2. 1 © ©1999 South-Western College Publishing PowerPoint Slides prepared by Ken Long Chapter 9: Maximizing Profit Principles of Economics by Fred M Gottheil

3. 2 What is Profit Maximization? The primary goal of a firm to achieve the most profit possible from its production and sales © ©1999 South-Western College Publishing

4. 3 What is Profit? Income earned by entrepreneurs © ©1999 South-Western College Publishing

5. 4 What is the accounting view of profit? Total Revenue minus total explicit costs

6. 5 What is the economic view of profit? Total Revenue minus all cost, both explicit and implicit

7. 6 Possible profit situations, short run Positive economic profit Negative economic profit (losses) Zero economic profit (normal rate of return)

8. 7 Find out more about entrepreneurs and other business owners: http://www.entrepreneurmag.com http://www.virtualentrepreneur.com http://www.be-your-own-boss.com http://www.tannedfeet.com © ©1999 South-Western College Publishing

9. 8 At what point of production are profits maximized? MR = MC © ©1999 South-Western College Publishing

10. 9 What does the word Margin mean? The marginal unit is the last unit produced © ©1999 South-Western College Publishing

11. 10 What is Marginal Revenue? The change in total revenue generated by the sale of one additional unit of goods or services © ©1999 South-Western College Publishing

12. 11 What is Marginal Cost? The cost incurred on the last unit produced © ©1999 South-Western College Publishing

13. 12 Why are profits maximized at MR = MC? MR > MC (produce more) MR < MC (produce less) MR = MC (no $ gained or lost on the last unit) © ©1999 South-Western College Publishing

14. 13 What is a Perfectly Competitive Market? homogeneous product many buyers and sellers no one has much market power easy entry & easy exit can sell all bring to market perfect information © ©1999 South-Western College Publishing

15. 14 What determines Price in a Free Market? Market Demand & Supply © ©1999 South-Western College Publishing

16. 15 The Market and the firm in Perfect Competition The Market P S D Individual firm P P=MR=d 15

17. 16 The Firm’s Demand Curve in Perfect Competition P P=MR=d 16 Quantity Price

18. 17 Why does P = MR in Perfect Competition? Because no matter how many units are brought to market, the firm can sell all of them at the market price © ©1999 South-Western College Publishing

19. 18 Why is a Perfectly Competitive firm’s demand curve horizontal at the market price? All units brought to market can be sold at the market price © ©1999 South-Western College Publishing

20. 19 What is Average Revenue? Total revenue divided by the quantity of goods or services sold, thus AR = P © ©1999 South-Western College Publishing

21. 20 Why does AR=P in all markets? Because each unit is sold for the same price at one point in time AR = TR / Q = P © ©1999 South-Western College Publishing

22. 21 Q MC P=MR Profits are maximized where MR = MC P 21 Q1Q2 Q3

23. 22 At Q3, MC>MR, should produce less At Q2, MC<MR, should produce more Leads to Q1, where MC=MR as profit maximizing output

24. 23 Measuring economic profit Need to put the ATC curve in the graph to show whether profits or losses being made

25. 24 Understanding the graphic view of profit As long as the price, P, exceeds the average total cost, there is profit per unit, multiply by the total number of units to get total profit.

26. 25 Understanding the graphic view of profit Can also see profit from the graph by taking the total revenue rectangle, which is price times quantity, and subtracting the total cost rectangle, which is average total cost times quantity, to get the profit rectangle

27. 26 ATC MC MR=P Economic Profit 26 Q1 Profit rectangle P P ATC

28. 27 ATC MC MR=P Economic Loss 27 P Loss Rectangle Q1 P ATC

29. 28 ATC MC Zero Profits 28 P Q1 P = MR P = ATC

30. 29 Does the MR = MC Rule apply to minimizing losses? YES © ©1999 South-Western College Publishing With one exception

31. 30 Why should a firm stay in business if it’s losing money? Because its losses may be less than its fixed costs © ©1999 South-Western College Publishing

32. 31 In other words, stay in business in the short run as long as price covers your average variable costs, if not, shut down

33. 32 What is a Fixed Cost? Costs that have to be paid regardless of the level of production © ©1999 South-Western College Publishing

34. 33 Are there any Fixed Costs in the Long Run? No, all costs are variable in the long run © ©1999 South-Western College Publishing

35. 34 ATC AVC MC MR=P ATC Loss - Stay Open, P>AVC 34 $ Q Q1

36. 35 ATC AVC MC MR=P Loss - Close Down, P<AVC 35 $ Q Q1 0

37. 36 What Should a Firm Do in the Short Run? Price (P) Is P > ATC? No Yes Continue to produce Is P > AVC? No Shut down yes Continue to produce

38. 37 Do firms follow the MC=MR rule? Lester, 1940’s, argued firms do not appear to use marginal analysis

39. 38 Machlup and Friedman disagree with Lester Firms do not have to “think” they use marginal analysis even though they are

40. 39 Is a firm’s first priority always maximizing profits? No! Sometime there are social, political and historical factors © ©1999 South-Western College Publishing

41. 40 Other views of firm behavior Do firms maximize sales, do managers build empires rather than maximize profits?

42. 41 Who is a Stakeholder? Someone who has a personal and consequential interest in the viability of the firm © ©1999 South-Western College Publishing

43. 42 Do Stakeholders always want to maximize profits? The preservation of the managerial class may have a higher priority © ©1999 South-Western College Publishing

44. 43 What does the word Margin mean? What is Total Revenue? What is Marginal Revenue? What is Marginal Cost? Why are profits maximized at MR = MC?Why are profits maximized at MR = MC? Why should a firm stay in business if it’s losing money?Why should a firm stay in business if it’s losing money?

45. 44 ENDEND © ©1999 South-Western College Publishing

46. 45 ATC AVC MC AC AVC Loss = Fixed Costs MR=P 45