INTRODUCTION ECONOMIC PROFITS

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1 INTRODUCTION This chapter addresses the following key questions: What are profits? What are the unique characteristics of competitive firms? How much output will a competitive firm produce? Chapter 7 THE COMPETITIVE FIRM THE PROFIT MOTIVE ECONOMIC PROFITS The basic incentive for producing goods and services is the expectation of profit. Profit is the difference between total revenue and total cost. The profit motive encourages businesses to produce the goods and services consumers desire, at prices they are willing to pay. Personal reasons also motivate producers. Producers seek social status and crave recognition. Non-owner managers of corporations may be more interested in their own jobs, salaries, and selfpreservation than earning profits for stockholders. 3 Economic profit is the difference between total revenues and total economic costs. Economic cost is the value of all resources used to produce a good or service opportunity cost. ECONOMIC PROFITS ECONOMIC PROFITS To determine a firm s economic profit, all implicit factor costs must be subtracted from observed accounting profit. Economic profits account for the use of all resources. Normal profit is the opportunity cost of capital zero economic profit. Economic profits represent something over and above normal profits. A productive activity reaps an economic profit only if it earns more than its opportunity cost. Whenever economic costs exceed explicit costs, observed (accounting) profits will exceed true (economic) profits. 5

2 ECONOMIC PROFITS ENTREPRENEURSHIP AND RISK The inducement to take on the added responsibilities of owning and operating a business is the potential for profit. The potential for profit is not a guarantee of profit. Substantial risks are attached to starting and operating a business. 7 MARKET STRUCTURE The opportunity for profit may be limited by the structure of the industry. Market structure is the number and relative size of firms in an industry. Perfect competition is market in which no buyer or seller has market power. Monopoly is a firm that produces the entire market supply of a particular good or service. MARKET STRUCTURE Perfect competition Imperfect competition Monopolistic competition Oligopoly Duopoly Monopoly 9 THE NATURE OF PERFECT COMPETITION A perfectly competitive industry has several distinguishing characteristics: Many firms lots of firms are competing for consumer purchases. Identical products the products of the different firms are identical, or nearly so. Low entry barriers it s relatively easy to get into the business. PRICE TAKERS A perfectly competitive firm has no market power and has no ability to alter the market price of the goods it produces. Market Power - The ability to alter the market price of a good or service. The output of a perfectly competitive firm is so small relative to market supply that it has no significant effect on the total quantity or price in the market. 11

3 MARKET DEMAND CURVES VS. FIRM DEMAND CURVES MARKET DEMAND CURVES VS. FIRM DEMAND CURVES It is important to distinguish between the market demand curve and the demand curve confronting a particular firm. While the actions of a single competitive firm are negligible, the unified actions of many such firms are not. The market demand curve for a product is always downward-sloping. The demand curve confronting a perfectly competitive firm is horizontal. PRICE (per shirt) The T-shirt market Equilibrium price Market supply Market demand Quantity (thousand shirts per day) Demand facing one shop Demand facing single firm Quantity (shirts per day) 13 1 THE PRODUCTION DECISION A competitive firm has only one decision to make: how much to produce. The production decision is the selection of the short-run rate of output (with existing plant and equipment). OUTPUT AND REVENUES In searching for the most desirable rate of output, the distinction between total revenue and total profit must be kept in mind. Total revenue - The price of the good multiplied by the quantity sold in a given time period. Total revenue = price X quantity 15 The total revenue curve of a perfectly competitive firm is an upward-sloping straight line, with a slope equal to. TOTAL REVENUE OUTPUT AND COSTS Total Revenue $ = $ Total revenue To maximize profits a firm must consider how increased production will affect costs as well as revenues. Producers are saddled with certain costs in the short-run. Short-run - The period in which the quantity (and quality) of some inputs cannot be changed Quantity 17 1

4 OUTPUT AND COSTS Fixed costs are incurred even if no output is produced. OUTPUT AND COSTS Once a firm starts producing output, it incurs variable costs as well. Fixed costs - Costs of production that do not change when the rate of output is altered, e.g., the cost of basic plant and equipment. Variable costs - Costs of production that change when the rate of output is altered, e.g. labor and material costs TOTAL COST OUTPUT AND COSTS Total Cost (dollars per time period) Fixed cost z Total cost Total costs escalate due to the law of diminishing returns The shape of the total cost curve reflects increasing marginal costs and the law of diminishing returns. Marginal cost is the increase in total costs associated with a one-unit increase in production. The primary objective of the producer is to find that one particular rate of output that maximizes profits. Output (units per time period) 1 TOTAL PROFIT PROFIT-MAXIMIZING RULE Revenues Or Costs (dollars per period) r s Total cost f h g Total revenue The best single rule for maximizing short-run profits is straightforward: Never produce a unit of output that costs more than it brings in. Output (units per period) 3

5 MARGINAL REVENUE = PRICE MARGINAL REVENUE = PRICE The contribution to total revenue of an additional unit of output is called marginal revenue. Marginal revenue (MR) is the change in total revenue that results from a one-unit increase in the quantity sold. For perfectly competitive firms, price equals marginal revenue. 5 MARGINAL REVENUE AND MARGINAL COST MARGINAL COST A firm s goal is not to maximize revenues, but to maximize profits. Marginal revenue is compared to marginal costs to determine the best level of output. What an additional unit of output brings in is its marginal revenue (MR). What it costs to produce is its marginal cost (MC). 7 PROFIT-MAXIMIZING RATE OF OUTPUT According to the profit-maximization rule a firm should produce at that rate of output where marginal revenue equals marginal cost. If marginal cost exceeds price, total profits decline if the additional output is produced. If marginal cost is less than price, total profits increase if the additional output is produced. Profits are maximized at the rate of output where price equals marginal cost. 9 SHORT-RUN PROFIT-MAXIMIZATION RULES FOR COMPETITIVE FIRM Price > MC increase output Price = MC maintain output and maximize profit Price < MC decrease output 30

6 PROFIT-MAXIMIZING RATE OF OUTPUT Price or Cost (per bushel) $1 1 Marginal cost MR B p = MC Profits decreasing MC B Profits increasing Profit-maximizing rate of output Price (= MR) Quantity (bushels per day) 31 ADDING UP PROFITS Profits can be computed in two ways. Total profit is the difference between total revenue and total cost. Total profit = total revenue total cost Total profit is average profit times the number sold. Profit per unit = price ATC Total profit = profit per unit X quantity Total profit = (p ATC) X q 3 ADDING UP PROFITS ALTERNATIVE VIEWS OF TOTAL PROFIT The profit-maximizing producer never seeks to maximize per-unit profits. What counts is total profits, not the amount of profit per unit. The profit-maximizing producer has no desire to produce at that rate of output where ATC is at a minimum. 33 Revenue or Cost (dollars per day) $ Total revenue and total cost Total revenue Total cost Maximum total profit Rate of Output Price or Cost (per unit) $1 1 Price and average cost Average total cost Total Profit Marginal cost Price Profit per unit Cost per unit Rate of Output 3 THE SHUTDOWN DECISION The short-run profit maximization rule does not guarantee any profits. Fixed costs must be paid even if all output ceases. A firm should shut down only if the losses from continuing production exceed fixed costs. PRICE VS. AVC Where price exceeds average variable cost but not average total cost, the profit maximizing rule minimizes losses. When price does not cover average variable costs at any rate of output, production should cease. The shutdown point is that rate of output where price equals minimum AVC. 35 3

7 THE SHUTDOWN POINT THE INVESTMENT DECISION Price or Cost ATC Profit X MC Price (=MR) AVC Quantity Loss MC ATC Price Y AVC Quantity Shutdown MC ATC AVC Price shutdown point Quantity The investment decision is the decision to build, buy, or lease plant and equipment. It also involves the decision to enter or exit an industry. The shut-down decision is a short-run response. Investment decisions are long-run decisions. Long-run A period of time long enough for all inputs to be varied (no fixed costs). 3 LONG-RUN COSTS In making long-run decisions, the producer is confronted with many possible cost figures. A producer will want to build, buy or lease a plant that is most efficient for the anticipated rate of output. DETERMINANTS OF SUPPLY The quantity of a good supplied is affected by all forces that alter marginal cost. The short-run determinants of a firm s supply include: The price of factor inputs. Technology (the available production function). Expectations (for costs, sales, technology). Taxes and subsidies SHORT-RUN SUPPLY CURVE SHORT-RUN SUPPLY CURVE The marginal cost curve is the short-run supply curve for a competitive firm. Supply curve A curve describing the quantities of a good a producer is willing and able to sell (produce) at alternative prices in a given time period, ceteris paribus. If any determinant of supply changes, the supply curve shifts. Price (per bushel) $1 1 Shutdown point Y Marginal cost curve X Short-run supply curve = for competitive firm Quantity Supplied (bushels per day)

8 TAXING BUSINESS Some tax changes alter short-run supply behavior. Others affect only long-run supply decisions. PROPERTY TAXES Property taxes are a fixed cost. They raise average costs and reduce profit. Because they don t affect marginal costs, they leave the profit-maximizing output unchanged. 3 PAYROLL TAXES Payroll taxes increase marginal costs. They reduce the profit maximizing rate of output. They increase average costs and lower total and per-unit profits. PROFIT TAXES Profit taxes are neither a fixed cost nor a variable cost. They don t affect marginal cost or prices. They don t affect production level decisions but may affect investment decisions. 5 IMPACT OF TAXES ON BUSINESS DECISIONS Property taxes affect fixed costs MC 1 ATC a ATC 1 Payroll taxes alter marginal costs MC b MC 1 ATC b ATC 1 Profits taxes don't change costs MC 1 ATC 1 THE COMPETITIVE FIRM End of Chapter 7 q 1 q b q 1 q1 7

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