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1 John Sloman Keith Norris PowerPoint to accompany

2 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia Lecture and Tutorial Purpose: To explain profit maximising conditions; Skills learning outcomes: -Students should be able to determine profit maximising output quantities; -Students should be able to calculate the profit at this level of output. This week – only up to the section titled some qualifications (Page 104).

3 Profit Maximisation Chapter 5

4 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia Build up a theory of Profit Maximisation What is the output and price where a firm maximises profits, How much profit does the firm make at that level? Total Profit = Total Revenue – Total Costs Tπ = TR – TC Similar to the cost breakdown there is: -Total Revenue, TR = P × Q -Average Revenue, P* = AR = TR / Q -Marginal Revenue, MR = TR / Q; *Exception is when there are different products in different markets then AR is the weighted average P

5 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia Revenue Curves MR (Marginal Revenue is the extra total revenue gained by selling one more unit (per time period). So if a firm sells an extra 20 units this month compared with what it expected to sell and, in the process earns an extra $100, then it is getting an extra $5 for each extra unit sold: MR = $5. Revenue curves when price is not affected by the firms output (horizontal demand curve): –Marginal Revenue (MR) = TR / Q = 100 / 20 = 5 How do the revenue concepts (i.e. TR, AR, MR vary with output; -Depends on market conditions for the particular firm; -Too small a firm cannot affect market prices & will have different looking revenue curves from a firm that is able to choose its own price.

6 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia Revenue Curves when Price is not affected by the firms output (Fig. 5.1) If the firm is very small relative to the whole market, it is likely to be a price taker; i.e. accept the market determined equilibrium price; But being so small, it can sell as much as it is capable of producing at the price (Fig.5.1); Diagram (a) is the market (b) the firm; Firm demand is tiny relative to the whole market; Look at scale differences on the horizontal axis in the two diagrams;

7 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia O O AR, MR ($) Q (millions)Q (hundreds) PePe S D (a) The market(b) The firm Deriving a Firms AR and MR: Price-taking Firm (fig. 5.1) Price ($)

8 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia O O AR, MR ($) PePe S D D = AR = MR Q (millions)Q (hundreds) (a) The market(b) The firm Deriving a Firms AR and MR: Price-taking Firm Price ($)

9 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia Deriving a Firms AR and MR: Price-taking Firm Market equilibrium price is $5 The firm is so small that any change in its output is too insignificant to affect the market price: -Therefore, the firm faces a horizontal demand curve at this price; -It can sell 200 units, 600 units, 1200 units or whatever without affecting the $5 price; -Therefore, AR is a constant $5; -Therefore, the firms AR curve is equivalent to its straight line demand curve.

10 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia Deriving a Firms AR and MR: Price-taking Firm With this horizontal demand curve, –MR curve = AR curve; –Since selling one or more unit at a constant price (AR) merely adds that amount to TR; –If an extra unit is sold at a constant price of $5, an extra $5 is earned. –Total Revenue (TR): As Price is constant, TR will increase at a constant rate as more is sold; The TR curve will be a straight line through the origin.

11 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia Q Quantity (units) Price = AR = MR ($) Total Revenue for a Price-taking Firm TR ($)

12 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia Quantity (units) Price = AR = MR ($) TR ($) Total Revenue for a Price-taking Firm Q TR ($)

13 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia TR Quantity (units) Price = AR = MR ($) TR ($) Total Revenue for a Price-taking Firm Q TR ($)

14 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia Revenue curves when the price varies with output Firm has a downward-sloping demand curve: -The firm has to lower the price to sell more; -If it raises its price it will sell less; -Average revenue (AR) = P; -P is reduced to sell ore then AR falls as output increases; -For price taking firm, the demand and AR curve are the same (Fig. 5.2) because AR = P; -The curve relating P to Q (i.e. demand curve) and AR to Q are the same curves (i.e. AR curves)

15 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia Revenue curves when the price varies with output When a firm faces a downward sloping demand curve, MR is < AR & may be negative: -P must be lowered to sell more each time period; -Means lowering P for extra units plus the units it would have sold at the previous P; -Thus MR = PLUS – RFAD (table 5.1 & next diagram) where: PLUS = price of last unit sold, and RFAD = revenue lost in selling the other units at a lower price when it could have sold them at a higher price;

16 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia Q (units) P =AR ($) AR AR, MR ($) Quantity AR and MR Curves for a Firm Facing a Downward-sloping Demand Curve

17 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia Q (units) P =AR ($) TR ($) MR ($) MR AR, MR ($) Quantity AR AR and MR Curves for a Firm Facing a Downward-sloping Demand Curve (Figure 5.2 p.100)

18 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia AR and MR Curves for a Firm Facing a Downward-sloping Demand Curve MR is the extra revenue gained from selling one more unit; MR values are entered in the spaces between the figures for the other three columns (Table 5.1 and figure 5.2); When demand is price elastic: -A decrease in price will lead to a proportionately larger increase in Qd, hence -An increase in sales revenue (total consumer expenditure), -Therefore MR is positive / increasing ; When demand is price inelastic: -A decrease in price will lead to a proportionately smaller increase in Qd, hence -An increase in sales revenue (total consumer expenditure), -Therefore MR is negative / declining; If MR is a positive figure TR is increasing (i.e. sales per time are 4 units or less in figure 5.2): -The demand curve will be elastic at that quantity, If MR is negative and TR is falling (i.e. at a level of sales of 5 or more units in figure 5.2) the demand curve will be inelastic: -A rise in quantity sold would lead to a fall in TR. Thus, the D or AR curve in figure 5.2 is elastic to the left of point r and inelastic to its right.

19 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia Quantity TR ($) Quantity (units) P = AR ($) TR ($) TR Curve for a Firm Facing a Downward-sloping Demand Curve

20 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia TR TR ($) Quantity (units) P = AR ($) TR ($) TR Curve for a Firm Facing a Downward-sloping Demand Curve – Figure 5.3 Quantity

21 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia Elasticity = -1 Elastic Inelastic AR, MR ($) Quantity MR AR AR and MR Curves for a Firm Facing a Downward-sloping Demand Curve (Figure 5.2)

22 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia TR Curve for a Firm Facing a Downward-sloping Demand Curve – Table 5.1, Figure 5.3 Revenue TR = P*Q (price times quantity, table 5.1); TR starts to fall when MR is negative (where demand becomes inelastic); TR is maximum where MR = 0; At this point, P єd = -1

23 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia TR Elasticity = -1 Elastic Inelastic TR ($) TR Curve for a Firm Facing a Downward-sloping Demand Curve – Figure 5.3. Quantity

24 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia TR Curve for a Firm Facing a Downward-sloping Demand Curve – Figure 5.3. Shifts in revenue curves -A change in any other determinant of demand, such as tastes, income or the price of other goods, will shift the D curve; -By affecting the P at which each level of output can be sold, there will be a shift in all three revenue curves; -TR increase – vertical shift of TR curve upwards; -TR decrease – vertical shift of TR curve downwards;

25 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia 5.2 Revenue, Costs and Profit What is the Short-run profit maximisation Output? Two ways to find this: -Maximise the difference between TR and TC using the TR and TC curves; -Use MR, AR, MC and AC curves (when comparing profit maximisation under different market conditions (Chapters 6 and 7); -Short run – at least one factor fixed; -Assume the firm is facing a downward sloping demand curve;

26 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia TR, TC, T ($) Quantity Finding Maximum Profit Using Total Curves

27 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia TR, TC, T ($) TR Quantity Finding Maximum Profit Using Total Curves

28 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia TR, TC, T ($) TR TC Quantity Finding Maximum Profit Using Total Curves – Table 5.2 and Figure 5.4

29 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia TR, TC, T ($) TR TC Quantity Finding Maximum Profit Using Total Curves

30 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia TR, TC, T ($) T TR TC Quantity Finding Maximum Profit Using Total Curves

31 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia TR, TC, T ($) T TR TC a b c d Quantity Finding Maximum Profit Using Total Curves

32 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia TR, TC, T ($) T TR TC d e f Quantity Finding Maximum Profit Using Total Curves

33 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia 5.2 Revenue, Costs and Profit Using marginal and average curves – table 5.3 based on table 5.2 data: –Stage 1: Profit is maximised at MR = MC (1)Produce table and draw curves – point e figure 5.5); (2)When Q MC and therefore a larger addition to revenue than to costs so total profit will increase (as production increases); (3)When Q > 3, MC > MR and therefore a larger addition to costs than to revenue so total profit will decrease (as production increases); (4)If you cannot add anything more to a total, than the total is the maximum

34 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia 5.2 Revenue, Costs and Profit Using marginal and average curves – table 5.3 based on table 5.2 data: –Stage 2: Measuring profit size using AR and AC curves; (1) Data from table 5.3 is plotted in figure 5.6. (2) Calculate Average Profit: Aπ = AR – AC at the profit maximising output of 3; (3) Calculate Total Profit: Tπ = Aπ * Q (shaded area in figure 5.6)

35 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia Quantity Costs and revenue ($) Finding the Profit-maximising Output Using Marginal Curves

36 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia Quantity Costs and revenue ($) MC Finding the Profit-maximising Output Using Marginal Curves

37 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia Quantity Costs and revenue ($) e MR MC Profit-maximising output Finding the Profit-maximising Output Using Marginal Curves

38 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia Quantity Costs and revenue ($) MC Measuring the Maximum Profit Using Average Curves – Figure 5.6 MR

39 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia Quantity Costs and revenue ($) MC AR Measuring the Maximum Profit Using Average Curves MR

40 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia Quantity Costs and revenue ($) MC AC AR b a Total profit = $1 x 3 = $4.00 Measuring the Maximum Profit Using Average Curves Total Profit MR

41 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia 5.2 Revenue, Costs and Profit Some qualifications: –Long-run profit maximisation –Assuming that the AR and MR curves are the same in the long run as in the short run, LR profit maximisation is where MR = long run MC; –The reasoning is the same as with the short-run case; –the meaning of profit –loss minimising: still produce where MR = MC

42 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia LOSS O Costs and revenue ($) Quantity MC AC AR MR Q AC AR Loss-minimising Output

43 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia Revenue, Costs and Profit Some qualifications –long-run profit maximisation –the meaning of profit –loss minimising: still produce where MR = MC –short-run shut-down point: P = AVC

44 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia O Costs and revenue ($) Quantity AR AVC AC P = AVC Q The Short-run Shut-down Point

45 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia Revenue, Costs and Profit Some qualifications: –When AR and MR curves are the same in both short and long run long-run profit maximisation output is where MR = MC (long–run) –the meaning of profit One element of cost is the opportunity cost to the owners of the firm incurred by being in business; i.e. Minimum return that owners must make on capital to prevent them from eventually deciding to close down and undertake alternative activities; It is a cost because (like wages and rent) it has to be covered if the firm is to continue producing; Sometimes known as normal profit and is included in the cost curves

46 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia Revenue, Costs and Profit Has two components: –Normal Profit (%) = rate of interest on riskless loan + a risk premium: (1)Initial capital investment – the interest that could have been earned by lending the capital in some risk less form (i.e. a bank savings account): -This defines the minimum rate of profit that entrepreneurs expect to earn. (2)Compensation for risk: - Varies according to business line; - Predictable patterns for food lines, relatively low: - Where outcomes are very uncertain (mineral exploration, fashion garment manufactures) relatively high. Thus earning normal profits means that owners will just be content to remain in that industry: - If they earn > normal profit => they will obviously prefer to stay in this business; - If they earn they will consider leaving and using their capital for another purpose.

47 John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia Revenue, Costs and Profit As Normal Profits are included in costs then any profits shown diagramatically must be over and above normal profit (figure 5.6): –Known as Supernormal Profit, Pure Profit, Economic Profit, Abnormal Profit, Producers Surplus, or sometimes simply Profit; –All mean excess of total profit over normal profit Loss Minimisation (at output where firm cannot make a profit) figure 5.7: - The AC curve is above the AR curve at all output levels; - Hence, the output at MR = MC is the loss-minimisation output; - The amount of loss (at MR = MC) is shown by the shaded area in figure 5.7 To produce or not to produce: -Fixed costs (rent and business rates) have to be paid even if we have zero (i.e. 0) output; -If the firm is covering more than its variable costs, it can go some way to paying off these fixed costs and therefore can continue to produce; -Short-run shut down point - It will shut down when it cannot cover variable costs (if AVC curve is above, or the AR curve is below (figure 5.8) -Long-run shut down point - If firm cannot cover LRAC (which includes normal profits) where the AR curve is tangential to LRAC curve.


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