The Theory of the Firm Economic (abnormal) profit, normal profit Goals of firms (profit maximization, etc.) Shut down price, break even price Most info from either (a) Tragakes or (b) Blink & Dorton

PROFIT: WHAT IS IT? TR - TC BUT…. IT’S NOT THAT SIMPLE!

PROFIT: WHAT IS IT? ECONOMIC PROFIT = Total Revenue – Total Cost Explicit (fixed + variable) Costs + Implicit (opportunity) Costs

PROFIT THEORY Normal Profit TR = TC Abnormal Profit (Economic Profit) TR > TC Loss TR < TC

PROFIT THEORY – EXAMPLES Firm A (ABNORMAL PROFIT) Firm B (NORMAL PROFIT) Firm C (LOSS) Total Revenue ($) 200,000 Total Fixed Cost ($) 40,000 Total Variable Cost ($) 80,000100,000120,000 Opportunity Cost ($) 60,000 Total Cost ($) 180,000200,000220,000

$60,000 In the previous example, how much was the entrepreneur giving up by working for this company?

Quiz: What are the equations? Normal Profit Abnormal Profit (Economic Profit) Loss

Quiz: What are the equations? Normal Profit TR = TC Abnormal Profit (Economic Profit) TR > TC Loss TR < TC

NORMAL vs. ABNORMAL PROFIT NORMAL –“zero economic profit” – DEFINITION #1: Minimum amount of revenue a firm must receive so it will keep running (instead of shutting down) – DEFINITION #2: Amount of revenue that covers all implicit costs, especially entrepreneurship ABNORMAL –Profit above normal (zero) profit

*ABNORMAL PROFIT *NORMAL PROFIT *LOSS? *ZERO ECONOMIC PROFIT? If revenues were $1 million and explicit costs were $850,000, what would the value of entrepreneurship (+ other implicit costs) need to be to have…

YES! BECAUSE THE OPPORTUNITY COST HAS BEEN COVERED (NO BETTER ALTERNATIVES EXIST) If revenues were $1 million, explicit costs were $850,000, and the value of entrepreneurship was $150,000, should the business keep operating?

Abnormal, normal, or loss? (Calculate) Firm AFirm B Firm C Total Revenue ($) 5,000,000210,000985,641 Total Fixed Cost ($) 1,500,00052,500305,835 Total Variable Cost ($) 3,000,000106,000517,212 Opportunity Cost ($) 500,00063,000130,000 Total Costs TYPE OF PROFIT/LOSS

Abnormal, normal, or loss? (Calculate) Firm AFirm B Firm C Total Revenue ($) 5,000,000210,000985,641 Total Fixed Cost ($) 1,500,00052,500305,835 Total Variable Cost ($) 3,000,000106,000517,212 Opportunity Cost ($) 500,00063,000130,000 Total Costs 5,000,000221,500953,047 TYPE OF PROFIT/LOSS Normal profit (+0) Loss (-11,500) Abnormal profit (+32,594)

WHAT ARE THE GOALS OF FIRMS? According to standard economic theory, the #1 goal is to achieve: PROFIT MAXIMIZATION 2 APPROACHES 2. CHOOSE LEVEL OF OUTPUT WHERE MC = MR 1. CHOOSE LEVEL OF OUTPUT WHERE TR – TC IS AS LARGE AS POSSIBLE TC = ECONOMIC COSTS

WHAT ARE THE GOALS OF FIRMS? Note: The approaches could also show LOSS MINIMIZATION (INSTEAD OF PROFIT MAXIMIZATION) 2 APPROACHES 2. CHOOSE LEVEL OF OUTPUT WHERE MC is closest to = MR (if MR never is large enough to meet MC ) 1. CHOOSE LEVEL OF OUTPUT WHERE TC- TR IS AS SMALL AS POSSIBLE TC = ECONOMIC COSTS

LET’S #1 FIRST: #1: CHOOSE LEVEL OF OUTPUT WHERE TR – TC IS AS LARGE AS POSSIBLE PROFIT MAXIMIZATION

UNDERSTANDING TOTAL COST Why does the total cost curve have that shape? Without looking, draw the TC, TVC, and TFC curves (be sure to label the x-axis & y-axis)

UNDERSTANDING TOTAL REVENUE Is this what happens if price is constant? (Note: This is when firms have no control over the price) What happens if price is variable? (Note: This is when firms have control over the price)

Putting the two together (TR/TC) if firm DOES NOT control (can’t change) price (PERFECT COMPETITION) Where is profit maximized (or loss minimized) in each scenario? Where is normal profit? Where is abnormal profit?

Putting the two together (TR/TC) if firm DOES control (can change) price (MONOPOLY) Which curve (from previous slide) should change? What was the symbol for profit?

TIME TO #2: MC = MR PROFIT MAXIMIZATION

UNDERSTANDING MARGINAL COST Without looking, draw a curve that shows AFC, AVC, ATC, and MC For today… focus on the MC!

UNDERSTANDING MARGINAL REVENUE What does the marginal revenue curve look like if the price is constant? (PERFECT COMPETITION) What does the marginal revenue curve look like if the price varies with output? (MONOPOLISTIC COMPETITION)

MR & AR: QUICK RECAP When are MR & AR the same? – w/perfect competition – w/a monopoly – w/both – w/neither When are MR & AR the same? – w/perfect competition – w/a monopoly – w/both – w/neither

UNDERSTANDING PROFIT MAXIMIZATION: Putting MR & MC together WHERE ON EACH CURVE IS PROFIT MAXIMIZED?

SAME IDEA AS PREVIOUS SLIDES… BUT A LIL’ MORE ADVANCED! PROFIT MAXIMIZATION MC = MR

UNDERSTANDING PROFIT MAXIMIZATION IN PERFECT COMPETITION Why is it the yellow shaded area? IS PROFIT MAXIMIZED WHERE MC = MR? YES! REVENUE = ___ X ___? In this example, Q = 11 P = MR = AR AR > ATC

UNDERSTANDING PROFIT MAXIMIZATION IN A MONOPOLY Why is it not from the exact point where MR = MC? IS PROFIT MAXIMIZED WHERE MC = MR? YES! IT IS ALSO WHERE LOSSES CAN BE MINIMIZED (SEE (b)) It is where AR is compared to AC

UNDERSTANDING PROFIT MAXIMIZATION IN A MONOPOLY WHAT TYPE OF PROFIT IS DEMONSTRATED IN (A)? ABNORMAL

Draw 2 curves that demonstrate MC = MR Profit maximization in perfect competition & in a monopoly

Why is profit maximized when MC = MR? Think about what happens when MC > MR Think about what happens when MC < MR

PRACTICE “Profit Maximization Brain Teaser” Worksheet

While 1 important goal for firms is PROFIT MAXIMIZATION, what are other goals? (FYI: some are complementary to profit max.) REVENUE MAXIMIZATION MANAGERS/EMPLOYEES love this…why? 1. Sales easier to measure than profits 2. Commissions/bonuses! 3. Feeling of success ***Note: Not really important to OWNERS*** SATISFICING ***Idea that no ONE goal (including profits) is dominant in a firm ***instead, compromises happen where many different objectives are pursued at a satisfactory, rather than a maximum level GROWTH MAXIMIZATION MANAGERS & OWNERS are pro-growth (getting bigger) 1. Owners love increasing economies of scale/lower costs, greater market power, ability to diversify (less dependence on single product) 2. Managers have improved chances for promotion, higher salaries, greater individual power CORPORATE SOCIAL RESPONSIBILITY AVOIDING socially undesirable activities (e.g. pollution, poor working conditions), DOING socially desirable activities (e.g. support for human rights/charities) Some firms are NON-PROFIT

SATISFICING IN ACTION Is my (your teacher!) only goal to have each of you get a 7 on the IB Econ exam? Is our school’s only goal to have students earn the highest mark possible for the IB diploma?

List the major goals of most firms Indicate the one(s) that favors owners more and the one(s) that favors managers more

KEY PRICES (“Prices per unit” a.k.a. “revenue per unit”) Beyond the issues already mentioned, firms must also consider the following: 1.the shut-down price *Short run (temporarily shut down) *Long run (permanently shut down & exit the market) 2.the break-even price

Is the shut down price anytime there is a loss? Firms often operate even if they are losing $$$ NO!

If a firm shuts down (temporarily or permanently), what costs does it lose? Think about it… FIXED

SHUT-DOWN PRICE: Should 1, 2, or 3 of these people keep operating in the short run? ArchieBatcatCharlie Total Revenue 80,000120,000150,000 Total Fixed Cost (including opportunity cost) 100,000 Total Variable Cost 100,000120,000140,000 Total Costs 200,000220,000240,000 LOSS

SHOULD: Charlie, Batcat (can cover TVC) SHOULD NOT: Archie (can’t cover TVC) ArchieBatcatCharlie Total Revenue 80,000120,000150,000 Total Fixed Cost (including opportunity cost) 100,000 Total Variable Cost 100,000120,000140,000 Total Costs 200,000220,000240,000 LOSS 120,000100,00090,000 Should any keep producing in the long run? No!!!

In the long run, firms shouldn’t stay open unless they make at least what kind of profit? NORMAL

RECAP: Does this show abnormal profit, normal profit, or a loss? Ms. Armstrong has a business. In her 3 rd year of operation, she sold $250,000 worth of goods. She spent $50,000 on rent and $185,000 on employees’ wages, electricity, inventory, etc. Should she stay in business?

SHUT-DOWN PRICE – DEFINITION: Level of price that enables a firm to cover its variable costs in the short run – Price = AR (avg revenue) – AR = PQ/Q – IN SHORT RUN… Where P = minimum AVC – (From this point & below…shut it down!) – IN LONG RUN… Where P = minimum ATC – (From this point & below…shut it down!) atc avc

SHUT-DOWN PRICE: QUICK RECAP I WHERE IS MR ON THIS GRAPH? WHERE IS AR ON THIS GRAPH? WHERE IS DEMAND ON THIS GRAPH? IS THIS GRAPH SHOWING PERFECT COMPETITION OR A MONOPOLY?

SHUT-DOWN PRICE: QUICK RECAP II CAN’T COVER VARIABLE COSTS? – IN SHORT RUN…SHUT IT DOWN! CAN’T COVER FIXED COSTS? – IN LONG RUN…SHUT IT DOWN! CAN’T COVER FIXED IN THE LONG RUN BUT CAN COVER ABOVE VARIABLE IN THE SHORT? – IN SHORT RUN…KEEP PRODUCING! (MINIMIZE LOSSES)

Draw a curve that shows the short- run & long-run shut-down price Be able to explain to your neighbor why those are the shut-down prices Consider what the Y-axis is!!! (Costs/Revenue/Price)

What are some examples of firms that should TEMPORARILY shut down? (Think of fixed v. variable costs)

***WARNING: NOT REQUIRED FOR IB ECON ALERT*** One should keep investing b/c so much (time/money/resources) has already been invested WHAT IS THE SUNK COST FALLACY?

BREAK-EVEN PRICE – DEFINITION: Level of price (revenue) at which a firm is able to make normal profit in the long run (where revenues greater than or equal to costs) – HINT Where P = minimum ATC – EXTRA INFO YES, it does factor in opportunity cost atc avc

***IN THE LONG RUN, THE BREAK-EVEN PRICE AND THE SHUT-DOWN PRICE ARE THE SAME.*** (If asked to only diagram one shut-down price, use the short term)

Tragakes diagrams

Break-even oil prices: Jan 2016 Should oil firms in Nigeria, Russia, Norway, (or now Iran?) shut down operations? It depends!

Putting It All Together Where is the long run shut-down price?

PRACTICE “Marginal Analysis and Profit Maximization” Worksheet

EXTRA SLIDES

“The ‘Shut-down Rule’ – When should a firm shut down in the face of economic loss?” OWuxR0-V8 (16:54) – Welker

Short Econ Vids from Mr. Clifford - Costs of Production and Perfect Competition PLE70CA726102FB294 AC/DC Economics

Exercise – Shut Down & Break Even Price Quantity of Labour Total Output Total Fixed Costs Total Variable Costs Total Costs Average Variable Costs (AVC) = TVC/ Output Average Total Cost (ATC) = TC/ Output Marginal Cost (MC) = Change in Total Costs / Change in Output Using the information below, determine the shut down & break price. 1.Complete the data missing in the table for AVC and ATC. 2.Determine the Shut Down and Break Even Price.

Revenue: $8 per unit (assumes opportunity costs are included) OutputTotal Revenue Total CostsVariable Cost Fixed CostsType of Loss Loss Abnormal Abnormal

Break Even Price Price Per Unit Output (units) Total Revenue Total Costs Average Revenue (Total Revenue / Quantity) or Average Revenue is Price. Average Total Costs $ $ $ $ $ What is the break even price? At $5, the price is too cheap and we will not break even.

Output (Machines) Total Cost $ (thousands) Average Cost $ (thousands) Marginal Cost $ (thousands) Using the following info, draw an appropriate graph to model different profit and loss situations. PriceQuantity Demanded Total RevenueMarginal Revenue