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PROFIT THEORY . IB ECONOMICS – A COURSE COMPANION (Blink & Dorton , 2007). PROFIT THEORY . How economist’s measure profit is different to accountants, because of the issue of opportunity cost.
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PROFIT THEORY IB ECONOMICS – A COURSE COMPANION (Blink & Dorton, 2007)
PROFIT THEORY • How economist’s measure profit is different to accountants, because of the issue of opportunity cost. • For example, a person might be making $80,000 a year profit from running their business, but they were making $80,000 a year as marketing manager before they started to run their own business. Running a business may involve more stress, and higher levels of uncertainty.
PROFIT THEORY How do economists measure profit? Total Profit = Total revenue – total cost (fixed, variable and opportunity cost)
PROFIT THEORY Normal Profit • If total revenue is equal to total cost, the firm is making normal profit. Abnormal Profit • If total revenue is greater than the total cost, the firm is making abnormal profit. Losses • If total revenue is less than total cost, then the firm is making losses.
Table Analysis – Firm A • A firm is making an abnormal profit of $20,000. • This means that the revenue earned by the firm is not only covering all the costs, but it is in fact $20,000 more. • This will make the entrepreneur happy, as he/she was expecting to cover her opportunity cost of $60,000 and in fact gets $80,000.
Table Analysis – Firm B • Firm B is making normal profit. • The revenue earned by the firm exactly covers all the costs. • The entrepreneur will be satisfied.
Table Analysis – Firm C • Firm C is making losses. • Although an accountant would say that the firm is making a profit of $40,000 ($200,000-$160,000) the entrepreneur will not be happy. • Fixed and variable costs are covered, but opportunity cost is not covered. • The entrepreneur should close down the firm, moving to the entrepreneur’s next best occupation.
Which one of the following firms is making abnormal profit, normal profits and losses?
PROFIT THEORY Beyond the issue of opportunity cost, firms must also consider the following: • The shut-down price. • The break-even price. • The profit-maximising level of output.
Shut Down Price • It is not unusual to see firms continue to operate, in the short run, even if they are making a loss. • It is also not unusual to see firms shut down for a short period of time and then open up again.
Shut Down Price Temporary Shut Down • The firm may close down temporarily in the short run and produce nothing. • It will only lose its total fixed costs – the costs that are unavoidable such as rent or the interest payments on loans. • Temporarily closing may be better than producing and not getting enough revenue to cover the variable costs.
Shut Down Price Example: Archie • Archie would be better not producing at all in the short turn and closing down temporarily. • Revenue gained has failed to cover all the variable costs. • By producing, Archie has costs of $120,000 not covered by revenue, but he only loses $100,000 of fixed costs if he did not produce.
Shut Down Price Example: Batcat • Total revenue of $120,000 means the variable costs of $120,000 are just covered. • They will lose $100,000 of fixed cost whether they produce or not produce. • In this situation it is likely that Batcat will continue to produce in order to maintain the continuity of production, thus pleasing customers and to maintain the employment of workers and the usage of inputs. This will please unions and suppliers.
Shut Down Price Example: Charlie • Charlie loses $90,000 by producing, since their total revenue covers their variable costs and also contributes $10,000 towards their fixed costs. • If they did not produce then Charlie would lose their fixed costs of $100,000. • Therefore Charlie will produce in the short run.
Short Run Losses • Firms making losses in the short run cannot do this forever. • Whether they produce or not in the short run, the firms need to plan ahead in the long run in order to change their combination of factors and to devise a situation where they are able to cover all their costs and make normal profits. If they cannot do this, they will have to close permanently.
Shut Down Price – Definition. • The Shut Down price is the level of price (revenue) that enables a firm to cover its variable costs in the short run • It is the price where price = the average variable costs in the short run. • If price (revenue) does not cover average variable costs, then the firm will shut down in the short run.
SHUT DOWN PRICE In this diagram the minimum price before shutdown is P. At this price the firm is able to cover its variable costs in the short run, because P = avc and so is only losing its fixed costs. At any price below P the firm will shut down in the short run. atc avc
Real World Examples –Shut Down Price • Many businesses open and close on a seasonable basis in very hot and cold climates. • For example an ice cream in store in Vienna shuts down in October and re opens again in April. • The act of temporarily closing down, because it cannot cover its variable costs is a good example of a firm that is not reaching its shut down price in the short run.
THE BREAK EVEN PRICE • The break-even price is the price at which a firm is able to make normal profit in the long run. • This means that it will break even, covering all of its costs, including opportunity cost. • The break even price is the level of price that enables a firm to cover all its costs in the long run: - the price where price = average total costs. • If the price does not cover average total costs in the long run, then the firm will shut down for good.
BREAK EVEN PRICE The break even price is P1. At this price the firm is able to cover its total costs, because P1 = atc, and so all costs are covered. atc avc
Exercise – Shut Down & Break Even Price Using the information below, determine the shut down & break price. Complete the data missing in the table for AVC and ATC. Determine the Shut Down and Break Even Price.
Break Even Price What is the break even price? At $5, the price is too cheap and we will not break even.
Trial & Error Process Based on this data, what can we say about the break even price? What would be the lowest price the firm would set??
Break Even Quantity Break Even Quantity = fixed costs contribution per unit Contribution per unit = price – variable cost per unit. Average Variable Costs: • Simple add up to the total variable cost and then determine the average. • This will not be the most accurate answer. • Naturally we can determine the break even quantity when each different labor combination.
Homework Question • At $8 per unit, what level of output will generate a normal profit? (break even) 1000 5.124 = 195.1600 (Units)
THE PROFIT MAXIMISING LEVEL OF OUTPUT The graph opposite shows the marginal costs and marginal revenue situation for a firm with a perfectly elastic demand curve. The MC curve cuts the MR curve at two points. The first point where MC=MR, q1, is the point of profit minimisation (loss maximisation). The firm has made a loss on every unit produced up to this level of output, because MC is greater than MR. From q1 to q2 the firm makes a a profit on every extra unit produced, because the MR is greater than MC. As long as the profit made between q1 and q2 is greater than the loss made on the first q1 units, then the firm will be making abnormal profits. Any unit that is produced beyond q2 will make a loss because MC would again be above MR. If the firm produces more than q2 the level of abnormal profit will begin to fall. It is at q2 where profits are maximised. Why does average revenue (AR) equal marginal revenue in this case??
The Profit Maximizing Level of Output A more common modified graph. Profit minimisation is not what a firm would want. To avoid confusion, the left hand part of the MC curve is normally omitted in diagrams. This means that only the profit maximising output q2 is shown. As a general rule we can say that: If a firm wishes to maximise it profits, it should produce at the level of output where the Marginal Cost (MC) cuts Marginal Revenue (MR) from below.
PROFIT MAXIMIZING OUTPUT FOR A NORMAL DEMAND & MR CURVE Profit is maximised by producing where MC = MR, at a level of output of q. The find the price we look at what consumers are willing to pay for this quantity. This is shown on the demand curve. It is found by going from q up to the demand curve and then across the y-axis.
GRAPHING ABNORMAL PROFITS In order to show a measureable amount of profit on a diagram (eg: simple shape like a diagram), the average cost curve can be added to the diagram. You must check that the MC curve cuts the AC curve at the lowest point in the AC curve. The profit-maximizing output is q and the price is p. The profit per unit of producing q is the difference between AR and AC. Thus the profit per unit is a – b. Since q units are produced, the total abnormal profit is the shaded area, ab x OQ.
ABNORMAL PROFIT, NORMAL PROFIT AND LOSSES Whether an abnormal profit is made will depend upon the position of the AC curve. The AC curve can be moved around to show what we want – abnormal profit, normal or losses. If the average cost curve is at AC, then the diagram shows an abnormal profit of pabc. If the average cost is represented by AC1 then normal profits is being made, because p = c1 . If average cost is shown by AC2, then a loss is being made.
Using the following info, draw an appropriate graph to model different profit and loss situations.
