The Profit Motive

1
The Profit Motive
Ch 7 Competitive Firms

• The basic incentive for producing goods and
  services is the expectation of profit.
• Profit total revenue - total cost

2
Other Motivations

• Personal reasons also motivate producers.
• Producers seek social status and crave
  recognition.
• Non-owner managers of corporations may be more
  interested in their own jobs, salaries, and
  self-preservation than earning profits for
  stockholders.
• Is the profit motive bad?

3
Economic vs. Accounting Profits

• The typical consumer believes that 35 of every
  sales dollar goes to profits.
• In reality, average profit per sales dollar is
  closer to 5.

4
Economic Profits

• Economic profit - the difference between total
  revenues and total economic costs.
• Economic cost - the value of all resources used
  to produce a good or service (opportunity cost).

5
Economic Profits

• To determine a firms economic profit, all
  implicit factor costs must be subtracted from
  observed accounting profit.

6
Economic Profits

• Normal profit - the opportunity cost of capital
  (zero economic profit).

• Economic profits represent something over and
  above normal profits.

• A productive activity reaps an economic profit
  only if it earns more than its opportunity cost.

7
Economic Profits
8
Market Structure

• The opportunity for profit may be limited by the
  structure of the industry.
• Market structure - the number and relative size
  of firms in an industry.

• Perfect competition - market in which no buyer or
  seller has market power.

9
Market Structure
Oligopoly
Duopoly
Monopoly
10
The Nature of Perfect Competition

• A perfectly competitive industry has several
  distinguishing characteristics
• Many firms lots of firms are competing for
  consumer purchases.
• Homogeneous products the products of the
  different firms are identical, or nearly so.
• Low entry barriers its relatively easy to get
  into the business.
• No Market Power output of each firm is so small
  that firms cannot alter the market price of a
  good or service (price takers).

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Market Demand Curves vs. Firm Demand Curves
The T-shirt market
Market supply
pe
pe
Market demand
12
The Production Decision

• A competitive firm has only one decision to make
  how much to produce.
• The production decision is the selection of the
  short-run rate of output (with existing plant and
  equipment).

13
Output and Costs

• To maximize profits a firm must consider how
  increased production will affect revenues and
  costs

• The total revenue curve of a perfectly
  competitive firm is an upward-sloping straight
  line, with a slope equal to pe.

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Total Revenue
15
Output and Costs

• Producers are saddled with certain costs in the
  short-run.

• Fixed costs are incurred even if no output is
  produced.

• Once a firm starts producing output, it incurs
  variable costs as well.

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Total Cost
Total cost
Total costs escalate due to the law of
diminishing returns
Fixed cost
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Total Profit
Total cost
Total revenue
Profits
Losses
f
h
g
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Profit-Maximizing Rule

• The best single rule for maximizing short run
  profits is straightforward
• Never produce a unit of output that costs more
  than it brings in.

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Marginal Revenue Price

• The contribution to total revenue of an
  additional unit of output is called marginal
  revenue.
• For perfectly competitive firms, price equals
  marginal revenue.

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Marginal Revenue Price

• Marginal revenue (MR) - the change in total
  revenue that results from a one-unit increase in
  the quantity sold.

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Marginal Revenue Price
22
Marginal Cost

• A firms goal is not to maximize revenues, but to
  maximize profits.

• What an additional unit of output brings in is
  its marginal revenue (MR).
• What it costs to produce is its marginal cost
  (MC).

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Marginal Cost
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Profit-Maximizing Rate of Output

• Profit-maximization rule
• a firm should produce at that rate of output
  where marginal revenue equals marginal cost.
• MR MC

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Short-Run Profit-Maximization Rules for
Competitive Firm

• Price gt MC ? increase output
• Price MC ? maintain output and maximize
  profit
• Price lt MC ? decrease output

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Profit-Maximizing Rate of Output
p MC
MRB
Profit-maximizing rate of output
MCB
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Adding Up Profits

• Profits can be computed in two ways.
• Total profit is the difference between total
  revenue and total cost.

Total profit total revenue total cost
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Adding Up Profits

• Total profit is average profit times the number
  sold.

Profit per unit price ATC
Total profit profit per unit X quantity
Total profit (p ATC) X q
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Alternative Views of Total Profit
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The Shutdown Decision

• The short-run profit maximization rule does not
  guarantee any profits.
• Fixed costs must be paid even if all output
  ceases.
• A firm should shut down only if the losses from
  continuing production exceed fixed costs.

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Price vs. AVC

• Where price exceeds average variable cost but not
  average total cost, the profit maximizing rule
  minimizes losses.

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The Shutdown Point

• When price does not cover average variable costs
  at any rate of output, production should cease.
• The shutdown point is that rate of output where
  price equals minimum AVC.

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The Shutdown Point
34
The Investment Decision

• The shut-down decision is a short-run response.

• Investment decisions are long-run decisions.

• The investment decision is the decision to build,
  buy, or lease plant and equipment.
• It also involves the decision to enter or exit an
  industry.

35
Long-Run Costs

• In making long-run decisions, the producer is
  confronted with many possible cost figures.
• A producer will want to build, buy or lease a
  plant that is most efficient for the anticipated
  rate of output.

36
Determinants of Supply

• The quantity of a good supplied is affected by
  all forces that alter marginal cost.

• The determinants of a firms supply include
• The price of factor inputs.
• Technology (the available production function).
• Expectations (for costs, sales, technology).
• Taxes and subsidies.

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Short-Run Supply Curve (MC Curve)
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16
14
X
12
10
Y
Shutdown point
Price (per bushel)
8
6
Marginal cost curve

Short-run supply curve for competitive firm
4
2
0
1
2
3
4
5
6
7
Quantity Supplied (bushels per day)
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Tax Effects

• Some tax changes alter short-run supply behavior.
• Others affect only long-run supply decisions.

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Property Taxes

• Property taxes are a fixed cost.
• They raise average costs and reduce profit.
• Because they dont affect marginal costs, they
  leave the profit-maximizing output unchanged.

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Payroll Taxes

• Payroll taxes increase marginal costs.
• They reduce the profit maximizing rate of output.
• They increase average costs and lower total and
  per-unit profits.

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Profit Taxes

• Profit taxes are neither a fixed cost nor a
  variable cost.
• They dont affect marginal cost or prices.
• They dont affect production level decisions but
  may affect investment decisions.

42
Impact of Taxes on Business Decisions