Profit

Syllabus Candidates should be able to: Define normal and supernormal profit Relate normal and supernormal profit to the objectives of the firm and the ability of different firms to make normal and supernormal profit Explain and illustrate the concept of profit maximisation using marginal cost and marginal revenue

Definitions Profit is the difference between revenue and total costs Profit = TR – TC Break even is when the firm makes neither a profit nor a loss but it just covers its costs. At break even TR = TC Economic cost is the total opportunity cost of production. Economic cost = money cost + imputed cost Economic cost = explicit cost + implicit cost

Definitions: accounting versus normal profit Accounting profit = TR – explicit costs Normal profit is the level of profit which is sufficient to keep the resources employed (rather than transfer them to something else). If you have to calculate it, it is the opportunity cost. E.g. running your own business may earn you £20,000 but you may have given up a job paying you £25,000. So you have given up £25,000 for £20,000! Normal profit = Opportunity cost = £25, Video on economic cost, economic profit

Definitions: supernormal profit = economic profit Supernormal profit = economic profit Supernormal profit = TR – explicit cost – implicit cost If economic profit = 0 this is known as normal profit as the revenues are enough to cover all costs (explicit and implicit) Firms earn normal profit when TR = TC or AR = AC Supernormal profit is the profit which is greater than normal profit. It is also known as abnormal profit Firms earn supernormal profit when TR > TC or AR > AC

Profit example For example, say you invest £100,000 to start a business, and in that year you earn £120,000 in profits. Your accounting profit would be £20,000. However, say that same year you could have earned an income of £45,000 had you been employed. Economic profit = 120, , ,000 = - £25,000 Therefore, you have an economic loss of £25,000 Normal profit = opportunity cost = £45,000 Supernormal profit = -£25,000

What happens… What would happen if a firm failed to earn normal profits? It would stop producing in the long run. What happens if a firm earns supernormal profit? Often, other firms would enter the market so that prices would fall and normal profits would be made (this may not happen in reality – see topic 3.3.9)

Diagram of normal and supernormal profit when price is constant Normal profit occurs when AR = AC Firm selling price is P, revenue = PQ = total cost Supernormal profit occurs when AR > AC, profit = red

Diagram of normal and supernormal profit when price falls Normal profit occurs when TR = TC or AR = AC Supernormal profit occurs when TR > TC or AR > AC Assume selling price = P, quantity = Q, Revenue = PQ = box PAQO Total costs = box CBQO Supernormal profit = PAQO - CBQO

Examples of objectives again (see topic 3.3.1): profit maximisation Firms may have different objectives such as profit, revenue or sales maximisation or even satisficing. What does profit maximisation mean? When does it occur? Profit maximisation: aim for highest profits possible Profit = TR – TC so try to maximise this. It occurs when marginal revenue = marginal cost, MR = MC

Profit maximisation example MR = MC QTRTCProfitMCMRMR-MC Plot TR & TC on one diagram, and MR & MC on another

Profit maximising diagrams Draw: (1)TC and TR on one graph (2)On a new diagram draw MC & MR (3)Where is max profit? MC

Profit maximising explanation 2 min silent video 3 min video

Examples of objectives again (see topic 3.3.1): revenue maximisation Firms may have different objectives such as revenue maximisation. What does revenue maximisation mean? Revenue maximisation: highest turnover (income) in total, so the firm is LESS concerned about profits Revenue maximisation will occur when MR = 0 Revenue maximisation can be encouraged by raising output and reducing the price

Reasons for revenue maximisation Managers may wish to maximise revenue rather than profits because their salaries might be tied to revenue Financial institutions may be more willing to lend to institutions with high sales revenues Increase market share Improve cash flow Break into new markets

Examples of objectives again (see topic 3.3.1): sales maximisation Firms may have different objectives such as sales maximisation. What does sales maximisation mean? Sales maximisation: increase the number of units sold without making a loss. This occurs when firms lower the price until AR = AC Not-for-profit organisations may choose to operate at this level of output. Profit making firms may use sales maximisation e.g. with predatory pricing where, so long as costs are covered, a firm may reduce price to drive rivals out of the market.

Sales maximising explanation Managers may wish to maximise sales volume rather than profit because they may be seeking to maximise market share in the short run and to drive other firms out of the industry. It may make the firm, being larger, less vulnerable to takeover or their salaries may be related to sales / size of the firm E.g. Philip Marlboro in 1993 on "Marlboro Friday“ cut prices by 40% per pack to stop the brand's market-share deterioration. Their share of the $47 billion U.S. cigarette market, which fell to 20% before Marlboro Friday, rebounded to 25%.

Profit, revenue and sales maximising diagram Plot a diagram showing a downward sloping linear demand curve (remember D = AR). Add MC, AC and MR (remember MR is twice as steep as AR) Mark on three distinct quantities showing: profit maximisation (MR = MC), revenue maximisation (MR = 0) and sales maximisation AR = AC

Profit, revenue and sales maximising diagram

Three maximising explanations Sales volume maximisation Sales volume is maximised at OQ 2, subject to a profit constraint, where AR = AC. The firm might be able to sell more than this, but the diagram shows that on all units of output beyond OQ 2, AC is greater than AR and, therefore, a loss would be incurred. So, OQ 2 maximise sales volume without a loss being incurred.

Video on profit, revenue and sales maximisation Pajholden video on objectives of firms with graph showing profit, revenue and sales maximisation

Profit maximising: the rule MC = MR explanation Marginal cost is the cost of making one more unit, and marginal revenue is the income from this extra unit. MR – MC gives the extra profit from the additional unit. As long as the firm can make additional profit by producing an additional unit it will continue to increase production. It will stop production when the additional unit makes a loss Thus profits will be maximised when MC = MR

Profit maximising: diagrams for MC = MR If demand is perfectly price elastic then the TR curve will be a diagonal line and MR (=AR=D) will be horizontal. At Q = 88 the gap is maximised between TC and TR. Also when Q = 88, MC = MR Note: sometimes there are two points where MC = MR, if this is the case then the first point is NOT the profit maximisation point since we need MC to be rising as well. MC

Shift in cost curves If costs for raw materials decrease then the marginal cost of production will be lower. The MC curve will shift downwards (right) MC1-> MC2 The profit maximising level will rise. Hence a fall in costs will lead to a rise in output

Shift in revenue curves If a good becomes fashionable then more consumers will buy it. This rise in revenue will lead to an increase in output. This will shift the MR upwards (right) The profit maximising output level will rise.

Shut down point in the short run Firms may not make a profit. In the short run, if they are covering variable costs, it may be best to continue production since they may be able to contribute towards fixed costs. In the long run all costs must be covered. Short run profit maximisation means that a firm will shut down only once its total revenue does not cover total variable costs

Videos Constructing the LRAC curve and showing profit diagrammatically:

Examples Profits at Allied Bakeries (bread manufacturer e.g. Sunblest) will fall in 2015 due to supermarket price wars and over-capacity in the UK bakery business. Bread prices £1.20 -> £1 -> 80p Associated British Foods (ABF) own Allied Bakeries, AB sugar (one of world’s largest sugar producers) and Primark (plus other brands)