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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