Transcript Slide 1

CHAPTER 10
PROFIT MAXIMIZATION ANALYSIS
2nd Semester, S.Y 2013 – 2014
Pangasinan State University
Social Science Department – PSU Lingayen
BACHELOR OF ARTS IN ECONOMICS
Econ 111 – ECONOMIC ANALYSIS
The Big Questions
•How do firms behave?
– The assumption:
• Profit is the main motivation for firms’
actions.
– How do firms maximize profit?
• By controlling their variables:
• Price (if possible)
• Quantity
• Cost
.
Pangasinan State University
Social Science Department – PSU Lingayen
BACHELOR OF ARTS IN ECONOMICS
Econ 111 – ECONOMIC ANALYSIS
What is Profit Maximization?
 The ultimate goal of a firm to achieve the most profit
possible from its production and sales.
 A profit-maximizing firm chooses both its inputs and
its outputs with the sole goal of achieving maximum
economic profits.
• seeks to maximize the difference between total revenue and total
economic costs
 If firms are strictly profit maximizers, they will make
decisions in a “marginal” way.
• examine the marginal profit obtainable from producing one more
unit of hiring one additional laborer.
• A firm sets its output where its marginal revenue equals its marginal
cost: MR(q) = MC(q).
Pangasinan State University
Social Science Department – PSU Lingayen
BACHELOR OF ARTS IN ECONOMICS
Econ 111 – ECONOMIC ANALYSIS
Two Steps to Maximizing Profit
 The firm’s profit function is:
𝑃(𝑥) = 𝑅(𝑥) − 𝐶(𝑥).
 To maximize its profit, any firm must answer two
questions:
 Output decision - If the firm produces, what output
level, q*, maximizes its profit or minimizes its loss?
 Shutdown decision - Is it more profitable to produce
q* or to shut down and produce no output?
Pangasinan State University
Social Science Department – PSU Lingayen
BACHELOR OF ARTS IN ECONOMICS
Econ 111 – ECONOMIC ANALYSIS
Profit Defined
 The income earned by the firms in the
production and sale of goods and services.
 Firm’s sales revenue minus its costs of
production
 Profit function is expressed by the equation:
Prof𝑖𝑡 𝑃 𝑥 = 𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑢𝑒 𝑅 𝑥 − 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡𝐶(𝑥)
Pangasinan State University
Social Science Department – PSU Lingayen
BACHELOR OF ARTS IN ECONOMICS
Econ 111 – ECONOMIC ANALYSIS
Total Revenue and Total Cost Defined
Total Revenue
 is the amount (in pesos) a firm receives from the
sale of its output.
 Price times quantity sold.
𝑇𝑅 = 𝑃 𝑥 𝑄
Total Cost
 The market value of the inputs a firm uses in
production.
 𝑇𝐶 = 𝐹𝐶 + 𝑉𝐶
Pangasinan State University
Social Science Department – PSU Lingayen
BACHELOR OF ARTS IN ECONOMICS
Econ 111 – ECONOMIC ANALYSIS
Break-even Analysis
Break-even point (BEP) is the point at which cost
or expenses and revenue are equal: there is no
net loss or gain, and a firm has "broken even".
For example, if a business firm sells fewer than
200 computers each month, it will make a loss, if it
sells more, it will be a profit. With this information,
the business managers will then need to see if
they expect to be able to make and sell 200
computers per month.
Pangasinan State University
Social Science Department – PSU Lingayen
BACHELOR OF ARTS IN ECONOMICS
Econ 111 – ECONOMIC ANALYSIS
Cost, Revenue and Profit Function
𝐶(𝑥) is the cost of producing 𝑥 units of a product
𝑅(𝑥) is revenue generated by selling 𝑥 units of a product
𝑃(𝑥) = 𝑅(𝑥) – 𝐶(𝑥) = the profit (or loss) generated by producing and selling x
units of the product.
The cost function is given by the formula.
C (𝑥) = 𝑎 + 𝑏𝑥.
Revenue Function 𝑅(𝑥) = 𝑃𝑥 (Price times Quantity)
Profit Function
𝑃 𝑥 = 𝑅 𝑥 − 𝐶(𝑥)
Pangasinan State University
Social Science Department – PSU Lingayen
BACHELOR OF ARTS IN ECONOMICS
Econ 111 – ECONOMIC ANALYSIS
Problem – Break Even Analysis
Suppose the fixed cost of production for a product is P100, the variable cost is
P6.00 per unit and the product sells for P10 per unit. What is the break-even
quantity and the break-even amount for total cost and total revenue?
Revenue Function: 𝑅(𝑥) = 10𝑥
Cost Function: 𝐶 𝑥 = 6𝑥 + 100
𝑅 𝑥 = 𝐶(𝑥)
Solving for 𝑥,
Solving for break-even 𝑇𝑅 𝑎𝑛𝑑 𝑇𝐶,
10𝑥 = 6𝑥 + 100
𝑅 𝑥 = 10𝑥 = 10 25 = 250
4𝑥 = 100
𝐶 𝑥 = 6𝑥 + 100
𝑥 = 25 (Break-even quantity)
= 6 25 + 100
= 250
Pangasinan State University
Social Science Department – PSU Lingayen
BACHELOR OF ARTS IN ECONOMICS
Econ 111 – ECONOMIC ANALYSIS
Break-even Analysis
Total
Revenue
Total Cost
0
0
100
-100
5
50
130
-80
10
100
160
-60
15
150
190
-40
20
200
220
-20
Output
Break-even Curve
Profit
550
TR
500
Cost, Revenue
450
TC
400
350
300
250
BEP
200
25
250
250
0
30
300
280
20
100
35
350
310
40
50
40
45
400
450
340
370
60
80
50
500
400
100
150
0
0
5
10
15
20
25
30
35
40
45
50
55
Output
Total Revenue
Total Cost
Revenue Function: 𝑅(𝑥) = 10𝑥
Cost Function: 𝐶 𝑥 = 6𝑥 + 100
Pangasinan State University
Social Science Department – PSU Lingayen
BACHELOR OF ARTS IN ECONOMICS
Econ 111 – ECONOMIC ANALYSIS
Let’s Check Your Understanding!
JNE Designs is planning to make a new chair. Fixed costs will be
P90, 000 and it will cost P150 to produce each chair (variable
costs). Each chair sells for P400.
1. Find the total cost 𝐶 (𝑥) producing 𝑥 chairs.
2. Find the total revenue 𝑅 𝑥 from the sale of 𝑥 chairs.
3. Find the total profit 𝑃 (𝑥) from the production and sale of 𝑥
chairs.
4. What profit will be the company realize from the production and
sale of 300 chairs? Of 800 chairs?
5. Determine the break-even point.
6. Graph the total cost, total revenue, and total profit function using
the same set of axes.
Pangasinan State University
Social Science Department – PSU Lingayen
BACHELOR OF ARTS IN ECONOMICS
Econ 111 – ECONOMIC ANALYSIS
Marginal Revenue and Marginal Cost
Defined
Marginal revenue


the additional revenue from selling one more unit of
output.
the change in revenue a firm gets from selling one more
unit of output: MR =DR/Dq
Marginal cost




is the additional cost of producing one more unit of output.
𝑀𝐶 =
∆𝑇𝐶
∆𝑄
or
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡
𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦
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.
Pangasinan State University
12
Social Science
Department
– PSU
Lingayen
Copyright
© Houghton Mifflin
Company.
All rights reserved.
BACHELOR OF ARTS IN ECONOMICS
Econ 111 – ECONOMIC ANALYSIS
Profit-Maximizing Rule
To maximize profit a competitive firm will expand production
until the revenue from an additional sale equals the cost of an
additional sale. In short, MR = MC.
 If marginal revenue is greater than marginal cost (MR > MC),
then an additional unit of output increases revenues more
than costs leading to greater profit.
 If marginal revenue is less than marginal cost (MR < MC),
then an additional unit of output increases costs more than
revenues leading to less profit.
 So, profit is maximized at a level of output where MR = MC.
 If MC > MR (P) then reduce Q to increase profits
 If MR (P) > MC then increase Q to increase profits
Pangasinan State University
Social Science Department – PSU Lingayen
BACHELOR OF ARTS IN ECONOMICS
Econ 111 – ECONOMIC ANALYSIS
Graphical Analysis – Profit Maximization
Pesos
600
MC
500
400
300
200
100
0
–100
–200
1
2
3
profit rises
4
5
6
7
profit falls
8
Output
MR
Pangasinan State University
Social Science Department – PSU Lingayen
BACHELOR OF ARTS IN ECONOMICS
Econ 111 – ECONOMIC ANALYSIS
MR = MC
Pangasinan State University
Social Science Department – PSU Lingayen
BACHELOR OF ARTS IN ECONOMICS
Econ 111 – ECONOMIC ANALYSIS
MR and MC Schedule
Profit
Marginal
Revenue
= Price
Marginal
Cost
Change
in Profit
Average
Cost
30
-30
0
0
0
0
50
34
16
50
4
46
34.0
2
100
40
60
50
6
44
20.0
3
150
51
99
50
11
39
17.0
4
200
68
132
50
17
33
17.0
5
250
91
159
50
23
27
18.2
6
300
120
180
50
29
21
20.0
7
350
156
194
50
36
14
22.29
8
400
206
194
50
50
0
25.75
9
450
296
154
50
90
-40
32.89
10
500
420
80
50
124
-74
42.0
Quanti
ty
Total
Revenue
Total
Cost
0
0
1
Pangasinan State University
Social Science Department – PSU Lingayen
BACHELOR OF ARTS IN ECONOMICS
Econ 111 – ECONOMIC ANALYSIS
MR and MC Curves
Marginal
Revenue
Marginal
Cost
0
0
0
1
50
4
2
50
6
3
50
11
4
50
17
5
50
23
6
50
29
7
50
36
8
50
50
9
50
90
10
50
124
Chart Title
Cost, Revenue
Output
140
130
120
110
100
90
80
70
60
50
40
30
20
10
0
MC
MR
AC
0
1
2
3
4
5
6
7
8
9
10
11
Output
Marginal Revenue
Marginal Cost
Average Cost
Pangasinan State University
Social Science Department – PSU Lingayen
BACHELOR OF ARTS IN ECONOMICS
Econ 111 – ECONOMIC ANALYSIS
Decision to Shut-Down, Enter or Exit
• The Firm's Short-Run Decision to Shut Down
– In certain circumstances, a firm will decide to shut
down and produce zero output.
– There is a difference between a temporary shutdown
and an exit from the market.
• A shutdown refers to a short-run decision not to produce
anything during a specific period of time because of current
market conditions.
• Exit refers to a long-run decision to leave the market.
• If a firm shuts down temporarily, it still must pay fixed costs.
• If a firm exits the industry in the long run, it has no costs.
Pangasinan State University
Social Science Department – PSU Lingayen
BACHELOR OF ARTS IN ECONOMICS
Econ 111 – ECONOMIC ANALYSIS
Decision to Shut-Down, Enter
or Exit
Pangasinan State University
Social Science Department – PSU Lingayen
BACHELOR OF ARTS IN ECONOMICS
Econ 111 – ECONOMIC ANALYSIS