Profit Maximisation And Shutdown Condition (Topic 8)

Question 1

Total revenue + graph (for price taker)

Answer 1

Total revenue is the total receipts from the sale of output

TR = P x Q

Draw

Question 2

Average revenue (AR)

Answer 2

AR = TR/Q

Revenue per output sold

Question 3

Marginal revenue + of price taker (graph)

Answer 3

MR = △TR / △Q

Addition to total revenue by selling one more unit

For a price taker, every additional unit of output would be sold at the same price, marginal revenue is therefore the price

Draw

Question 4

Profit

Answer 4

Profit = Total revenue - Total cost
Profit = (P x Q) - (ATC x Q)

Question 5

How to find the output level (Q) in order to get the largest possible value for profit

Answer 5

1) TR - TC method

Profit maximising output is where TR - TC is at a maximum. Graphically, the vertical distance between TR and TC is the greatest at that output level.

Draw

2) MR = MC method

When MR > MC, producing one more unit adds more to revenue than to cost, producing one more unit raises profit, the firm will increases output

When MR < MC, producing one more unit adds more to cost than to revenue, producing one more unit reduces profit, the firm will therefore decrease output

When MR = MC, producing one more unit is equal to its cost, profit is maximised

Draw

Question 6

How do firms decide on whether to continue production

Answer 6

By looking at their profits or losses at their profit maximisation output level. Even at the profit maximisation output, firms can still make losses

Write equations

Question 7

Economic profit, should a firm produce or shutdown?

Answer 7

TR > TC or P > ATC

Produce, as revenue earned will cover all its cost

If you shutdown your loss = TFC

Question 8

Normal profit, should a firm produce or shutdown?

Answer 8

TR = TC or P = minimum ATC

Produce, as revenue earned can cover all its cost

(Assuming that P > AVC or TR > TVC, after paying off TVC, should continue to produce as your total loss is not the full TFC)

Question 9

Economic losses, should a firm produce or shutdown?

Answer 9

TR < TC or P < ATC

Do not immediately shutdown

Produce: P > AVC, price can cover AVC, to minimise loss to an amount less than the TFC

Shutdown: P < AVC, price cannot cover AVC, by shutting down you restrict the loss to only the TFC

Bear full FC: P = min AVC, at the shutdown point whether a firm chooses to produce or shutdown does not matter as the loss = FC either way