© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Profits in Short Run

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair The Concept of Profit Profit is the difference between total revenue and total cost.Profit is the difference between total revenue and total cost. The economic concept of profit takes into account the opportunity cost of capital.The economic concept of profit takes into account the opportunity cost of capital. Total economic cost includes a normal rate of return. A normal rate of return is the rate that is just sufficient to keep current investors interested in the industry. Total economic cost includes a normal rate of return. A normal rate of return is the rate that is just sufficient to keep current investors interested in the industry. Break even is a situation in which a firm is earning exactly a normal rate of return.Break even is a situation in which a firm is earning exactly a normal rate of return.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Optimum Level of Output (short – run) 7.3 Output Q1Q1 E MC, MR MC MR 0 If MR > MC, an increase in output will increase profits. If MR < MC, a decrease in output will increase profits. So profits are maximized when MR = MC at Q 1 (so long as the firm covers average variable costs)

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Blue Velvet Car Wash Weekly Costs Maximizing Profit–An Example If Blue Velvet washes 800 cars each week, it takes in revenues of $4,000.If Blue Velvet washes 800 cars each week, it takes in revenues of $4,000. This revenue is sufficient to cover both fixed costs of $2,000 and variable costs of $1,600, leaving a positive economic profit of $400 per week.This revenue is sufficient to cover both fixed costs of $2,000 and variable costs of $1,600, leaving a positive economic profit of $400 per week. TOTAL FIXED COSTS (TFC) TOTAL VARIABLE COSTS (TVC) (800 WASHES) TOTAL COSTS (TC = TFC + TVC) $3, Normal return to investors $1, Labor Materials $ 1, Total revenue (TR) at P = $5 (800 x $5) $4, Other fixed costs (maintenance contract, insurance, etc.) 1,000$1,600 Profit (TR  TC) $400 $2,000

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Firm Earning Positive Profits in the Short Run To maximize profit, the firm sets the level of output where marginal revenue equals marginal cost.To maximize profit, the firm sets the level of output where marginal revenue equals marginal cost.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Firm Earning Positive Profits in the Short Run Profit is the difference between total revenue and total cost.Profit is the difference between total revenue and total cost.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Minimizing Losses Operating profit (or loss) or net operating revenue equals total revenue minus total variable cost (TR – TVC).Operating profit (or loss) or net operating revenue equals total revenue minus total variable cost (TR – TVC). If revenues exceed variable costs, operating profit is positive and can be used to offset fixed costs and reduce losses, and it will pay the firm to keep operating. If revenues exceed variable costs, operating profit is positive and can be used to offset fixed costs and reduce losses, and it will pay the firm to keep operating.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Minimizing Losses If revenues are smaller than variable costs, the firm suffers operating losses that push total losses above fixed costs. In this case, the firm can minimize its losses by shutting down. If revenues are smaller than variable costs, the firm suffers operating losses that push total losses above fixed costs. In this case, the firm can minimize its losses by shutting down. Operating profit (or loss) or net operating revenue equals total revenue minus total variable cost (TR – TVC).Operating profit (or loss) or net operating revenue equals total revenue minus total variable cost (TR – TVC).

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair A Firm Will Operate If Total Revenue Covers Total Variable Cost Minimizing Losses CASE 1: SHUT DOWN CASE 2: OPERATE AT PRICE = $3 Total Revenue (q = 0) $0 Total Revenue ($3 x 800) $2,400 Fixed costs Variable costs Total costs + $$$$$$$$ 2, ,000 Fixed costs Variable costs Total costs + $$$$$$$$ 2,000 1,600 3,600 Profit/loss (TR  TC) $2,000 Operating profit/loss (TR  TVC) $800 Total profit/loss (TR  TC) $1,200

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Minimizing Losses When price equals $3.50, revenue is sufficient to cover total variable cost but not total cost.When price equals $3.50, revenue is sufficient to cover total variable cost but not total cost.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Minimizing Losses As long as price (which is equal to average revenue per unit) is sufficient to cover average variable costs, the firm stands to gain by operating instead of shutting down.As long as price (which is equal to average revenue per unit) is sufficient to cover average variable costs, the firm stands to gain by operating instead of shutting down.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Minimizing Losses The difference between ATC and AVC equals AFC. Then, AFC  q = TFC (the brown area).The difference between ATC and AVC equals AFC. Then, AFC  q = TFC (the brown area).

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Minimizing Losses The blue area equals losses.The blue area equals losses. The green area equals operating profit.The green area equals operating profit.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Long-Run Average Costs

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Long-Run Average Costs

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Long-Run Adjustments to Short-Run Conditions Firms expand in the long-run when increasing returns to scale are available.Firms expand in the long-run when increasing returns to scale are available.

© 2002 Prentice Hall Business PublishingPrinciples of Economics, 6/eKarl Case, Ray Fair Long-Run Adjustments to Short-Run Conditions Prices will be driven down to the minimum point on the LRAC curve.Prices will be driven down to the minimum point on the LRAC curve.