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  1. Production & Profits

  2. Production and Profits • Jennifer and Jason run an organic tomato farm • The market price of organic tomatoes is $18 per bushel • Jennifer and Jason are price takers – they can sell as much as they like at that price • What is there profit-maximizing level of output by direct calculation?

  3. Production and Profit • Total Revenue = P x Q • Profit = TR – TC • Profit is maximized at an output of 5 bushels, where profit is equal to $18

  4. Marginal Analysis & Profit-Maximizing Quantity of Output • Marginal Analysis is when the optimal amount of an activity is the level at which marginal benefit is equal to marginal cost • To apply to profit-maximization: considering the effect on a producer’s profit of increasing output by one unit • Marginal revenue is the change in total revenue generated by an additional unit of output

  5. Marginal Analysis & Profit-Maximizing Quantity of Output • Marginal revenue formula: MR = ∆TR/∆Q

  6. Marginal Analysis & Profit-Maximizing Quantity of Output • Jennifer and Jason can maximize their profit by producing bushels up to the point at which the marginal revenue is equal to marginal cost • Producer’s optimal output rule: profit is maximized by producing the quantity at which the MR of the last unit produced is equal to its marginal cost MR = MC at the optimal quantity of output

  7. Marginal Analysis & Profit-Maximizing Quantity of Output

  8. Marginal Analysis & Profit-Maximizing Quantity of Output • The net gain being negative in the 6th and 7th bushels illustrates another rule: • Price-taking firm’s optimal output rule – a price taking firm’s profit is maximized by producing the quantity of out put at which the market price is equal to the marginal cost of the last unit produced • P = MC at the price-taking firm’s optimal quantity of output

  9. Marginal Analysis & Profit-Maximizing Quantity of Output • Really, the price-taking firm’s optimal output rule is just an application of the optimal output rule to the case of a price-taking firm • WHY? • In the case of a price-taking firm, marginal revenue is equal to the market price

  10. The Price-Taking Firm’s Profit-Maximizing Quantity of Output Price, cost of bushel MC Optimal point $24 20 E Market price MR = P 18 16 12 8 The marginal revenue curve shows how marginal revenue varies as output varies 6 0 1 2 3 4 5 6 7 Quantity of tomatoes (bushels) Profit-maximizing quantity

  11. Marginal Analysis & Profit-Maximizing Quantity of Output • Are all price-taking firm’s production decision summed up as “produce up to the point where marginal cost of production is equal to the price?” • NO! • Before you apply Marginal Analysis to determine how much to produce, a producer must answer an “either-or” question—should it produce at all?

  12. When is Production Profitable? • Economic profit is the measure based on the opportunity cost of resources used in the business • To calculate economic profit, a firm’s total cost incorporates the implicit cost (benefits forgone in the next best use of the firm’s resources) as well as explicit cost incurred by the firm

  13. When is Production Profitable? • What determines if Jennifer and Jason’s farm earns a profit or generates a loss? • Whether the market price of organic tomatoes is more or less than the farm’s minimum average total cost

  14. Calculation of short-run AVC and short-run ATC**short-run due to all variables are fixed costs**

  15. Costs and Production in the Short Run Price, cost of bushel $30 MC Minimum average total cost 18 A T C C Break even price MR = P 14 0 1 2 3 4 5 6 7 Quantity of tomatoes (bushels) Minimum-cost output

  16. When is Production Profitable? • Profit is equal to total revenue minus total cost, TR-TC: • If TR > TC, the firm is profitable. • If TR = TC, the firm breaks even. • If TR < TC, the firm incurs a loss.

  17. When is Production Profitable? • Also can express this in terms of revenue and cost per unit of output • Divide profit by number of units of output, Q: Profit/Q = TR/Q – TC/Q • TR/Q is average revenue (market price) • TC/Q is average total cost

  18. Profitability and the Market Price Market Price = $18 Price, cost of bushel Minimum average total cost Area of the shaded rectangle shows Jennifer and Jason’s total profit when market price is $18. Can be expressed: Profit = TR – TC = (TR/Q – TC/Q) x Q Or Profit = (P – ATC) x Q MC E MR = P $18 Profit A T C 14.40 14 Z Break even price C 0 1 2 3 4 5 6 7 Quantity of tomatoes (bushels)

  19. Profitability and the Market Price Market Price = $10 Price, cost of bushel Minimum average total cost MC A T C Y $14.67 14 Break even price C Loss MR = P 10 A 0 1 2 3 4 5 6 7 Quantity of tomatoes (bushels)

  20. Profitability and the Market Price • How does a producer know, in general, whether or not its business will be profitable? • Need to compare the market price to the producer’s minimum average total cost

  21. Profitability and the Market Price For Jennifer and Jason, minimum average total cost ($14) occurs at an output quantity of 4 bushels. Whenever market price exceeds minimum average total cost, the producer can find some output level for which the average total cost is less than the market price. Market Price = $10 Price, cost of bushel Minimum average total cost MC If the market price is less than minimum average total cost, there is not output level at which price exceeds average total cost. Due to this, the firm will be unprofitable at any quantity of output. A T C Y $14.67 14 Break even price C Loss MR = P 10 A 0 1 2 3 4 5 6 7 Quantity of tomatoes (bushels)

  22. Profitability and the Market Price • Minimum average total cost of a price-taking firm is its break-even price • The price at which it earns zero profit (called economic profit) • At firm will earn positive profit when the market price is above the break-even price and it will suffer losses when the market price is below the break-even price

  23. Profitability and the Market Price • Rules determining whether a producer of a good is profitable depends on a comparison of the market price of the good to the producer’s break-even price: • Whenever market price exceeds minimum average total cost, the producer is profitable. • Whenever the market price equals minimum average total cost, the producer breaks even. • Whenever market price is less than minimum average total cost, the producer is unprofitable.

  24. Production & Profits Notes

  25. Production and Profit • Total Revenue = • Profit = • Profit is maximized at an output of 5 bushels, where profit is equal to $18

  26. Marginal Analysis & Profit-Maximizing Quantity of Output • Marginal Analysis is • To apply to profit-maximization: considering the effect on a producer’s profit of increasing output by one unit • Marginal revenue is the change in total revenue generated by an additional unit of output

  27. Marginal Analysis & Profit-Maximizing Quantity of Output • Marginal revenue formula:

  28. Marginal Analysis & Profit-Maximizing Quantity of Output • Jennifer and Jason can maximize their profit by producing bushels up to the point at which the marginal revenue is equal to marginal cost • Producer’s optimal output rule:

  29. Marginal Analysis & Profit-Maximizing Quantity of Output

  30. Marginal Analysis & Profit-Maximizing Quantity of Output • The net gain being negative in the 6th and 7th bushels illustrates another rule: • Price-taking firm’s optimal output rule – • P = MC at the price-taking firm’s optimal quantity of output

  31. Marginal Analysis & Profit-Maximizing Quantity of Output • Really, the price-taking firm’s optimal output rule is just an application of the optimal output rule to the case of a price-taking firm • WHY? • In the case of a price-taking firm, marginal revenue is equal to the market price

  32. The Price-Taking Firm’s Profit-Maximizing Quantity of Output Price, cost of bushel MC Optimal point $24 20 E Market price MR = P 18 16 12 8 6 0 1 2 3 4 5 6 7 Quantity of tomatoes (bushels) Profit-maximizing quantity

  33. Marginal Analysis & Profit-Maximizing Quantity of Output • Are all price-taking firm’s production decision summed up as “produce up to the point where marginal cost of production is equal to the price?” • NO! • Before you apply Marginal Analysis to determine how much to produce, a producer must answer an “either-or” question—should it produce at all?

  34. When is Production Profitable? • Economic profit is the measure based on the opportunity cost of resources used in the business • To calculate economic profit,

  35. When is Production Profitable? • What determines if Jennifer and Jason’s farm earns a profit or generates a loss? • Whether the market price of organic tomatoes is more or less than the farm’s minimum average total cost

  36. Calculation of short-run AVC and short-run ATC**short-run due to all variables are fixed costs**

  37. Costs and Production in the Short Run Price, cost of bushel $30 MC Minimum average total cost 18 A T C C Break even price MR = P 14 0 1 2 3 4 5 6 7 Quantity of tomatoes (bushels) Minimum-cost output

  38. When is Production Profitable? • Profit is equal to total revenue minus total cost, TR-TC: • If TR > TC, • If TR = TC, • If TR < TC,

  39. When is Production Profitable? • Also can express this in terms of revenue and cost per unit of output • Divide profit by number of units of output, Q: • TR/Q is average revenue (market price) • TC/Q is average total cost

  40. Profitability and the Market Price Market Price = $18 Price, cost of bushel Minimum average total cost MC E MR = P $18 A T C 14.40 14 Z Break even price C 0 1 2 3 4 5 6 7 Quantity of tomatoes (bushels)

  41. Profitability and the Market Price Market Price = $10 Price, cost of bushel Minimum average total cost MC A T C Y $14.67 14 Break even price C MR = P 10 A 0 1 2 3 4 5 6 7 Quantity of tomatoes (bushels)

  42. Profitability and the Market Price • How does a producer know, in general, whether or not its business will be profitable? • Need to compare the market price to the producer’s minimum average total cost

  43. Profitability and the Market Price Market Price = $10 Price, cost of bushel MC A T C Y $14.67 14 C MR = P 10 A 0 1 2 3 4 5 6 7 Quantity of tomatoes (bushels)

  44. Profitability and the Market Price • Minimum average total cost of a price-taking firm is its break-even price • The price at which it earns zero profit • At firm will earn positive profit when the market price is above the break-even price and it will suffer losses when the market price is below the break-even price

  45. Profitability and the Market Price • Rules determining whether a producer of a good is profitable depends on a comparison of the market price of the good to the producer’s break-even price: • Whenever market price exceeds minimum average total cost, • Whenever the market price equals minimum average total cost, • Whenever market price is less than minimum average total cost,