Econ Chapter 23

Profit Maximization
Economics, Sixth Edition

Boyes/Melvin

Chapter 23
2

Copyright Houghton Mifflin Company. All rights reserved.
Profit Maximization
The objective of a for-profit firm is to
maximize profit.
Profit is the value of output sold, less the
costs of the inputs used. Inputs include
land, labor, and capital.
IN ECONOMICS: Each cost is an
opportunity costthe amount necessary
to keep the owners of the resources from
moving it to an alternative use.
3

Profit Maximization
One of the resources is capital, and the
cost of capital is also an opportunity cost.
Capital is acquired through:
Loans (debt)
Equity (stock) sales (of ownership rights) in
public companies.
The cost of debt is the interest paid on the debt.
The cost of equity is the alternative returns that the shareholders could have gotten had they
chosen to invest elsewhereit is the investors opportunity cost.
Clearly the investors expect at least a normal rate of profita rate of profit at least comparable to that available
elsewhere.

4

Profit Maximization
One of the resources is capital, and the cost of capital is also an opportunity cost.
Capital is acquired through:
Loans (debt)
Equity (stock) sales (of ownership rights) in public companies.
The cost of debt is the interest paid on the debt.
The cost of equity is the alternative returns that
the shareholders could have gotten had they
chosen to invest elsewhereit is the investors
opportunity cost.
Clearly the investors expect at least a normal rate of
profita rate of profit at least comparable to that
available elsewhere.

5

Profit Maximization
The profit figure reported in annual reports and
income statements is accounting profit.
Accounting profit is the total revenue less total costs,
except for the opportunity cost of capital.

Economic profit is the total revenue less total
costs, including all opportunity costs.
It is the return to shareholders that exceeds the return
they could expect from an alternative investment. That
is, it is the profit over and above a normal rate of profit.
6

Economic Profit
Zero economic profit is a NORMAL PROFIT
expectation. Often called a normal accounting
profit

With ZERO ECONOMIC PROFITS:
All opportunity costs are covered, but not exceeded
Owners/investors receive just the same return as they
could expect in their next best investment option
Accounting profits are generally positive
Investors have no incentive to move their investment to
a different firm
7

Economic Profit
POSITIVE ECONOMIC PROFIT: means that all
opportunity costs are covered + there is revenue
in excess of those costs

The firm is returning more to its owners than the
owners opportunity cost
Opportunity costs for investors/owners, is the profit they
could expect in the next best investment.
Investors have an incentive to invest in competing firms
to try and capture some of the high profits
Positive economic profits are not normal in the long
term
There are usually also accounting profits
8

Economic Profit
Negative economic profit: means that the firms
opportunity costs are not fully covered by
revenue

There may be accounting profits, and there may not
be
Owners/investors could find a higher profit option in
some other investment (hence, their opportunity costs
are higher than their return on this investment)
There is an incentive for investors to move their
resources elsewhere
9

Role of Economic Profit
Economic profit operates as a
coordinating factor in the economy.
When a firm earns a positive economic
profit, investors in the firm are earning
better returns that they normally would
with competing investments.
Other investors will want to invest in the
firm, too. As a result, resources will flow
to where they earn more.
10

Demand and Cost Curves
Profit is the difference between total revenue and
total costs.
In the figure on the next slide, at price P
1
selling
quantity Q
1
, the total revenue is P
1
Q
1
, or the area
of the rectangle ABCD.
The total cost for quantity Q
1
is ABEF.
Profit is the difference between the rectangle
ABCD and ABEF, which is FECD.
Finding the profit-maximizing quantity of output
involves comparing marginal cost and marginal
revenue.
11

Graphical Analysis of Profit
12

Profit Maximizing: MR=MC
Marginal cost is the additional cost of producing one more
unit of output.
Marginal revenue is the additional revenue from selling one
more unit of output.
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.
The supply rule is: Produce and offer for sale the quantity
at which MR=MC.
13

Profit Maximization with MR=MC
14

Marginal Revenue Curve
With a downward sloping (normal)
demand curve, the MR curve is
Below the demand curve
Half way between the demand curve and the
vertical axis
Twice as steep as the demand curve
Intersects the horizontal axis at the quantity
where demand is unit elastic

15

Marginal Revenue Curve
With a horizontal (flat) demand curve
the Marginal Revenue curve is
identical to the demand curve.
MR=D=P

16

Market Structure
The selling environment in which a
firm produces and sells its product is
called a market structure.
It is defined by three characteristics:
The number of firms in the market
The ease of entry and exit of firms
The degree of product differentiation
17

Market Structure Models (1)
Perfect Competition is characterized by:
Many large firms, so large that no one firm has the
ability to affect the market. If one firm tried to raise the
price, there are so many other firms selling at the lower
price that no one would buy their product. So the firms
are price takersthey have to go along with the market
price..
Identical products (standardized or undifferentiated).
The products are identical, generic products.
Easy entry into the industry.
The demand curve is perceived by each firm to be
horizontal (flat)
18

Perfect Competition
Each firm can sell as much of its product as it
can produce at the competitive market price
The firm sells nothing if it raises its price
The firm has no incentive to reduce its price
MR = P = Demand Curve
The firms demand curve is FLAT
19

Monopoly:
This is a market structure in which there is just one firm,
and entry by other firms is not possible.
Because there is only one firm, consumers have only
one place to buy the good. There are no close
substitutes.
The firm does have the power to set the price, but still
sets an optimal price to maximize profit. If the
monopolist sets the price too high, revenue will decline.
Nonetheless, the firm is a price maker.
The firms demand curve is the market demand curve,
and it is downward sloping.

20

Monopolistic Competition is characterized by:
A large number of firms
Easy entry
Differentiated products (This is the distinguishing
feature!)
Because each firms product is slightly different, each
firm is kind of a mini-monopolythe only producer of
that specific product. (But there are many firms making
close substitutes)
This allows the firm to be a price maker.
The firms demand curve is downward sloping and
depending on the differentiation of the firms product, it
may be fairly inelastic.

21

Oligopoly is characterized by:
Few firmsmore than one, but few enough so
each firm alone can affect the market.
Example: Automobile manufacturers.
Entry is more difficult, but can occur.
The firms are interdependenteach is affected
by what others do.
The demand curve is downward sloping for
each firm.
22

Summary of Market Structures
Characteristics Behavior
Market
Structure
Number of
Firms
Entry
Condition
Product Type Price Strategy Promotion
Strategy
Perfect
Competition
Very Many Easy Standardized Price taker None
Monopoly One None Only one
product
Price maker Little
Monopolistic
Competition
Many Easy Differentiated Price maker Large
amount
Oligopoly Few Impeded Standardized
or
Differentiated
Interdependent Little or
Large
Amount
23

The Demand Curve Facing
an Individual Firm
24

Profit Maximization
for the Price Taker and Price Maker
25

Profit Maximizing:
MR = MC Always!!!
For all firms, at ALL TIMES,
regardless of the market structure
they face, the profit maximizing
solution is:

MR = MC

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Profit Maximization

Economics, Sixth Edition

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