1. Profit Maximization Day 2
Ap micro 10/13

2. Warm Up
Kate’s Katering: Assume the catered meals industry is perfectly competitive. Her fixed cost is $100/day.
Quantity of Meals VC FC TC
AVC
ATC MC $0 10
200 20
300 30
480 40
700 50
1,000

3. Quantity of Meals VC FC TC
AVC
ATC MC $0
$100
--- 10
200
100
300 20 30
400 15
480
580 16
19.33 18 40
700
800
17.50 22 50
1,000
1100

4. When is Production Profitable?
Depends on economic profit: a measure based on the opportunity cost of resources used in the business -- TR minus explicit and implicit costs (benefits forgone in the next best use of the firms resources)
Vs.
Accounting profit = TR-TC (only explicit costs)
We will assume that our cost totals include explicit and implicit costs, and profit totals are economic profit

5. Break Even Point
Price, cost of bushel
At point C (the minimum average total cost), the market price is $14 and output is 4 bushels of tomatoes (the minimum-cost output).
$30 MC
Minimum average total cost 18 A T C C
Break even price 14 MR = P 1 2 3 4 5 6 7
Quantity of tomatoes (bushels)
Minimum-cost output
This is where MC cuts the ATC curve at its minimum. Minimum average total cost is equal to the firm’s break-even price.

6. Profitability Graph
The farm is profitable because price exceeds minimum average total cost, the break-even price, $14.
The farm’s optimal output choice is (E)  output of 5 bushels.
The average total cost of producing bushels is (Z on the ATC curve) $14.40
Market Price = $18
Price, cost of bushel
Minimum average total cost MC E
$18 MR = P
14.40
Profit A T C 14 Z
Break even price C
The vertical distance between E and Z:
farm’s per unit profit, $18.00 − $14.40 = $3.60
Total profit:5 × $3.60 = $18.00 1 2 3 4 5 6 7
Quantity of tomatoes (bushels)

7. Unprofitable Graph
The farm is unprofitable because the price falls below the minimum average total cost, $14.
The farm’s optimal output choice is (A)  output of 3 bushels.
The average total cost of producing bushels is (Y on the ATC curve) $14.67
Market Price = $10
Price, cost of bushel
Minimum average total cost MC A T C
$14.67 Y 14
Break even price C
Loss 10 MR = P
The vertical distance between A and Y:
farm’s per unit loss, $14.67 − $10.00 = $4.67
Total profit:3 × $4.67 = approx. $14.00 A 1 2 3 4 5 6 7
Quantity of tomatoes (bushels)

8. Price = $18: Firm produces 5 units, is profiting
Price = $14: Firm produces 4, is breaking even
Price = $12: Firm produces 3.5, is incurring a loss, will stay in business in short run, exits industry in long run
Price = $10 or less: Firm exits industry immediately
Price, cost of bushel
Short-run individual supply curve MC
$18 E A T C 16 A VC 14 C 12 B 10 A
Minimum average variable cost 1 2 3
3.5 4 5 6 7
Quantity of tomatoes (bushels)

9. Profit, Break-Even, Loss, Shut Down Decisions
Whenever P > ATC, the producer is profitable.
Whenever P = ATC, the producer breaks even.
Whenever AVC < P < ATC, the producer is unprofitable – should stay in business in the short run.
Whenever P < AVC, the producer should shut down immediately.

10. Shut Down Vs. Loss in SR Scenario
Our business has a fixed cost of $20,000 per year. We incur an economic loss of $10,000 per year.
In the short run:
If we stay in business, we owe $10,000.
If we close down, we owe $20,000.
What should we do?
Scenario 2:
Our business has a fixed cost of $8000 per year. We incur an economic loss of $10,000 per year.
In the short run:
If we stay in business, we lose $10,000.
If we close, we owe $8000.
What should we do?

11. Practice Problem Using the warm up: Quantity of Meals VC FC TC AVC ATCMC $0
$100
--- 10
200
100
300 20 30
400 15
480
580 16
19.33 18 40
700
800
17.50 22 50
1,000
1100

12. What is the break-even price?
What is the shut-down price?
Suppose that the price at which Kate can sell meals is $21 per meal. How many meals will she produce? In the short run, will Kate earn a profit? In the short run, should she produce or shut down?
Suppose that the price falls to $17 per meal. How many meals will she produce? In the short run, will Kate earn a profit? Should she produce or shut down?
Suppose the price falls to $13. In the short run, will Kate earn a profit? Should she produce or shut down?

13. What is the break-even price? $19.33 (min ATC)
What is the shut-down price? $15 (min AVC)
Suppose that the price at which Kate can sell meals is $21 per meal. In the short run, will Kate earn a profit? In the short run, should she produce or shut down? Will profit and produce
Suppose that the price falls to $17 per meal. In the short run, will Kate earn a profit? Should she produce or shut down? Will not profit, still produce
Suppose the price falls to $13. In the short run, will Kate earn a profit? Should she produce or shut down? Not profit, shut down now