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ECON 211
ELEMENTS OF ECONOMICS I
Session 5– Profit Maximization (Part 1)
Lecturer: Dr. (Mrs.) Nkechi S. Owoo, Department of Economics
Contact Information: [email protected]
College of Education
School of Continuing and Distance Education
2014/2015 – 2016/2017
Session Overview
• Session 5 explains how a firm sets its price and output level in the
short run under the assumption that the firm’s goal is to maximize
its economic profit.
• There are two approaches to finding a firm’s short-run profitmaximizing level of output.
– In the total revenue and total cost approach, the firm calculates profit as
the difference between total revenue and total cost, and produces the
quantity of output where profit is greatest.
– In the marginal revenue and marginal cost approach, the firm maximizes
profit when it sets marginal revenue equal to marginal cost. These two
approaches are demonstrated with tables and graphs.
• The first session deals with the introduction to a number of
concepts while the second session deals with the TR/TC and
MR/MC approach.
Slide 2
Session Outline
The key topics to be covered in the session are as follows:
• The Goal of Profit Maximization
• Understanding Profit
• The Firm’s Constraint
– Demand Constraint
– Cost Constraint
Slide 3
Reading List
• Hall and Lieberman
– Chapter 7, pp:196-202
Slide 4
Topic One
THE GOAL OF PROFIT
MAXIMIZATION
Slide 5
The Goal Of Profit Maximization
• In order to analyze firms’ decision-making process, we
need to know what the firm is trying to maximize
• In this analysis, we assume that firms are single economic
decision-makers whose main goal is to maximize profits.
• This assumption helps us to understand how firms decide
–
–
–
–
What prices to charge
How much to produce
Whether to temporarily shut down the firm or keep operating
Whether to enter a new market or exit an existing one
6
Understanding Profit
• Profit is defined as the difference between a firms
sales revenue and its costs of production
• There are two ways of expressing profits:
– Accounting profit
• Total revenue minus accounting costs
• This is mostly used by accountants and takes into account
only explicit costs
– Economic profit
• Total revenue minus all costs of production
• Recognizes all the opportunity costs of production - both
explicit costs and implicit costs
7
Understanding Profits
• Which of the two types of profits is the correct one?
• It depends
– For tax purposes, the government is interested in profits as
measured by accountants
• The government is only interested in money earned, and not
money that could have been earned had a firm done
something else with its time or resources
– For the purposes of understanding the behaviour of firms,
economic profits is better
Slide 8
Why are there Profits?
• When we observe households income, we note that
there are a variety of payments that accrue
– Those who provide firms with land receive rent; the
payment for land
– Those who provide labour receive a wage or a salary
– Those who lend firms money so they can purchase capital
equipment receive interest
– A firms profits go to its owners
• But what do the owners of these firms provide that earns
them this payment?
Slide 9
Why Are there Profits?
• Economists view profits as payment for two
contributions of entrepreneurs
– Risk-taking
– Innovation
• Risk-taking
– Sometimes, in taking the risk of starting a business, the
consequences of failure are so severe that the reward for
success must be large enough to induce an entrepreneur to
establish a business
• Innovation
– Profits are also a reward for innovation
– Innovation makes a substantial contribution to production and
therefore, profit is a reward for those who innovate
Slide 10
Topic One
THE FIRMS CONSTRAINTS
Slide 11
The Firm’s Constraint
• If firms were free to earn whatever level of profit
they wanted, they would earn virtually infinite profit
– This would make owners very happy
• However, firms are not free to earn unlimited profits
• Firms face constraints on both:
– Revenue
– Cost
Slide 12
The Demand Constraint
• The constraint on firms revenue arises from the demand
curve
• This curve tells us the different quantities that consumers
are willing and able to buy at different prices
• We are, for the purposes of this session, more interested
in the demand curve facing the firm
• The demand curve facing the firm refers to the quantity
of output that customers will choose to purchase from
that firm, at different prices
– we are interested in one firm and all buyers who are potential
customers of that firm
Slide 13
The Demand Constraint
• Let us consider a hypothetical firm- Ned’s Beds, a
manufacturer of bed frames
• The table on the next slide lists the different prices that
Ned could charge for each bed frame and the number of
these that he can sell at each price
• Like other types of demand curves, the demand facing
Neds Beds is downward sloping
– This indicates that in order to sell more beds, Ned must lower
his price
• Therefore, once Neds Beds decides on an output level, it
has also determined the maximum price it can charge
Slide 14
Demand and Total Revenue
The Demand Curve Facing the Firm
15
Demand and Total Revenue
• Each time a firm chooses its level of output, it also
determines its total revenue
– Why?
– Because once we know the level of output, we also know
the highest price the firm can charge
– Total Revenue= Price x Output
• Because Ned’s demand curve slopes downwards, he
must lower his price each time his output increases,
or else he will not be able to sell all he produces
• With more units of output but with each selling at a
lower price, total revenue could increase or decrease
Slide 16
Demand and Total Revenue
Figure 1 The Demand Curve Facing the Firm
Price
Per Bed
$600
450
Demand Curve
Facing Ned’s Beds
2
5
Number of Bed
17
Frames per Day
The Cost Constraint
• Every firm struggles to reduce costs
– But there is a limit on how low costs can go
– These impose a second constraint on the firm
• Where do these limits come from?
– The Production function
• This is determined by firms technology
• In the long run, the firm can use any method in its production
function
• In the short run however, some inputs are fixed
– The firm must pay the prices of each of the inputs that it uses
• Greater output implies greater costs, and greater costs
imply lower profits, all else remaining constant
Slide 18
The Profit-Maximizing Output Level
• In the next session, using information on firms’
demand and cost constraints, we examine how firms
arrive at their profit-maximizing level of production
Slide 19
References
• Economics: Principles and Applications: Hall R.E. and
Lieberman M. (2008), Thomson/ South Western (4th
Edition)
Slide 20
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