Topic no.8 Profit maximisation and shutdown condition Flashcards
- Define and calculate the following: i) Total revenue ii) Average revenue ii) Marginal revenue - Apply profit maximisation rule - Understand how to tell whether the firm should continue production or shutdown
What are the profit maximisation in a firm?
i) Total revenue (TR)
[Total receipts from the sale of output]
TR = Price x Quantity
*Price taker
ii) Average revenue (AR)
Revenue per output sold.
AR = TR/Q
iii) Marginal revenue (MR)
Addition to total revenue resulting from the sale of one more unit of output.
MR = △TR/△Q
[Price taker, every additional unit of output sold at constant price; marginal revenue is therefore the price in this case]
What is the meaning of the profit maximisation rule?
Recognising that income earned by the entrepreneur is called profit.
Given central economic assumption of scarcity, objective of the firm is to maximize profit.
Profit = TR - TC
= (P x Q) - (ATC XQ)
What are the 2 methods of the profit maximisation rule?
i) TR - TC method
Profit-maximising output is where TR - TC is at its maximum. Graphically, the vertical distance between TR and TC is the greatest at that output level.
ii) MR = MC method
Firm compares the amount that each additional unit of output produced and sold would add to TR and TC and decides whether it is profitable to produce or cut back on that additional unit.
*** MR = addition to total revenue by selling one more unit
MC = addition to total cost by making one more unit
How do firms decide on whether to continue production?
Looking at their profits/losses at their profit maximisation output level. Even at the profit maximisation output, firms can still make losses.
a) Economic Profit (TR > TC or P > ATC)
[When at the profit maximising output, price is greater than the average total cost of producing the output]
(When a firm is making economic profit, it should continue to produce as the revenue more than covers all its cost.)
b) Normal Profit (TR = TC or P = ATC)
[When at the profit maximising output, price equals the average total cost of producing the output]
(When a firm is making normal profit, it should still continue to produce as revenue it earns can cover all its cost)
c) Losses (TR < TC or P < ATC)
[Economic losses are made when at the loss minimising output, price is less than average total cost of producing output]
(A firm can produce or shutdown when it is making economic loss)
What to consider before deciding to produce or shutdown?
Can the price of the goof cover the AVC of producing it?
a) Price an cover AVC → produce, as to minimise loss to an amount less than the TFC
b) Price cannot cover AVC → shutdown, as restrict the loss to only the TFC
