down
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What is a Fixed Cost?
Costs that have to be
paid regardless of the
level of production
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Are there any Fixed
Costs in the Long Run?
No, all costs are
variable in the long run
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$
Loss - Stay Open, P>AVC
ATC
MC
ATC
MR=P
AVC
Q1
34
Q
34
Loss - Close Down, P<AVC
$
MC
ATC
AVC
MR=P
0
Q1
Q
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What Should a Firm Do in the Short Run?
Yes
Continue to produce
Is P > ATC?
yes
Continue to produce
Price (P)
No
Is P > AVC?
No
Shut down
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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
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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
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Do Stakeholders always
want to maximize profits?
The preservation of the
managerial class may
have a higher priority
©1999 South-Western College Publishing
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•
•
•
•
•
What does the word Margin mean?
What is Total Revenue?
What is Marginal 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
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Loss = Fixed Costs
AC
MR=P
MC
ATC
AVC
AVC
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