Lesson 5 - Theory Of The Firm: Profits Flashcards
What is profit?
The difference between revenue from selling a product and the cost of producing it
What is a firms main objective in terms of profit?
Profit maximisation
What is normal profit?
The minimum amount of profit needed to keep a firm in the market (covers costs but doesn’t attract other firms into the market)
What are abnormal/supernormal profits?
Extra profit over and above normal profit (attracts firms into the market in the absence of barriers)
What are the roles of profit in markets?
Source of finance - easier to borrow if you are profitable, profits can be reinvested (organic growth)
Reward for innovation - incentivises entrepreneurs
Incentive - encourages managers to work if they have a share in the business, incentivises entrepreneurs to innovate
Resource allocation - supernormal profits attract firms to markets, so resource are being allocated where demand is rising
Economic efficiency - firms are incentivised to cut costs and be efficient in order to maximise their profits
What are the main objectives of firms?
Survival - first is to ensure that they survive to carry on the firm
Revenue - maximisation, putting sales ahead of profits, MR = 0
Profits - producing at the profit maximisation level (MC = MR)
Sales - maximising (achieving the highest amount of sales without making a loss), where AC = AR
Satisficing - seeking a satisfactory level of profit to keep shareholders happy
What is profit maximisation?
- when MC = MR
- at this point, output is at the highest point without marginal costs being higher than marginal revenues
What is profit satisficing?
- aiming to make just enough profits to keep shareholders happy
Why may workers/managers choose to profit satisfice?
- reducing the pressure on themselves
- reducing risk
What is revenue maximisation?
- Ignoring profits and focusing on selling as much as possible, maybe to increase their market share and push rivals out
- MR = 0
- highest level of output and revenue before the revenue of producing the next product is negative
What is Galbraith’s argument?
When there is a divorce between ownership and control, those in control will tend to prioritise sales maximisation, and profit satisfice to keep shareholders happy
What is the principal/agent problem?
The principles (shareholders and managers) have different incentives, which increases the risk of managers pursuing their own benefits without concern about potential failure
What is innovation?
The application of new technologies to production
Explain the concept of creative destruction
The innovation of a new product leads to the destruction of the market of an existing one (example = Nokia was destroyed when the iphone was invented)
When is it okay to keep firms that are making losses open in the short term?
- when the revenue they make is able to cover fixed costs, so its more beneficial for them to stay open than shut
