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Chapter 22. Profit Maximization. The Profit Motive. The basic incentive for producing goods & services is the expectation of profit. Profit is the difference between Total Revenue & Total Cost. Chapter 22. 2. Motives To Produce. A.K.A. - Why run your own business? Expected Profit

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Profit Maximization

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Chapter 22

Chapter 22

Profit Maximization


The profit motive

The Profit Motive

  • The basic incentive for producing goods & services is the expectation of profit.

  • Profit is the difference between Total Revenue & Total Cost.

Chapter 22

2


Motives to produce

Motives To Produce

  • A.K.A. - Why run your own business?

    • Expected Profit

    • Social Status

    • Flexible hours

    • Control

    • Sense of mission/purpose

Chapter 22

3


Profit maximization

Profit Maximization

  • The objective of a for-profit firm is to maximize profit.

  • Each cost is an opportunity cost

    • the amount necessary to keep the owners of the resources from moving it to an alternative use.

Chapter 22

4


Economic profit

Economic Profit

  • The difference between total revenues & total economic costs

Chapter 22

5


Economic costs

Economic Costs

  • The value of all resources used in production

  • Includes:

    • Direct Costs of land, buildings, tools, ingredients & labor

    • Opportunity Costs for land, buildings, & tools

    • Cost of Debt – the interest paid on loans

Chapter 22

6


Profit maximization

Risk

  • The potential for profit is not a guarantee of profit.

    • remember the risk-return tradeoff.

  • There are many risks to starting a business.

Chapter 22

7


Market structure

Market Structure

  • The selling environment in which a firm produces and sells its product is called a market structure.

  • It is defined by three characteristics:

    • The number & size of firms in the market

    • The ease of entry and exit of firms

    • The degree of product differentiation

Chapter 22

8


5 market structures

5 Market Structures

  • Perfect (or Pure) Competition

  • Monopolistic Competition

  • Oligopoly

  • Duopoly

  • Monopoly

Chapter 22

9


Summary of market structures

Summary of Market Structures

Chapter 22

10


Perfect competition characteristics

Perfect Competition Characteristics

  • Many firms

  • Identical products – many substitutes

  • Low barriers to entry – easy to get into

  • Firm has no market power

  • Firm is a Price Taker

  • Advertising is unnecessary

  • Ex: Agriculture products.

Chapter 22

11


Price takers

Price Takers

  • With so many producers, no single producer has market power. They have no control over the price they charge, because their customer’s can easily get the same product from somewhere else.

  • The Demand curve the firm faces is flat.

    • No single firm could come close to satisfying the total demand for the product.

Chapter 22

12


Firm s demand in perfect competition

Firm’s Demand in Perfect Competition

Chapter 22

13


Industry s demand in perfect competition

Industry’s Demand in Perfect Competition

Chapter 22

14


Production decision

Production Decision

  • With no control over price, the firm has only one decision to make: How much to produce.

  • This is a short-term decision based on their existing plant & equipment, and the current price of their product.

Chapter 22

15


Output revenues

Output & Revenues

  • Total Revenue = Price X Quantity

    • The more you produce, the more revenue you make

Chapter 22

16


Output costs

Output & Costs

  • To maximize profits, a firm must consider how increased production will affect costs as well as revenues.

    • Fixed costs must be paid even if no output is produced

    • Variable costs increases as production increases

Chapter 22

17


Output costs1

Output & Costs

  • Total Costs = TFC + TVC

Chapter 22

18


Output costs2

Output & Costs

  • Total Costs = TFC + TVC

profit

loss

Chapter 22

19


Output costs3

Output & Costs

Chapter 22

20


Basic profit maximizing rule

Basic Profit Maximizing Rule

  • Never produce a unit of output that cost more than it brings in.

  • The goal of the firm is to maximize profit, not revenue.

Chapter 22

21


Marginal revenue

Marginal Revenue

  • MR = Price

  • Change in revenue

    Change in sales

  • Marginal means “extra”

    • This is the extra revenue for each extra item you sell. That is the price you sell it for.

Chapter 22

22


Marginal revenue marginal cost

Marginal Revenue & Marginal Cost

  • Marginal revenue (Price) is the extra income from selling an extra item.

  • Marginal cost is the extra costs to produce that extra item.

  • So, we consider them at the same time…

Chapter 22

23


Short run profit maximizing rules

Short-Run Profit Maximizing Rules

If:

  • Price > MC increase output (make more)

  • Price < MC decrease output (make less)

  • Price = MC maintain output

    • Profit maximizing point

Chapter 22

24


Profit maximizing

Profit Maximizing

Chapter 22

25


Adding up profits

Adding Up Profits

  • Total Profit = TR – TC

    Or

  • Total Profit = (P-ATC) x Q

Chapter 22

26


Goals

Goals:

  • The goal is to maximize total profit

  • Not to:

    • Maximize per-unit profit

    • Produce where ATC is at a minimum

  • It is about profit, not efficiency!

Chapter 22

27


Profit maximizing1

Profit Maximizing

Chapter 22

28


Examples

Examples:

AtMR=MC

  • Price = $3

  • ATC = $2.25

  • Q = 300

  • TR = $900

  • TC = $675

  • Profit = $225

At Minimum ATC

  • Price = $3

  • ATC = $2

  • Q = 200

  • TR = $600

  • TC = $400

  • Profit = $200

Chapter 22

29


Taking a loss

Taking A Loss

  • Price < ATCPrice > AVC

Chapter 22

30


Shutdown

Shutdown

  • Price < ATCPrice < AVC

Chapter 22

31


Short run supply determinants

Short-Run Supply Determinants

  • The quantity produced is affected by anything that changes Marginal Cost

    • Price of inputs (ingredients)

    • Technology

    • Expectations

    • Taxes & Subsidies

Chapter 22

32


Short run supply demand

Short-Run Supply & Demand

  • The MC curve is the short-run Supply curve for the company

    • (from the breakeven point to maximum profit point)

Chapter 22

33


Taxes and supply

Taxes and Supply

  • Some taxes alter short run behavior

  • Some taxes alter long run behavior

Chapter 22

34


1 property taxes

1. Property Taxes

  • Are a fixed cost

  • Raises Total Costs & reduces total profit

  • Increases Breakeven quantity

    • Raises FC

  • Does not change Profit Maximizing quantity.

    • Do not alter marginal costs

Chapter 22

35


1 property taxes1

1. Property Taxes

Chapter 22

36


2 payroll taxes

2. Payroll Taxes

  • Are a variable cost

  • Raises Total Costs, reduces total profit & per-unit profit

  • Increases Breakeven quantity

    • Reduces Contribution Margin

  • Reduces Profit Maximizing quantity.

    • Increases marginal costs

Chapter 22

37


2 payroll taxes1

2. Payroll Taxes

Chapter 22

38


3 profit income taxes

3. Profit (income) Taxes

  • Are neither a fixed or variable cost

  • Does not change Breakeven quantity

  • Does not change Profit Maximizing quantity.

    • Do not alter marginal costs

  • Might affect investment decisions

  • Profit doesn’t change – just where the profit goes.

Chapter 22

39


4 sales taxes

4. Sales Taxes

  • Are neither a fixed or variable cost

  • Does not change Breakeven quantity

  • Does not change Profit Maximizing quantity.

    • Do not alter marginal costs

  • This is collected at the end of a sale.

Chapter 22

40


3 4 profit sales taxes

3 & 4. Profit & Sales Taxes

Chapter 22

41


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