Microeconomics (Part 3E): (Step 3) Select Q (and associated P) to maximize Profit (Profit = Total Revenue – Total Cost)
Microeconomics
(Part 3E): (Step 3) Select Q (and associated P) to maximize Profit (Profit = Total Revenue – Total Cost)
a. Definition of Profit
- Profit = Total Revenue – Total Cost
- Profit = (Price – Average Total Cost) Quantity
b. Profit Rectangle
- If the firm produces a quantity at which P > ATC, the
firm is profitable.
- If the firm produces a quantity at which P = ATC, the firm
breaks even.
- If the firm produces a quantity at which P < ATC, the
firm incurs a loss.
c. General optimum output rule: Q at MR = MC (Photo by ExpertsMind)
- According to the optimal output rule, profit is
maximized by producing the quantity of output at which the marginal revenue of
the last unit produced is equal to the marginal cost.
d. Price-taker (perfectly competitive firm)
- Total Revenue = Price x Quantity
- Profit = Total Revenue – Total Cost
- The profit-maximizing principle of marginal analysis:
the optimal amount of an activity is the level at which marginal benefit is
equal to marginal cost.
- The marginal revenue curve shows how marginal
revenue varies as output varies.
- According to the price-taking firm’s optimal output
rule, a price-taking firm’s profit is maximized by producing the quantity
of output at which the market price is equal to the marginal cost of the last
unit produced.
- Economic profit: the measure of profit based on the
opportunity cost of resources used in the business.
- Accounting profit: the profit calculated using only
the explicit costs incurred by the firm.
- If the firm produces a quantity at which P > ATC, the firm
is profitable.
- If the firm produces a quantity at which P = ATC, the firm
breaks even.
- If the firm produces a quantity at which P < ATC, the
firm incurs a loss.
Break-Even Price
- The break-even price of a price-taking firm is the
market price at which it earns zero profit.
- Whenever the market price exceeds minimum average
total cost, the producer is profitable.
- Whenever the market price equals minimum average
total cost, the producer breaks even.
- Whenever the market price is less than minimum
average total cost, the producer is unprofitable.
Summary
- Optimal Output Rule: Produce the quantity at which MR
= MC.
- For a price-taking firm, MR = P and its marginal
revenue curve is a horizontal line at the market price.
- Price-taking firm’s optimal output rule: produce
the quantity at which P = MC. However, a firm that produce the optimal quantity
may not be profitable.
- A firm is profitable if TR exceeds TC, or if market price exceeds
its break-even price (minimum ATC).
- If market price exceeds the break-even price, the
firm is profitable.
- If market price is less than the break-even price,
the firm is unprofitable.
- If the market price equals the break-even price,
the firm breaks even.
- When profitable, the firm’s per unit profit is P – ATC.
- When unprofitable, the firm’s per unit profit is ATC – P.
e. Price-maker
- A monopolist is the sole supplier of its good. Therefore,
the demand curve is simply the market demand curve (which slopes downward).
- The monopolist’s marginal revenue curve is always below
the demand curve.
- MR = MC at the monopolist’s profit-maximizing quantity
of output.
- P = MC at the perfectly competitive firm’s profit-maximizing
quantity of output.
- P > MR = MC at the monopolist’s profit
maximizing quantity of output.
In a competitive industry, a monopolist does the
following:
- Produces a small quantity: Q (monopoly) < Q (industry)
- Charges a higher price: P (monopoly) > P (industry)
- Earns a profit.
- At the monopolist’s profit-maximizing output level, marginal
cost = marginal revenue, which is less than market price.