Profit Maximization CHAPTER 9 © 2016 CENGAGE LEARNING. ALL RIGHTS RESERVED. MAY NOT BE COPIED, SCANNED, OR DUPLICATED, IN WHOLE OR IN PART, EXCEPT FOR USE AS PERMITTED IN A LICENSE DISTRIBUTED WITH A CERTAIN PRODUCT OR SERVICE OR OTHERWISE ON A PASSWORD-PROTECTED WEBSITE FOR CLASSROOM USE.

The objective of a for-profit firm is to maximize profit. Profit is total revenue less the costs of the resources (land, labor, capital) used. Total revenue is the price of goods and services multiplied by the quantity sold, PQ. Profit = PQ – Cost of land, labor, and capital Profit Maximization

Marginal Revenue and Marginal Cost © 2016 CENGAGE LEARNING. ALL RIGHTS RESERVED. MAY NOT BE COPIED, SCANNED, OR DUPLICATED, IN WHOLE OR IN PART, EXCEPT FOR USE AS PERMITTED IN A LICENSE DISTRIBUTED WITH A CERTAIN PRODUCT OR SERVICE OR OTHERWISE ON A PASSWORD-PROTECTED WEBSITE FOR CLASSROOM USE. The profit maximizing quantity of output can be determined by comparing marginal revenue and marginal cost. Marginal cost is the additional cost of producing one more unit of output. Marginal revenue is the additional revenue from selling one more unit of output. Profit is maximized at the output level where marginal revenue and marginal cost are equal. The supply rule is: Produce and offer for sale the quantity at which MR=MC.

MR and MC © 2016 CENGAGE LEARNING. ALL RIGHTS RESERVED. MAY NOT BE COPIED, SCANNED, OR DUPLICATED, IN WHOLE OR IN PART, EXCEPT FOR USE AS PERMITTED IN A LICENSE DISTRIBUTED WITH A CERTAIN PRODUCT OR SERVICE OR OTHERWISE ON A PASSWORD-PROTECTED WEBSITE FOR CLASSROOM USE. Marginal Revenue = Change in Total Revenue/Change in Total Output MR = ΔTR/ΔQ Marginal Cost = Change in Total Cost/Change in Total Output MC = ΔTC/ΔQ Comparing marginal revenue and marginal cost determines whether the firm needs to supply more or less in order to maximize profit.

Profit Maximization © 2016 CENGAGE LEARNING. ALL RIGHTS RESERVED. MAY NOT BE COPIED, SCANNED, OR DUPLICATED, IN WHOLE OR IN PART, EXCEPT FOR USE AS PERMITTED IN A LICENSE DISTRIBUTED WITH A CERTAIN PRODUCT OR SERVICE OR OTHERWISE ON A PASSWORD-PROTECTED WEBSITE FOR CLASSROOM USE.

Profit Maximization © 2016 CENGAGE LEARNING. ALL RIGHTS RESERVED. MAY NOT BE COPIED, SCANNED, OR DUPLICATED, IN WHOLE OR IN PART, EXCEPT FOR USE AS PERMITTED IN A LICENSE DISTRIBUTED WITH A CERTAIN PRODUCT OR SERVICE OR OTHERWISE ON A PASSWORD-PROTECTED WEBSITE FOR CLASSROOM USE.

Market Structure © 2016 CENGAGE LEARNING. ALL RIGHTS RESERVED. MAY NOT BE COPIED, SCANNED, OR DUPLICATED, IN WHOLE OR IN PART, EXCEPT FOR USE AS PERMITTED IN A LICENSE DISTRIBUTED WITH A CERTAIN PRODUCT OR SERVICE OR OTHERWISE ON A PASSWORD-PROTECTED WEBSITE FOR CLASSROOM USE. The selling environment in which a firm produces and sells its product is called a market structure. Defined by three characteristics: ◦The number of firms in the market ◦The ease of entry and exit of firms ◦The degree of product differentiation

Characteristics of Market Structures © 2016 CENGAGE LEARNING. ALL RIGHTS RESERVED. MAY NOT BE COPIED, SCANNED, OR DUPLICATED, IN WHOLE OR IN PART, EXCEPT FOR USE AS PERMITTED IN A LICENSE DISTRIBUTED WITH A CERTAIN PRODUCT OR SERVICE OR OTHERWISE ON A PASSWORD-PROTECTED WEBSITE FOR CLASSROOM USE.

Perfect Competition © 2016 CENGAGE LEARNING. ALL RIGHTS RESERVED. MAY NOT BE COPIED, SCANNED, OR DUPLICATED, IN WHOLE OR IN PART, EXCEPT FOR USE AS PERMITTED IN A LICENSE DISTRIBUTED WITH A CERTAIN PRODUCT OR SERVICE OR OTHERWISE ON A PASSWORD-PROTECTED WEBSITE FOR CLASSROOM USE. Perfect Competition is a market structure characterized by: ◦Many large firms, so large that no one firm has the ability to affect the market. These firms are price takers—they have to go along with the market price. ◦Identical products – the products are perfect substitutes. ◦Easy entry into the industry. ◦The demand curve is horizontal.

Perfect Competition © 2016 CENGAGE LEARNING. ALL RIGHTS RESERVED. MAY NOT BE COPIED, SCANNED, OR DUPLICATED, IN WHOLE OR IN PART, EXCEPT FOR USE AS PERMITTED IN A LICENSE DISTRIBUTED WITH A CERTAIN PRODUCT OR SERVICE OR OTHERWISE ON A PASSWORD-PROTECTED WEBSITE FOR CLASSROOM USE.

Monopoly © 2016 CENGAGE LEARNING. ALL RIGHTS RESERVED. MAY NOT BE COPIED, SCANNED, OR DUPLICATED, IN WHOLE OR IN PART, EXCEPT FOR USE AS PERMITTED IN A LICENSE DISTRIBUTED WITH A CERTAIN PRODUCT OR SERVICE OR OTHERWISE ON A PASSWORD-PROTECTED WEBSITE FOR CLASSROOM USE. Monopoly is a market structure in which there is just one firm, and entry by other firms is not possible. ◦There are no close substitutes. ◦The firm has the power to set the price, but still sets an optimal price to maximize profit. If the monopolist sets the price too high, revenue will decline. The firm is a price maker. ◦The firm’s demand curve is the market demand curve, and it is downward sloping.

Monopoly © 2016 CENGAGE LEARNING. ALL RIGHTS RESERVED. MAY NOT BE COPIED, SCANNED, OR DUPLICATED, IN WHOLE OR IN PART, EXCEPT FOR USE AS PERMITTED IN A LICENSE DISTRIBUTED WITH A CERTAIN PRODUCT OR SERVICE OR OTHERWISE ON A PASSWORD-PROTECTED WEBSITE FOR CLASSROOM USE.

Monopolistic Competition © 2016 CENGAGE LEARNING. ALL RIGHTS RESERVED. MAY NOT BE COPIED, SCANNED, OR DUPLICATED, IN WHOLE OR IN PART, EXCEPT FOR USE AS PERMITTED IN A LICENSE DISTRIBUTED WITH A CERTAIN PRODUCT OR SERVICE OR OTHERWISE ON A PASSWORD-PROTECTED WEBSITE FOR CLASSROOM USE. Monopolistic Competition is characterized by: ◦A large number of firms ◦Easy entry ◦Differentiated products -- because each firm’s product is slightly different, each firm is kind of a mini-monopoly— the only producer of that specific product. ◦This allows the firm to be a price maker. ◦The firm’s demand curve is downward sloping and depending on the differentiation of the firm’s product, it may be fairly inelastic.

Monopolistic Competition © 2016 CENGAGE LEARNING. ALL RIGHTS RESERVED. MAY NOT BE COPIED, SCANNED, OR DUPLICATED, IN WHOLE OR IN PART, EXCEPT FOR USE AS PERMITTED IN A LICENSE DISTRIBUTED WITH A CERTAIN PRODUCT OR SERVICE OR OTHERWISE ON A PASSWORD-PROTECTED WEBSITE FOR CLASSROOM USE.

Oligopoly © 2016 CENGAGE LEARNING. ALL RIGHTS RESERVED. MAY NOT BE COPIED, SCANNED, OR DUPLICATED, IN WHOLE OR IN PART, EXCEPT FOR USE AS PERMITTED IN A LICENSE DISTRIBUTED WITH A CERTAIN PRODUCT OR SERVICE OR OTHERWISE ON A PASSWORD-PROTECTED WEBSITE FOR CLASSROOM USE. Oligopoly is characterized by: ◦Few firms—more than one, but few enough so each firm alone can affect the market. ◦Entry is more difficult, but can occur. ◦The firms are interdependent—each is affected by what others do. ◦The demand curve is downward sloping for each firm, but its shape depends on the behavior of competitors.

Summary of Market Structures © 2016 CENGAGE LEARNING. ALL RIGHTS RESERVED. MAY NOT BE COPIED, SCANNED, OR DUPLICATED, IN WHOLE OR IN PART, EXCEPT FOR USE AS PERMITTED IN A LICENSE DISTRIBUTED WITH A CERTAIN PRODUCT OR SERVICE OR OTHERWISE ON A PASSWORD-PROTECTED WEBSITE FOR CLASSROOM USE.

Choosing Price and Quantity to Maximize Profit © 2016 CENGAGE LEARNING. ALL RIGHTS RESERVED. MAY NOT BE COPIED, SCANNED, OR DUPLICATED, IN WHOLE OR IN PART, EXCEPT FOR USE AS PERMITTED IN A LICENSE DISTRIBUTED WITH A CERTAIN PRODUCT OR SERVICE OR OTHERWISE ON A PASSWORD-PROTECTED WEBSITE FOR CLASSROOM USE.

Accounting Profit © 2016 CENGAGE LEARNING. ALL RIGHTS RESERVED. MAY NOT BE COPIED, SCANNED, OR DUPLICATED, IN WHOLE OR IN PART, EXCEPT FOR USE AS PERMITTED IN A LICENSE DISTRIBUTED WITH A CERTAIN PRODUCT OR SERVICE OR OTHERWISE ON A PASSWORD-PROTECTED WEBSITE FOR CLASSROOM USE. The profit figure reported in annual reports and income statements is accounting profit: Accounting Profit = PQ – (cost of land) - (cost of labor) – (cost of capital)

Economic Profit © 2016 CENGAGE LEARNING. ALL RIGHTS RESERVED. MAY NOT BE COPIED, SCANNED, OR DUPLICATED, IN WHOLE OR IN PART, EXCEPT FOR USE AS PERMITTED IN A LICENSE DISTRIBUTED WITH A CERTAIN PRODUCT OR SERVICE OR OTHERWISE ON A PASSWORD-PROTECTED WEBSITE FOR CLASSROOM USE. Accounting profit does not include the cost of ownership – called equity capital. Economic profit includes all opportunity costs. Economic profit = accounting profit – cost of equity capital

Economic Profit © 2016 CENGAGE LEARNING. ALL RIGHTS RESERVED. MAY NOT BE COPIED, SCANNED, OR DUPLICATED, IN WHOLE OR IN PART, EXCEPT FOR USE AS PERMITTED IN A LICENSE DISTRIBUTED WITH A CERTAIN PRODUCT OR SERVICE OR OTHERWISE ON A PASSWORD-PROTECTED WEBSITE FOR CLASSROOM USE. Economists refer to a firm that subtracts value, whose cost of equity capital is greater than its accounting profit, as having negative economic profit. A firm that neither adds value nor subtracts it is a firm whose revenue is sufficient to pay the costs of inputs, but generates nothing in excess of this. This result is referred to as zero economic profit. If a firm is returning more to its owners than the owners’ opportunity cost, the firm is said to be earning a positive economic profit.

Role of Economic Profit © 2016 CENGAGE LEARNING. ALL RIGHTS RESERVED. MAY NOT BE COPIED, SCANNED, OR DUPLICATED, IN WHOLE OR IN PART, EXCEPT FOR USE AS PERMITTED IN A LICENSE DISTRIBUTED WITH A CERTAIN PRODUCT OR SERVICE OR OTHERWISE ON A PASSWORD-PROTECTED WEBSITE FOR CLASSROOM USE. Economic profit operates as a coordinating factor in the economy. ◦When a firm earns a positive economic profit, investors in the firm are earning better returns than they normally would with competing investments. ◦Other investors will want to invest in firm, too. As a result, resources will flow to where they earn more.