econ chapter 23

Profit Maximization Economics, Sixth EditionBoyes/Melvin Chapter 23

Copyright Houghton Mifflin Company. All rights reserved.

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Copyright Houghton Mifflin Company. All rights reserved.Profit MaximizationThe objective of a for-profit firm is to maximize profit. Profit is the value of output sold, less the costs of the inputs used. Inputs include land, labor, and capital.IN ECONOMICS: Each cost is an opportunity costthe amount necessary to keep the owners of the resources from moving it to an alternative use.


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Copyright Houghton Mifflin Company. All rights reserved.Profit MaximizationOne of the resources is capital, and the cost of capital is also an opportunity cost.Capital is acquired through:Loans (debt)Equity (stock) sales (of ownership rights) in public companies.The cost of debt is the interest paid on the debt.The cost of equity is the alternative returns that the shareholders could have gotten had they chosen to invest elsewhereit is the investors opportunity cost.Clearly the investors expect at least a normal rate of profita rate of profit at least comparable to that available elsewhere.


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Copyright Houghton Mifflin Company. All rights reserved.Profit MaximizationThe profit figure reported in annual reports and income statements is accounting profit. Accounting profit is the total revenue less total costs, except for the opportunity cost of capital.

Economic profit is the total revenue less total costs, including all opportunity costs.It is the return to shareholders that exceeds the return they could expect from an alternative investment. That is, it is the profit over and above a normal rate of profit.


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Copyright Houghton Mifflin Company. All rights reserved.Economic ProfitZero economic profit is a NORMAL PROFIT expectation. Often called a normal accounting profit

With ZERO ECONOMIC PROFITS:All opportunity costs are covered, but not exceededOwners/investors receive just the same return as they could expect in their next best investment optionAccounting profits are generally positiveInvestors have no incentive to move their investment to a different firm


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Copyright Houghton Mifflin Company. All rights reserved.Economic ProfitPOSITIVE ECONOMIC PROFIT: means that all opportunity costs are covered + there is revenue in excess of those costs

The firm is returning more to its owners than the owners opportunity costOpportunity costs for investors/owners, is the profit they could expect in the next best investment.Investors have an incentive to invest in competing firms to try and capture some of the high profitsPositive economic profits are not normal in the long termThere are usually also accounting profits


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Copyright Houghton Mifflin Company. All rights reserved.Economic ProfitNegative economic profit: means that the firms opportunity costs are not fully covered by revenue

There may be accounting profits, and there may not beOwners/investors could find a higher profit option in some other investment (hence, their opportunity costs are higher than their return on this investment)There is an incentive for investors to move their resources elsewhere


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Copyright Houghton Mifflin Company. All rights reserved.Role of Economic ProfitEconomic profit operates as a coordinating factor in the economy. When a firm earns a positive economic profit, investors in the firm are earning better returns that they normally would with competing investments. Other investors will want to invest in the firm, too. As a result, resources will flow to where they earn more.


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Copyright Houghton Mifflin Company. All rights reserved.Demand and Cost CurvesProfit is the difference between total revenue and total costs. In the figure on the next slide, at price P1 selling quantity Q1, the total revenue is P1Q1, or the area of the rectangle ABCD.The total cost for quantity Q1 is ABEF.Profit is the difference between the rectangle ABCD and ABEF, which is FECD.Finding the profit-maximizing quantity of output involves comparing marginal cost and marginal revenue.


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Copyright Houghton Mifflin Company. All rights reserved.Graphical Analysis of Profit


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Copyright Houghton Mifflin Company. All rights reserved.Profit Maximizing: MR=MCMarginal cost is the additional cost of producing one more unit of output. Marginal revenue is the additional revenue from selling one more unit of output.If the marginal cost is less than marginal revenue, then producing and selling one more unit of output will be profitable. Profit is maximized at the output level where marginal revenue and marginal cost are equal. This is the point at which expanding output is no longer profitable.The supply rule is: Produce and offer for sale the quantity at which MR=MC.


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Copyright Houghton Mifflin Company. All rights reserved.Profit Maximization with MR=MC


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Copyright Houghton Mifflin Company. All rights reserved.Marginal Revenue CurveWith a downward sloping (normal) demand curve, the MR curve is Below the demand curveHalf way between the demand curve and the vertical axisTwice as steep as the demand curveIntersects the horizontal axis at the quantity where demand is unit elastic


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Copyright Houghton Mifflin Company. All rights reserved.Marginal Revenue CurveWith a horizontal (flat) demand curve the Marginal Revenue curve is identical to the demand curve.MR=D=P


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Copyright Houghton Mifflin Company. All rights reserved.Market StructureThe selling environment in which a firm produces and sells its product is called a market structure. It is defined by three characteristics:The number of firms in the marketThe ease of entry and exit of firmsThe degree of product differentiation


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Copyright Houghton Mifflin Company. All rights reserved.Market Structure Models (1)Perfect Competition is characterized by:Many large firms, so large that no one firm has the ability to affect the market. If one firm tried to raise the price, there are so many other firms selling at the lower price that no one would buy their product. So the firms are price takersthey have to go along with the market price..Identical products (standardized or undifferentiated). The products are identical, generic products.Easy entry into the industry.The demand curve is perceived by each firm to be horizontal (flat)


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Copyright Houghton Mifflin Company. All rights reserved.Market Structure Models (1)Perfect CompetitionEach firm can sell as much of its product as it can produce at the competitive market priceThe firm sells nothing if it raises its priceThe firm has no incentive to reduce its priceMR = P = Demand CurveThe firms demand curve is FLAT


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Copyright Houghton Mifflin Company. All rights reserved.Market Structure Models (2)Monopoly:This is a market structure in which there is just one firm, and entry by other firms is not possible. Because there is only one firm, consumers have only one place to buy the good. There are no close substitutes.The firm does have the power to set the price, but still sets an optimal price to maximize profit. If the monopolist sets the price too high, revenue will decline. Nonetheless, the firm is a price maker. The firms demand curve is the market demand curve, and it is downward sloping.


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Copyright Houghton Mifflin Company. All rights reserved.Market Structure Models (3)Monopolistic Competition is characterized by:A large number of firmsEasy entryDifferentiated products (This is the distinguishing feature!)Because each firms product is slightly different, each firm is kind of a mini-monopolythe only producer of that specific product. (But there are many firms making close substitutes)This allows the firm to be a price maker.The firms demand curve is downward sloping and depending on the differentiation of the firms product, it may be fairly inelastic.


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Copyright Houghton Mifflin Company. All rights reserved.Market Structure Models (4)Oligopoly is characterized by:Few firmsmore than one, but few enough so each firm alone can affect the market.Example: Automobile manufacturers.Entry is more difficult, but can occur.The firms are interdependenteach is affected by what others do.The demand curve is downward sloping for each firm.


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Copyright Houghton Mifflin Company. All rights reserved.Summary of Market Structures

CharacteristicsBehaviorMarket StructureNumber of FirmsEntry ConditionProduct TypePrice StrategyPromotion StrategyPerfect CompetitionVery ManyEasyStandardizedPrice takerNoneMonopolyOneNoneOnly one productPrice makerLittleMonopolistic CompetitionManyEasyDifferentiatedPrice makerLarge amountOligopolyFewImpededStandardized or DifferentiatedInterdependentLittle or Large Amount


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Copyright Houghton Mifflin Company. All rights reserved.Profit Maximizing:MR = MC Always!!!For all firms, at ALL TIMES, regardless of the market structure they face, the profit maximizing solution is:

MR = MC


econ chapter 23

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