Chapter 4-2: Profit Maximising Objective Flashcards
Accounting Profit
TR - TC (Accounting costs aka explicit costs only)
Economic Profit
TR - TC (economic costs, sum of explicit and implicit costs)
All profit mentioned in the chapter come under this
Normal Profit
Minimum amount of profit which a firm must acquire in order to induce the firm to remain in operation
Insufficient to attract new firms to enter the industry
TR = TC
AR = AC
Supernormal Profit (Abnormal profit)
Level of profit above normal profit, which will attract new firms into the industry
Means that entrepreneur’s earnings are in excess of what he could earn in the next best alternative
TR>TC / AR>AC
Subnormal Profit (Loss)
Level of profit below normal profit which will force the least efficient firms or the firms at the margin to leave the industry
Means entrepreneur is earning less than what he could earn in the next best alternative
TR
Profit Maximisation
Putting costs and revenue together to find the level of output at which economic profit is greatest
Firm is assumed to be in eqm when it maximises total economic profit
Achieved at the level of output where addition to total revenue from sale of last unit is equal to addition to total cost of producing it. MR=MC
Factors that cause demand to change
PTIDE - both MR and AR increase Price of related goods and services T&P of consumers Income of households Demographics Expectations
Changes in Costs
Assuming no change in demand, when fixed costs such as rental and interest payment for bank loans of a firm change, only AC will change. Profits change but not equilibrium price and output.
Assuming no change in demand, when variable costs such as costs of raw materials, wages and utility bills change, firm’s profits, eqm price and output all change. Both AC and MC change.
Firm earning subnormal profits that continues production
Firm’s TR is able to cover all its TVC but not all TFC
If firm closes down, firm will insure all its FC
However if the firm can cover all its TVC but …, it will still be profitable to continue production since only a fraction of total fixed cost cannot be recovered from sale of goods
Continue production in short-run
No marginal cost in using fixed assets eg plant capacity
Fixed costs are costs that firms need to incur even if output = 0 and do not rise with level of output
Not an important consideration in firm’s decision to continue production if variable costs can be covered
Current situation could be temporary (demand decrease due to recession, hence AR < AC) - There could be a turnaround in the future - closing down even temporarily may mean loss of client base and current staff which means hiring of new staff which requires training and time
Firm earning subnormal profits that shuts down
Firm unable to recover all TVC and any TFC from sale of goods (TR), the firm will shut-down on short run
Makes sense for firm to stop producing since it cannot cover the cost of its total variable inputs required to produce its goods. Only cost firm will incur if it shuts down is fixed cost which is lower than total COP (TC)
Temporary suspension of production, not going out of industry
It may resume production again if situation becomes favourable - SD is SR affair
But shut down operations - cannot avoid fixed costs
Firm in short run earning subnormal profits - indifferent to continuing or shutting down
Firm is earning just enough revenue to cover TVC
TR cover TVC is the same as AR covering AVC (same for all the other scenarios)
Long-run shut down conditions for firms earning subnormal profits
Long run - no FC
All costs are VC
As long as TR cannot cover TC - subnormal profits - shut down permanently and leave industry
Firm exits - wind up all operations, capital resources get free for use in another venture
