Download Profits, Goals of Firms, and Key Prices File

The Theory of the Firm
• Economic (abnormal) profit, normal
profit
• Goals of firms (profit maximization,
etc.)
• Shut down price, break even price
Most info from either (a) Tragakes or (b) Blink & Dorton
PROFIT: WHAT IS IT?
TR - TC
BUT….
IT’S NOT THAT
SIMPLE!
PROFIT: WHAT IS IT?
ECONOMIC PROFIT =
Total Revenue – Total Cost
Explicit (fixed + variable)
Costs + Implicit
(opportunity) Costs
PROFIT THEORY
Normal Profit
• TR = TC
Abnormal Profit (Economic Profit)
• TR > TC
Loss
• TR < TC
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)
(LOSS)
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
In the previous example, how
much was the entrepreneur
giving up by working for this
company?
$60,000
Quiz: What are the equations?
Normal Profit
Abnormal Profit (Economic Profit)
Loss
Quiz: What are the equations?
Normal Profit
• TR = TC
Abnormal Profit (Economic Profit)
• TR > TC
Loss
• TR < TC
NORMAL vs. ABNORMAL PROFIT
• NORMAL
– “zero economic
profit”
– DEFINITION #1:
• Minimum amount of
revenue a firm must
receive so it will keep
running (instead of
shutting down)
– DEFINITION #2:
• Amount of revenue that
covers all implicit costs,
especially
• ABNORMAL
– Profit above
normal (zero)
profit
If revenues were $1 million and
explicit costs were $850,000,
what would the value of
entrepreneurship (+ other implicit
costs) need to be to have…
*ABNORMAL PROFIT
*NORMAL PROFIT
*LOSS?
*ZERO ECONOMIC PROFIT?
If revenues were $1 million,
explicit costs were $850,000, and
the value of entrepreneurship
was $150,000, should the
business keep operating?
YES!
BECAUSE THE OPPORTUNITY
COST HAS BEEN COVERED
(NO BETTER
Abnormal, normal, or loss? (Calculate)
Total Revenue
($)
Total Fixed
Cost ($)
Total Variable
Cost ($)
Opportunity
Cost ($)
Total Costs
TYPE OF
PROFIT/LOSS
Firm A
Firm B
Firm C
5,000,000
1,500,000
3,000,000
500,000
210,000
52,500
106,000
63,000
985,641
305,835
517,212
130,000
Abnormal, normal, or loss? (Calculate)
Total Revenue
($)
Total Fixed
Cost ($)
Total Variable
Cost ($)
Opportunity
Cost ($)
Total Costs
TYPE OF
PROFIT/LOSS
Firm A
Firm B
Firm C
5,000,000
1,500,000
3,000,000
500,000
5,000,000
210,000
52,500
106,000
63,000
221,500
985,641
305,835
517,212
130,000
953,047
Normal profit Loss
(+0)
Abnormal profit
(-11,500) (+32,594)
WHAT ARE THE GOALS OF FIRMS?
According to standard economic
theory, the #1 goal is to achieve:
PROFIT
2 APPROACHES
MAXIMIZATION
CHOOSE LEVEL OF OUTPUT WHERE
2. CHOOSE LEVEL OF OUTPUT WHE
TR – TC IS AS LARGE AS POSSIBLE
MC = MR
TC = ECONOMIC COSTS
WHAT ARE THE GOALS OF FIRMS?
Note: The approaches could also
show LOSS
MINIMIZATION
(INSTEAD OF PROFIT MAXIMIZATION)
2 APPROACHES
CHOOSE LEVEL OF OUTPUT WHERE
TC- TR IS AS SMALL AS POSSIBLE
TC = ECONOMIC COSTS
2. CHOOSE LEVEL OF
OUTPUT WHERE
MC is closest to =
PROFIT MAXIMIZATION
LET’S LOOK @ #1 FIRST:
#1: CHOOSE LEVEL OF OUTPUT
WHERE
UNDERSTANDING TOTAL
COST
Without looking, draw the TC, TVC, and TFC curves
(be sure to label the x-axis & y-axis)
Why does the total cost curve have that shape?
UNDERSTANDING TOTAL
REVENUE
Is this what happens if price is constant?
(Note: This is when firms have no control over the price)
What happens if price is variable?
(Note: This is when firms have control over the price)
Putting the two together (TR/TC)
if firm DOES NOT control (can’t change) price
(PERFECT COMPETITION)
Where is profit
maximized (or
loss
minimized) in
each scenario?
Where is
normal profit?
Where is
abnormal
profit?
Putting the two together (TR/TC)
if firm DOES control (can change) price
(MONOPOLY)
Which curve (from
previous slide)
should change?
What was the
symbol for profit?
PROFIT MAXIMIZATION
TIME TO LOOK @ #2:
MC = MR
UNDERSTANDING MARGINAL
COST
For today…
focus on the
MC!
Without looking, draw a curve that shows
AFC, AVC, ATC, and MC
UNDERSTANDING MARGINAL
REVENUE
What does the marginal revenue curve look like if the price is constant?
(PERFECT COMPETITION)
What does the marginal revenue curve look like if the price varies with output?
(MONOPOLISTIC COMPETITION)
MR & AR:
QUICK RECAP
• When are MR & AR the same?
–w/perfect competition
–w/a monopoly
–w/both
–w/neither
UNDERSTANDING PROFIT MAXIMIZATION:
Putting MR & MC together
WHERE ON
EACH CURVE
IS PROFIT
MAXIMIZED?
MC = MR
PROFIT MAXIMIZATION
SAME IDEA AS PREVIOUS SLIDES…
BUT A LIL’ MORE ADVANCED!
UNDERSTANDING PROFIT MAXIMIZATION
IN PERFECT COMPETITION
IS PROFIT
MAXIMIZED
WHERE MC = MR?
YES!
Why is it the yellow shaded
area?
REVENUE = ___ X ___?
In this example,
Q = 11
P = MR = AR
AR > ATC
UNDERSTANDING PROFIT MAXIMIZATION
IN A MONOPOLY
IS PROFIT
MAXIMIZED
WHERE MC = MR?
YES!
IT IS ALSO WHERE
LOSSES CAN BE
MINIMIZED (SEE (b))
Why is it not from the exact
point where MR = MC?
It is where
AR is compared to AC
UNDERSTANDING PROFIT MAXIMIZATION
IN A MONOPOLY
WHAT TYPE OF PROFIT
IS DEMONSTRATED IN
(A)?
ABNORMAL
Draw 2 curves that demonstrate
MC = MR
Profit maximization in
perfect competition & in a monopoly
Why is profit maximized when
MC = MR?
Think about what happens when MC > MR
Think about what happens when MC < MR
PRACTICE
“Profit Maximization Brain Teaser”
Worksheet
While 1 important goal for firms is PROFIT
MAXIMIZATION, what are other goals?
(FYI: some are complementary to profit max.)
REVENUE MAXIMIZATION
SATISFICING
•
•
•
•
•
***Idea that no ONE goal (including profits)
is dominant in a firm
***instead, compromises happen where
many different objectives are pursued at a
satisfactory, rather than a maximum level
MANAGERS/EMPLOYEES love this…why?
1. Sales easier to measure than profits
2. Commissions/bonuses!
3. Feeling of success
***Note: Not really important to
OWNERS***
GROWTH MAXIMIZATION
• MANAGERS & OWNERS are pro-growth
(getting bigger)
• 1. Owners love increasing economies of
scale/lower costs, greater market power,
ability to diversify (less dependence on
single product)
• 2. Managers have improved chances for
promotion, higher salaries, greater
individual power
CORPORATE SOCIAL
RESPONSIBILITY
AVOIDING socially undesirable activities
(e.g. pollution, poor working conditions),
DOING socially desirable activities (e.g.
support for human rights/charities)
Some firms are NON-PROFIT
SATISFICING IN ACTION
Is my (your teacher!) only goal to have each of
you get a 7 on the IB Econ exam?
Is our school’s only goal to have students earn
the highest mark possible for the IB diploma?
List the major goals of most firms
Indicate the one(s) that favors owners more
and the one(s) that favors managers more
KEY PRICES
(“Prices per unit” a.k.a. “revenue per unit”)
Beyond the issues already mentioned, firms
must also consider the following:
1.the shut-down price
*Short run (temporarily shut down)
*Long run (permanently shut down &
exit the market)
2.the break-even price
Is the shut down price anytime there
is a loss?
NO!
Firms often operate even if
they are losing $$$
If a firm shuts down (temporarily or
permanently), what costs does it lose?
FIXED
Think about it…
SHUT-DOWN PRICE:
Should 1, 2, or 3 of these people keep operating in
the short run?
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
SHOULD: Charlie, Batcat (can cover TVC)
SHOULD NOT: Archie (can’t cover TVC)
Should any keep producing in the long run?
No!!!
Archie
Batcat
Charlie
Total Revenue
Total Fixed Cost
(including opportunity
cost)
Total Variable Cost
Total Costs
LOSS
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
In the long run, firms shouldn’t stay
open unless they make at least
what kind of profit?
NORMAL
RECAP: Does this show
abnormal profit, normal profit, or a loss?
• Ms. Armstrong has a business. In her 3rd year of
operation, she sold $250,000 worth of goods.
• She spent $50,000 on rent and $185,000 on
employees’ wages, electricity, inventory, etc.
• Should she stay in business?
SHUT-DOWN PRICE
• SHUT-DOWN PRICE
– DEFINITION:
• Level of price that enables a
firm to cover its variable
costs in the short run
– Price = AR (avg revenue)
– AR = PQ/Q
– IN SHORT RUN…
• Where P = minimum AVC
– (From this point &
below…shut it down!)
– IN LONG RUN…
• Where P = minimum ATC
– (From this point &
below…shut it down!)
atc
avc
SHUT-DOWN PRICE:
QUICK RECAP I
•
•
•
•
WHERE IS MR ON THIS GRAPH?
WHERE IS AR ON THIS GRAPH?
WHERE IS DEMAND ON THIS GRAPH?
IS THIS GRAPH SHOWING PERFECT COMPETITION OR A MONOPOLY?
SHUT-DOWN PRICE:
QUICK RECAP II
• CAN’T COVER VARIABLE COSTS?
– IN SHORT RUN…SHUT IT DOWN!
• CAN’T COVER FIXED COSTS?
– IN LONG RUN…SHUT IT DOWN!
• CAN’T COVER FIXED IN THE LONG RUN BUT CAN
COVER ABOVE VARIABLE IN THE SHORT?
– IN SHORT RUN…KEEP PRODUCING!
(MINIMIZE LOSSES)
Draw a curve that shows the shortrun & long-run shut-down price
Be able to explain to your neighbor
why those are the shut-down prices
Consider what the Y-axis is!!!
(Costs/Revenue/Price)
What are some examples of firms that
should TEMPORARILY shut down?
(Think of fixed v. variable costs)
***WARNING: NOT REQUIRED FOR
IB ECON ALERT***
WHAT IS
THE SUNK COST
FALLACY?
One should keep investing b/c so much
(time/money/resources) has already been invested
BREAK-EVEN PRICE
• BREAK-EVEN PRICE
– DEFINITION:
• Level of price (revenue) at
which a firm is able to make
normal profit in the long run
• (where revenues greater
than or equal to costs)
– HINT
• Where P = minimum ATC
– EXTRA INFO
• YES, it does factor in
opportunity cost
atc
avc
***IN THE LONG RUN, THE BREAK-EVEN PRICE AND
THE SHUT-DOWN PRICE ARE THE SAME.***
(If asked to only diagram one shut-down price, use the short term)
Tragakes diagrams
Break-even
oil prices:
Jan 2016
Should oil firms
in Nigeria, Russia,
Norway, (or now
Iran?) shut down
operations?
It depends!
Putting It All Together
Where is the long run shut-down price?
PRACTICE
“Marginal Analysis and Profit
Maximization” Worksheet
EXTRA SLIDES
“The ‘Shut-down Rule’ – When
should a firm shut down in the face
of economic loss?”
https://www.youtube.com/watch?v=_OWuxR0-V8
(16:54) – Welker
Short Econ Vids from Mr. Clifford Costs of Production and Perfect
Competition
https://www.youtube.com/playlist?list=
PLE70CA726102FB294
AC/DC Economics
Exercise – Shut Down & Break Even Price
Quantity
of Labour
Total
Output
Total
Fixed
Costs
Total
Variable
Costs
Total
Costs
Average
Variable
Costs
(AVC) =
Average
Total
Cost
(ATC) =
TVC/
Output
TC/
Output
Marginal
Cost
(MC) =
Change in
Total
Costs /
Change in
Output
0
0
1000
0
1000
0
-
1
100
1000
300
1300
3
13
3
2
250
1000
600
1600
2.4
6.4
2
3
350
1000
900
1900
2.57
5.43
3
4
400
1000
1200
2200
3
5.5
6
5
440
1000
1500
2500
3.41
5.68
7.5
Using the information below, determine the shut down & break price.
1. Complete the data missing in the table for AVC and ATC.
2. Determine the Shut Down and Break Even Price.
Revenue: $8 per unit
(assumes opportunity costs are included)
Output
0
100
250
350
400
440
Total
Revenue
800
2000
2800
3200
3520
Total Costs
Variable
Cost
Fixed Costs
Type of Loss
1000
0
1000
-
1300
300
1000
Loss
1600
600
1000
Abnormal
1900
900
1000
Abnormal
2200
1200
1000
2500
1500
1000
Break Even Price
Price Per
Unit
Output
(units)
Total
Revenue
Total
Costs
Average
Average
Revenue
Total Costs
(Total
Revenue /
Quantity) or
Average
Revenue is
Price.
$25
100
2500
1300
25
13
$20
$15
$10
$5
250
350
400
440
5000
5250
4000
2200
1600
1900
2200
2500
20
15
10
5
6.4
5.43
5.5
5.68
What is the break even price? At $5, the price is too
cheap and we will not break even.
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