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The Profit Motive

Ch 7 – Competitive Firms. The Profit Motive. The basic incentive for producing goods and services is the expectation of profit. Profit = total revenue - total cost. Other Motivations. Personal reasons also motivate producers. Producers seek social status and crave recognition.

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The Profit Motive

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  1. Ch 7 – Competitive Firms The Profit Motive • The basic incentive for producing goods and services is the expectation of profit. • Profit = total revenue - total cost

  2. Other Motivations • 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 self-preservation than earning profits for stockholders. Is the profit motive bad?

  3. Economic vs. Accounting Profits • The typical consumer believes that 35¢ of every sales dollar goes to profits. • In reality, average profit per sales dollar is closer to 5¢.

  4. Economic Profits • Economic profit - the difference between total revenues and total economic costs. • Economiccost - the value of all resources used to produce a good or service (opportunity cost).

  5. Economic Profits • To determine a firm’s economic profit, all implicit factor costs must be subtracted from observed accounting profit.

  6. Economic Profits • Normal profit - 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.

  7. Economic Profits

  8. Market Structure • The opportunity for profit may be limited by the structure of the industry. • Market structure - the number and relative size of firms in an industry. • Perfect competition - market in which no buyer or seller has market power.

  9. Imperfect competition Perfect Monopolistic competition competition Market Structure Oligopoly Duopoly Monopoly

  10. The Nature of Perfect Competition • A perfectly competitive industry has several distinguishing characteristics: • Many firms – lots of firms are competing for consumer purchases. • Homogeneous products – the products of the different firms are identical, or nearly so. • Low entry barriers – it’s relatively easy to get into the business. • No Market Power – output of each firm is so small that firms cannot alter the market price of a good or service (price takers).

  11. Demand facing one shop Equilibrium price PRICE (per shirt) Demand facing single firm Quantity (thousand shirts per day) Quantity (shirts per day) Market Demand Curves vs. Firm Demand Curves The T-shirt market Market supply pe pe Market demand

  12. The Production Decision • A competitive firm has only one decision to make: how much to produce. • Theproduction decision is the selection of the short-run rate of output (with existing plant and equipment).

  13. Output and Costs • To maximize profits a firm must consider how increased production will affect revenues and costs • The total revenue curve of a perfectly competitive firm is an upward-sloping straight line, with a slope equal to pe.

  14. $96 Total revenue 88 80 72 64 56 Total Revenue 48 40 32 24 16 pe= $8 8 0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity Total Revenue

  15. Output and Costs • Producers are saddled with certain costs in the short-run. • Fixed costs are incurred even if no output is produced. • Once a firm starts producing output, it incurs variable costs as well.

  16. z Total Cost (dollars per time period) Output (units per time period) Total Cost Total cost Total costs escalate due to the law of diminishing returns Fixed cost

  17. r Revenues Or Costs (dollars per period) s Output (units per period) Total Profit Total cost Total revenue Profits Losses f h g

  18. Profit-Maximizing Rule The best single rule for maximizing short run profits is straightforward: Never produce a unit of output that costs more than it brings in.

  19. Marginal Revenue = Price • The contribution to total revenue of an additional unit of output is called marginal revenue. • For perfectly competitive firms, price equals marginal revenue.

  20. Marginal Revenue = Price • Marginal revenue(MR) - the change in total revenue that results from a one-unit increase in the quantity sold.

  21. Marginal Revenue = Price

  22. Marginal Cost A firm’s goal is not to maximize revenues, but to maximize profits. • What an additional unit of output brings in is its marginal revenue (MR). • What it costs to produce is its marginal cost (MC).

  23. Marginal Cost

  24. Profit-Maximizing Rate of Output Profit-maximization rule : a firm should produce at that rate of output where marginal revenue equals marginal cost. MR = MC

  25. Short-Run Profit-Maximization Rules for Competitive Firm Price > MC  increase output Price = MC maintain output and maximize profit Price < MC decrease output

  26. $18 Marginal cost 16 Profits decreasing 14 Price (= MR) 12 Profits increasing 10 Price or Cost (per bushel) 8 6 4 2 0 1 2 3 4 5 6 7 Quantity (bushels per day) Profit-Maximizing Rate of Output p = MC MRB Profit-maximizing rate of output MCB

  27. 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

  28. Adding Up Profits • 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

  29. Total revenue and total cost Price and average cost $90 $18 Average total cost 80 16 70 14 Total revenue Price Total Profit 60 12 Maximum total profit Profit per unit 50 10 Revenue or Cost (dollars per day) Price or Cost (per unit) 40 8 30 Total cost 6 Cost per unit Marginal cost 20 4 10 2 0 1 2 3 4 5 6 7 0 1 2 3 4 5 6 7 Rate of Output Rate of Output Alternative Views of Total Profit

  30. 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.

  31. Price vs. AVC • Where price exceeds average variable cost but not average total cost, the profit maximizing rule minimizes losses.

  32. The Shutdown Point • When price does not cover average variable costs at any rate of output, production should cease. • Theshutdown point is that rate of output where price equals minimum AVC.

  33. Profit Loss Shutdown 18 MC MC 16 ATC MC ATC ATC Price (=MR) 14 X 12 AVC AVC 10 Price Price or Cost Y 8 AVC 6 Price 4 shutdown point 2 0 1 2 3 4 0 1 2 3 4 5 6 7 8 0 1 2 3 4 5 6 7 8 5 6 7 8 Quantity Quantity Quantity The Shutdown Point

  34. The Investment Decision • The shut-down decision is a short-run response. • Investment decisions are long-run decisions. • Theinvestmentdecision is the decision to build, buy, or lease plant and equipment. • It also involves the decision to enter or exit an industry.

  35. 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.

  36. Determinants of Supply • The quantity of a good supplied is affected by all forces that alter marginal cost. • The 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.

  37. Short-Run Supply Curve (MC Curve) $18 16 14 X 12 10 Y Shutdown point Price (per bushel) 8 6 Marginal cost curve = Short-run supply curve for competitive firm 4 2 0 1 2 3 4 5 6 7 Quantity Supplied (bushels per day)

  38. Tax Effects • Some tax changes alter short-run supply behavior. • Others affect only long-run supply decisions.

  39. 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.

  40. 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.

  41. 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.

  42. Payroll taxes alter marginal costs Profits taxes don't change costs Property taxes affect fixed costs MCb MC1 MC1 MC1 ATCa ATCb ATC1 ATC1 ATC1 pe pe pe q1 qb q1 q 1 Impact of Taxes on Business Decisions

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