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Profit Maximization: Maximizing Revenue and Minimizing Costs in Business, Study notes of Business

Business

An introduction to profit maximization, a key concept in microeconomics. It explains how a firm determines the optimal level of output to produce based on marginal revenue and marginal cost. The document also covers profit maximization in perfect competition and the long run. Numerical examples are included to illustrate the concepts.

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Lecture # 15 – Profit Maximization

I. Profit Maximization: A General Rule

• Having defined production and found the cheapest way to produce a given level

of output, the last step in the firm's problem is to decide how much output to

produce. This is profit maximization.

• Profit = total revenue - total cost.

o Total revenue -- the amount of money the firm gets from the sale of

output.

o Average revenue -- revenue per unit sold.

o Marginal revenue -- revenue gained by selling one additional unit.

• Profits are maximized when marginal revenue = marginal cost.

II. Profit Maximization in Perfect Competition

• MC = MR maximizes profits for any market structure. What differs across market

structures is marginal revenue. We begin by looking at perfect competition.

• Recall the features of perfect competition:

1. Many buyers and sellers, so that price is taken as given

 No one firm can influence price.

2. Firms sell identical products

 It doesn’t matter who you buy from.

3. Perfect information

 Everyone knows their options.

4. No barriers to entry or exit

 Anyone who wants to enter the market (or leave the market if they

are losing money) can.

• In perfect competition, firms are price takers.

o MR = P = AR in perfect competition.

 Thus, an individual firm's demand curve is a straight line -- it is

perfectly elastic.

Partial preview of the text

Download Profit Maximization: Maximizing Revenue and Minimizing Costs in Business and more Study notes Business in PDF only on Docsity!

Lecture # 15 – Profit Maximization

I. Profit Maximization: A General Rule

Having defined production and found the cheapest way to produce a given level

of output, the last step in the firm's problem is to decide how much output to

produce. This is profit maximization.

Profit = total revenue - total cost.

o Total revenue -- the amount of money the firm gets from the sale of

output.

o Average revenue -- revenue per unit sold.

o Marginal revenue -- revenue gained by selling one additional unit.

Profits are maximized when marginal revenue = marginal cost.

II. Profit Maximization in Perfect Competition

MC = MR maximizes profits for any market structure. What differs across market

structures is marginal revenue. We begin by looking at perfect competition.

Recall the features of perfect competition:

1. Many buyers and sellers, so that price is taken as given

 No one firm can influence price.

2. Firms sell identical products

 It doesn’t matter who you buy from.

3. Perfect information

 Everyone knows their options.

4. No barriers to entry or exit

 Anyone who wants to enter the market (or leave the market if they

are losing money) can.

In perfect competition, firms are price takers.

o MR = P = AR in perfect competition.

 Thus, an individual firm's demand curve is a straight line -- it is

perfectly elastic.

o We can use P = MR = AR to show profits on a diagram that includes AC,

MC, MR, and AR.

 The vertical distance between average revenue (or price) and

average cost is the average profit, or profit per unit.

 Multiplied by the quantity sold, this becomes total profit.

 Graphically, this is the shaded rectangle below.

The shut down point

o Recall that fixed costs are sunk in the short run. They must be paid

whether or not the firm operates.

o Thus, if the firm can cover its variable costs, it should operate in the short

run, even if it is losing money.

o The firm should operate as long as P >= AVC.

 If P > AVC, the firm is making enough money to cover the variable

costs of production, and also some money that it can apply towards

its fixed costs.

 It may lose money, but it would lose more if it shut down.

o If P < AVC, the firm shuts down.

 If the firm operated, it would not even make enough money to cover

its variable costs.

o The next page shows the numbers from the handout in class.

We can use two lessons from profit maximization to derive the short-run supply

curve for a perfectly competitive firm.

1. If P >= AVC, the firm produces where P = MC (because P = MR for a

perfectly competitive firm).

2. If P < AVC, the firm shuts down.

o Therefore, the supply curve is the MC curve above the AVC.

III. Profit Maximization in the Long Run

In the short-run, firms are constrained by their fixed costs (such as the capacity

of their factory). In the long-run, they can change all variables, so larger profits

are possible.

However, larger profits are not an equilibrium!!!
If profits are being made, firms will enter the market.

o This shifts the supply curve out, lowering the market price.

o This occurs until there are no longer any economic profits.

Similarly, if firms are losing money, firms leave the market.

o This shifts the supply curve in, raising the market price.

o This occurs until we reach zero economic profits.

Lesson : in long-run equilibrium, there are zero economic profits.

Definition of long-run equilibrium:

1. All firms are maximizing profits.

2. No firm has incentive to enter or exit, because all firms are earning zero

economic profit.

 Note that economic profits include opportunity costs

 Thus, zero economic profit includes the value of your next best

option -- what would you be earning if you weren't in your current

business?

3. Price is such that Q S = Q D.

Note that, to do the analysis, we typically use two graphs: an industry supply and

Profit Maximization: Maximizing Revenue and Minimizing Costs in Business, Study notes of Business

Related documents

Partial preview of the text

Download Profit Maximization: Maximizing Revenue and Minimizing Costs in Business and more Study notes Business in PDF only on Docsity!

Lecture # 15 – Profit Maximization

I. Profit Maximization: A General Rule

of output, the last step in the firm's problem is to decide how much output to

produce. This is profit maximization.

o Total revenue -- the amount of money the firm gets from the sale of

output.

o Average revenue -- revenue per unit sold.

o Marginal revenue -- revenue gained by selling one additional unit.

II. Profit Maximization in Perfect Competition

structures is marginal revenue. We begin by looking at perfect competition.

1. Many buyers and sellers, so that price is taken as given

 No one firm can influence price.

2. Firms sell identical products

 It doesn’t matter who you buy from.

3. Perfect information

 Everyone knows their options.

4. No barriers to entry or exit

 Anyone who wants to enter the market (or leave the market if they

are losing money) can.

o MR = P = AR in perfect competition.

 Thus, an individual firm's demand curve is a straight line -- it is

perfectly elastic.

o We can use P = MR = AR to show profits on a diagram that includes AC,

MC, MR, and AR.

 The vertical distance between average revenue (or price) and

average cost is the average profit, or profit per unit.

 Multiplied by the quantity sold, this becomes total profit.

 Graphically, this is the shaded rectangle below.

o Recall that fixed costs are sunk in the short run. They must be paid

whether or not the firm operates.

o Thus, if the firm can cover its variable costs, it should operate in the short

run, even if it is losing money.

o The firm should operate as long as P >= AVC.

 If P > AVC, the firm is making enough money to cover the variable

costs of production, and also some money that it can apply towards

its fixed costs.

 It may lose money, but it would lose more if it shut down.

o If P < AVC, the firm shuts down.

 If the firm operated, it would not even make enough money to cover

its variable costs.

o The next page shows the numbers from the handout in class.

curve for a perfectly competitive firm.

1. If P >= AVC, the firm produces where P = MC (because P = MR for a

perfectly competitive firm).

2. If P < AVC, the firm shuts down.

o Therefore, the supply curve is the MC curve above the AVC.

III. Profit Maximization in the Long Run

of their factory). In the long-run, they can change all variables, so larger profits

are possible.

o This shifts the supply curve out, lowering the market price.

o This occurs until there are no longer any economic profits.

o This shifts the supply curve in, raising the market price.

o This occurs until we reach zero economic profits.

1. All firms are maximizing profits.

2. No firm has incentive to enter or exit, because all firms are earning zero

economic profit.

 Note that economic profits include opportunity costs

 Thus, zero economic profit includes the value of your next best

option -- what would you be earning if you weren't in your current

business?

3. Price is such that Q S = Q D.

demand diagram and the cost curves for a typical firm.

o The intersection of supply and demand determines the market price.

o The firm takes this as given and determines its quantity by comparing

price to MC.

o If firms are making positive profits (starting at P 0 and Q 0 below), other

firms will enter the market.

 This shifts out the supply curve (the blue supply curve), lowering

the price and reducing profits for each firm.

 The process continues until there are zero economic profits.

 The price is at the bottom of the average cost curve.

o Because firms are losing money, some firms exit the market.

 This shifts the in curve in, raising prices.

 Supply shifts out until firms once again earn zero economic

profits. This is the blue line below. Note that prices return to their

original level in this example.