Learning Targets: • Distinguish between economic and normal profit. • Explain why a firm will continue even when it earns zero economic profit? • Why is economic profit is also called supernormal profit or abnormal profit. • Explain positive and negative profit.
Profit • Profit = TR – TC • The reward for enterprise • Profits help in the process of directing resources to alternative uses in free markets
Profit • Economic Profit= Total revenue- economic cost(implicit cost + explicit cost) • Normal Profit- the minimum amount required to keep a firm running • Revenue= economic cost or economic Profit = zero • This is also known as break-even point of a firm. • allocation
Why a firm continues to operate even when earning zero economic profit? • Note That: • When a firm is earning normal profit, it has covered all its opportunity cost (implicit cost) and will continue to operate
Positive and Negative Profit: • Economic profit can be zero, positive of negative • supernormal or abnormal profit: • Positive economic profit is also referred to as supernormal or abnormal profit. • This is because it involves profit over and above the economic profit.
Profit To summarize: • Positive economic profit = TR>economic cost, the firm supernormal profit • Zero economic profit= TR=economic cost, the firm earns normal profit • Negative economic profit = TR<economic profit, the firm makes a loss (sub-normal profit)
Learning Targets • Explain the goal of profit maximization where the difference between TR and TC is minimized or when MC=MR
Profit Maximization • Involves determining the levels of output that the firm should produce to make profit as large as possible. • Yet firms do not always make profit as revenue is not sufficient to cover all costs
Profit maximization based on TR & TC Approach • This is based on the simple principle of TR-TC=economic profit • If the difference between TR and TCis positive, the firm is making abnormal profit • If the difference between TR and TC is = to 0, the firm is making normal profit • If the difference between TR and TC is negative, the firm is making a loss
Profit Max. using TR and TC with NO price control Normal econ profit TC-TR=0 Loss minimization TR<TC Profit maximization TR>TC
Profit Max using TR and TC- has price control Profit maximization -At point Qmax, profit is maximized -At point Q1 and Q2, ECON PROFIT=0 (break-even point) Loss Minimization -Firm is making a loss as TC>TR, However, loss is minimized at point Q1min
Profit Maximization Based of MC & MR • A firms profit max. rule is to choose to produce when MC=MR Why is this so? -Consider a firm is producing at point Q1 in both graphs, where MR>MC, if this firm increases its output by 1 unit, the MR>MC until it intercepts MR=MC. -but at Q2, MC>MR, therefore the firm must cut down its Q output
Explain the relationship between the given curves.
Added to total profit Reduces total profit by this amount Total added to profit Added to total profit Profit Why? If the firm were to produce the 104th unit, this last unit would cost more to produce than it earns in revenue (-105) this would reduce total profit and so would not be worth producing. The profit maximising output is where MR = MC Assume output is at 100 units. The MC of producing the 100th unit is 20. The MR received from selling that 100th unit is 150. The firm can add the difference of the cost and the revenue received from that 100th unit to profit (130) Cost/Revenue The process continues for each successive unit produced. Provided the MC is less than the MR it will be worth expanding output as the difference between the two is ADDED to total profit If the firm decides to produce one more unit – the 101st – the addition to total cost is now 18, the addition to total revenue is 140 – the firm will add 128 to profit. – it is worth expanding output. MC MC – The cost of producing ONE extra unit of production MR – the addition to total revenue as a result of producing one more unit of output – the price received from selling that extra unit. 150 145 140 120 40 30 20 MR 18 Output 100 101 102 103 104
Homework • Describe alternative goals of firms, revenue max., growth max., satisficing and corporate social responsibility. • Due next week
Test your knowledge • What are the two approaches max. by firms? • What is the profit max. rule of firms in each of the two approaches?