1. PowerPoint to accompany
John Sloman
Keith Norris

2. Lecture and Tutorial Purpose:
To explain profit maximising conditions;
Skills learning outcomes:
- Students should be able to determine profit maximising output quantities;
- Students should be able to calculate
the profit at this level of output.
This week – only up to the section titled some qualifications (Page 104).
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

3. Chapter 5
Profit Maximisation

4. Build up a theory of Profit Maximisation
What is the output and price where a firm maximises profits,
How much profit does the firm make at that level?
Total Profit = Total Revenue – Total Costs
Tπ = TR – TC
Similar to the cost breakdown there is:
- Total Revenue, TR = P × Q
- Average Revenue, P* = AR = TR / Q
- Marginal Revenue, MR = TR / Q;
*Exception is when there are different products in different markets then AR is the weighted average P
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

5. Revenue Curves
MR (Marginal Revenue is the extra total revenue gained by selling one more unit (per time period). So if a firm sells an extra 20 units this month compared with what it expected to sell and, in the process earns an extra $100, then it is getting an extra $5 for each extra unit sold: MR = $5.
Revenue curves when price is not affected by the firm’s output (horizontal demand curve):
Marginal Revenue (MR) = ∆TR / ∆Q = 100 / 20 = 5
How do the revenue concepts (i.e. TR, AR, MR vary with output;
- Depends on market conditions for the particular firm;
- Too small a firm cannot affect market prices & will have different looking revenue curves from a firm that is able to choose its own price.
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

6. i.e. accept the market determined equilibrium price;
Revenue Curves when Price is not affected by the firm’s output (Fig. 5.1)
If the firm is very small relative to the whole market, it is likely to be a price taker;
i.e. accept the market determined equilibrium price;
But being so small, it can sell as much as it is capable of producing at the price (Fig.5.1);
Diagram (a) is the market (b) the firm;
Firm demand is tiny relative to the whole market;
Look at scale differences on the horizontal axis in the two diagrams;
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

7. Deriving a Firm’s AR and MR: Price-taking Firm (fig. 5.1)
AR, MR ($) Pe D O O
Q (millions)
Q (hundreds)
(a) The market
(b) The firm
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

8. Deriving a Firm’s AR and MR: Price-taking Firm
AR, MR ($)
D = AR
= MR Pe D O O
Q (millions)
Q (hundreds)
(a) The market
(b) The firm
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

9. Deriving a Firm’s AR and MR: Price-taking Firm
Market equilibrium price is $5
The firm is so small that any change in its output is too insignificant to affect the market price:
- Therefore, the firm faces a horizontal demand ‘curve’ at this price;
- It can sell 200 units, 600 units, 1200 units or whatever without affecting the $5 price;
- Therefore, AR is a constant $5;
- Therefore, the firm’s AR curve is equivalent to its straight line demand curve.
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

10. Deriving a Firm’s AR and MR: Price-taking Firm
With this horizontal demand curve,
MR curve = AR curve;
Since selling one or more unit at a constant price (AR) merely adds that amount to TR;
If an extra unit is sold at a constant price of $5, an extra $5 is earned.
Total Revenue (TR):
As Price is constant, TR will increase at a constant rate as more is sold;
The TR ‘curve’ will be a straight line through the origin.
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

11. Total Revenue for a Price-taking Firm
Quantity
(units)
Price = AR
= MR ($)
200
400
600
800
1000
1200 5
TR ($) Q
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

12. Total Revenue for a Price-taking Firm
Quantity
(units)
Price = AR
= MR ($) TR
($)
200
400
600
800
1000
1200 5
1000
2000
3000
4000
5000
6000
TR ($) Q
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

13. Total Revenue for a Price-taking FirmTR
Quantity
(units)
Price = AR
= MR ($) TR
($)
200
400
600
800
1000
1200 5
1000
2000
3000
4000
5000
6000
TR ($) Q
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

14. Revenue curves when the price varies with output
Firm has a downward-sloping demand curve:
- The firm has to lower the price to sell more;
- If it raises its price it will sell less;
- Average revenue (AR) = P;
- P is reduced to sell ore then AR falls as output increases;
- For price taking firm, the demand and AR curve are the same (Fig. 5.2) because AR = P;
- The curve relating P to Q (i.e. demand curve) and AR to Q are the same curves (i.e. AR curves)
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

15. Revenue curves when the price varies with output
When a firm faces a downward sloping demand curve, MR is < AR & may be negative:
- P must be lowered to sell more each time period;
- Means lowering P for extra units plus the units it would have sold at the previous P;
- Thus MR = PLUS – RFAD (table 5.1 & next diagram)
where:
PLUS = price of last unit sold, and
RFAD = revenue lost in selling the other units at a lower price when it could have sold them at a higher price;
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

16. AR and MR Curves for a Firm Facing a Downward-sloping Demand CurveQ
(units)
P =AR
($) 1 2 3 4 5 6 7 8 7 6 5 4 3 2
AR, MR ($) AR
Quantity
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

17. AR and MR Curves for a Firm Facing a Downward-sloping Demand Curve (Figure 5.2 p.100)Q
(units)
P =AR
($) TR
($) MR
($) 1 2 3 4 5 6 7 8 7 6 5 4 3 2 8 14 18 20 6 4 2 -2 -4
AR, MR ($) AR
Quantity MR
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

18. AR and MR Curves for a Firm Facing a Downward-sloping Demand Curve
MR is the extra revenue gained from selling one more unit;
MR values are entered in the spaces between the figures for the other three columns (Table 5.1 and figure 5.2);
When demand is price elastic:
- A decrease in price will lead to a proportionately larger increase in Qd, hence
- An increase in sales revenue (total consumer expenditure),
- Therefore MR is positive / increasing ;
When demand is price inelastic:
- A decrease in price will lead to a proportionately smaller increase in Qd, hence
- Therefore MR is negative / declining;
If MR is a positive figure TR is increasing (i.e. sales per time are 4 units or less in figure 5.2):
- The demand curve will be elastic at that quantity,
If MR is negative and TR is falling (i.e. at a level of sales of 5 or more units in figure 5.2) the demand curve will be inelastic:
- A rise in quantity sold would lead to a fall in TR.
Thus, the D or AR curve in figure 5.2 is elastic to the left of point r and inelastic to its right.
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

19. TR Curve for a Firm Facing a Downward-sloping Demand Curve
Quantity
(units) 1 2 3 4 5 6 7
P = AR
($) 8 TR 14 18 20
TR ($)
Quantity
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

20. TR Quantity (units) P = AR ($) TR ($) TR ($) 1 2 3 4 5 6 7 8 7 6 5 4 3
TR Curve for a Firm Facing a Downward-sloping Demand Curve – Figure 5.3 TR
Quantity
(units)
P = AR
($) TR
($)
TR ($) 1 2 3 4 5 6 7 8 7 6 5 4 3 2 8 14 18 20
Quantity
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

21. AR and MR Curves for a Firm Facing a Downward-sloping
Demand Curve (Figure 5.2)
Elastic
Elasticity = -1
Inelastic
AR, MR ($) AR
Quantity MR
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

22. TR = P*Q (price times quantity, table 5.1);
TR Curve for a Firm Facing a Downward-sloping Demand Curve – Table 5.1, Figure 5.3 Revenue
TR = P*Q (price times quantity, table 5.1);
TR starts to fall when MR is negative (where demand becomes inelastic);
TR is maximum where MR = 0;
At this point, Pєd = -1
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

23. TR Elasticity = -1 Inelastic Elastic TR ($) Quantity
TR Curve for a Firm Facing a Downward-sloping Demand Curve – Figure 5.3.
Elasticity = -1
Elastic
Inelastic TR
TR ($)
Quantity
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

24. Shifts in revenue curves
TR Curve for a Firm Facing a Downward-sloping Demand Curve – Figure 5.3.
Shifts in revenue curves
- A change in any other determinant of demand, such as tastes, income or the price of other goods, will shift the D curve;
- By affecting the P at which each level of output can be sold, there will be a shift in all three revenue curves;
- TR increase – vertical shift of TR curve upwards;
- TR decrease – vertical shift of TR curve downwards;
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

25. 5.2 Revenue, Costs and Profit
What is the Short-run profit maximisation Output?
Two ways to find this:
- Maximise the difference between TR and TC using the TR and TC curves;
- Use MR, AR, MC and AC curves (when comparing profit maximisation under different market conditions (Chapters 6 and 7);
- Short run – at least one factor fixed;
- Assume the firm is facing a downward sloping demand curve;
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

26. Finding Maximum Profit Using Total Curves
TR, TC, TP ($)
Quantity
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

27. Finding Maximum Profit Using Total CurvesTR
TR, TC, TP ($)
Quantity
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

28. Finding Maximum Profit Using Total Curves – Table 5.2 and Figure 5.4TC TR
TR, TC, TP ($)
Quantity
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

29. Finding Maximum Profit Using Total CurvesTC TR
TR, TC, TP ($)
Quantity
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

30. Finding Maximum Profit Using Total CurvesTC TR
TR, TC, TP ($)
Quantity TP
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

31. Finding Maximum Profit Using Total CurvesTC b TR a
TR, TC, TP ($) c d
Quantity TP
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

32. Finding Maximum Profit Using Total CurvesTC d e TR
TR, TC, TP ($) f
Quantity TP
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

33. 5.2 Revenue, Costs and Profit
Using marginal and average curves – table 5.3 based on table 5.2 data:
Stage 1: Profit is maximised at MR = MC
(1) Produce table and draw curves – point e figure 5.5);
(2) When Q < 3, MR > MC and therefore a larger addition to revenue than to costs so total profit will increase (as production increases);
(3) When Q > 3, MC > MR and therefore a larger addition to costs than to revenue so total profit will decrease (as production increases);
(4) If you cannot add anything more to a total, than the total is the maximum
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

34. 5.2 Revenue, Costs and Profit
Using marginal and average curves – table 5.3 based on table 5.2 data:
Stage 2: Measuring profit size using AR and AC curves;
(1) Data from table 5.3 is plotted in figure 5.6.
(2) Calculate Average Profit:
Aπ = AR – AC at the profit maximising output of 3;
(3) Calculate Total Profit:
Tπ = Aπ * Q (shaded area in figure 5.6)
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

35. Finding the Profit-maximising Output Using Marginal Curves
Costs and revenue ($)
Quantity
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

36. Finding the Profit-maximising Output Using Marginal CurvesMC
Costs and revenue ($)
Quantity
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

37. Finding the Profit-maximising Output Using Marginal CurvesMC
Costs and revenue ($)
Profit-maximising
output e
Quantity MR
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

38. Measuring the Maximum Profit Using Average Curves – Figure 5.6MC
Costs and revenue ($)
Quantity MR
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

39. Measuring the Maximum Profit Using Average CurvesMC
Costs and revenue ($) AR
Quantity MR
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

40. Measuring the Maximum Profit Using Average CurvesMC
Total profit =
$1⅓ x 3 = $4.00 AC a
Costs and revenue ($)
6.00 4⅔
Total Profit b AR
Quantity MR
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

41. 5.2 Revenue, Costs and Profit
Some qualifications:
Long-run profit maximisation
Assuming that the AR and MR curves are the same in the long run as in the short run, LR profit maximisation is where MR = long run MC;
The reasoning is the same as with the short-run case;
the meaning of ‘profit’
loss minimising: still produce where MR = MC
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

42. Loss-minimising OutputMC AC
Loss-minimising Output AR AC
LOSS Q
Costs and revenue ($) AR O
Quantity MR
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

43. Revenue, Costs and Profit
Some qualifications
long-run profit maximisation
the meaning of ‘profit’
loss minimising: still produce where MR = MC
short-run shut-down point: P = AVC
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

44. The Short-run Shut-down PointAC
The Short-run Shut-down Point
AVC AR
P =
AVC
Costs and revenue ($) Q O
Quantity
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

45. Revenue, Costs and Profit
Some qualifications:
When AR and MR curves are the same in both short and long run
long-run profit maximisation output is where MR = MC (long–run)
the meaning of ‘profit’
One element of cost is the opportunity cost to the owners of the firm incurred by being in business;
i.e. Minimum return that owners must make on capital to prevent them from eventually deciding to close down and undertake alternative activities;
It is a cost because (like wages and rent) it has to be covered if the firm is to continue producing;
Sometimes known as normal profit and is included in the cost curves
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

46. Revenue, Costs and Profit
Has two components:
Normal Profit (%) = rate of interest on riskless loan + a risk premium:
(1) Initial capital investment – the interest that could have been earned by lending the capital in some risk less form (i.e. a bank savings account):
This defines the minimum rate of profit that entrepreneurs expect to earn.
(2) Compensation for risk:
- Varies according to business line;
- Predictable patterns for food lines, relatively low:
- Where outcomes are very uncertain (mineral exploration, fashion garment manufactures) relatively high.
Thus earning normal profits means that owners will just be content to remain in that industry:
- If they earn > normal profit => they will obviously prefer to stay in this business;
- If they earn < normal profit => they will consider leaving and using their capital for another purpose.
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia

47. Revenue, Costs and Profit
As Normal Profits are included in costs then any profits shown diagramatically must be over and above normal profit (figure 5.6):
Known as Supernormal Profit, Pure Profit, Economic Profit, Abnormal Profit, Producer’s Surplus, or sometimes simply Profit;
All mean excess of total profit over normal profit
Loss Minimisation (at output where firm cannot make a profit) figure 5.7:
- The AC curve is above the AR curve at all output levels;
Hence, the output at MR = MC is the loss-minimisation output;
The amount of loss (at MR = MC) is shown by the shaded area in figure 5.7
To produce or not to produce:
- Fixed costs (rent and business rates) have to be paid even if we have zero (i.e. 0) output;
- If the firm is covering more than its variable costs, it can go some way to paying off these fixed costs and therefore can continue to produce;
- Short-run shut down point - It will shut down when it cannot cover variable costs (if AVC curve is above, or the AR curve is below (figure 5.8)
- Long-run shut down point - If firm cannot cover LRAC (which includes normal profits) where the AR curve is tangential to LRAC curve.
John Sloman, Keith Norris: Principles of Economics 2e © 2007 Pearson Education Australia