Ch08

The Concept of Profit

• Profit is the difference between total revenue
and total cost.
• The economic concept of profit takes into
account the opportunity cost of capital.
• Total economic cost includes a normal rate of
return. A normal rate of return is the rate that is
just sufficient to keep current investors interested
in the industry.
• Breaking even is a situation in which a firm is
earning exactly a normal rate of return.

© 2002 Prentice Hall Business Publishing Principles of Economics, 6/e Karl Case, Ray Fair

Maximizing Profit–An Example

Blue Velvet Car Wash Weekly Costs
TOTAL VARIABLE COSTS TOTAL COSTS
TOTAL FIXED COSTS (TFC) (TVC) (800 WASHES) (TC = TFC + TVC) $ 3,600
1. Normal return to 1. Labor $ 1,000 Total revenue (TR)
investors $ 1,000 2. Materials 600 at P = $5 (800 x $5) $ 4,000
2. Other fixed costs $ 1,600 Profit (TR − TC) $ 400
(maintenance contract,
insurance, etc.) 1,000
$ 2,000

• If Blue Velvet washes 800 cars each week, it
takes in revenues of $4,000.
• This revenue is sufficient to cover both fixed costs
of $2,000 and variable costs of $1,600, leaving a
positive economic profit of $400 per week.

Firm Earning Positive Profits in the
Short Run

• To maximize profit, the firm sets the level of output
where marginal revenue equals marginal cost.

Firm Earning Positive Profits in the
Short Run

• Profit is the difference between total revenue and
total cost.

Minimizing Losses

• Operating profit (or loss) or net
operating revenue equals total revenue
minus total variable cost (TR – TVC).
• If revenues exceed variable costs, operating
profit is positive and can be used to offset fixed
costs and reduce losses, and it will pay the firm
to keep operating.


Minimizing Losses

• Operating profit (or loss) or net
operating revenue equals total revenue
minus total variable cost (TR – TVC).
• If revenues are smaller than variable costs, the
firm suffers operating losses that push total
losses above fixed costs. In this case, the firm
can minimize its losses by shutting down.


Minimizing Losses

A Firm Will Operate If Total Revenue Covers Total Variable Cost
CASE 1: SHUT DOWN CASE 2: OPERATE AT PRICE = $3
Total Revenue (q = 0) $ 0 Total Revenue ($3 x 800) $ 2,400

Fixed costs $ 2,000 Fixed costs $ 2,000
Variable costs + 0 Variable costs + 1,600
Total costs $ 2,000 Total costs $ 3,600

Profit/loss (TR − TC) − $ 2,000 Operating profit/loss (TR − TVC) $ 800
Total profit/loss (TR − TC) − $ 1,200


Minimizing Losses

• When price equals $3.50, revenue is sufficient to
cover total variable cost but not total cost.


Minimizing Losses

• As long as price (which is equal to average revenue per
unit) is sufficient to cover average variable costs, the firm
stands to gain by operating instead of shutting down.

Minimizing Losses

• The difference between ATC and AVC equals
AFC. Then, AFC  q = TFC (the brown area).

Minimizing Losses

• The blue area equals losses.
• The green area equals operating profit.

Shutting Down to Minimize Loss

A Firm Will Shut Down If Total Revenue Is Less Than Total Variable
Cost
CASE 1: SHUT DOWN CASE 2: OPERATE AT PRICE = $1.50
Total Revenue (q = 0) $ 0 Total revenue ($1.50 x 800) $ 1,200

Fixed costs $ 2,000 Fixed costs $ 2,000
Variable costs + 0 Variable costs + 1,600
Total costs $ 2,000 Total costs $ 3,600

Profit/loss (TR − TC) − $ 2,000 Operating profit/loss (TR − TVC) − $ 400
Total profit/loss (TR − TC) − $ 2,400


Short-Run Supply Curve of a Perfectly
Competitive Firm
• The short-run
supply curve of a
competitive firm is
the part of its
marginal cost curve
that lies above its
average variable
cost curve.


The Short-Run Industry Supply Curve

• The industry supply curve in the short-run is the
horizontal sum of the marginal cost curves (above AVC)
of all the firms in an industry.


Profits, Losses, and Perfectly Competitive
Firm Decisions in the Long and Short Run

SHORT-RUN SHORT-RUN LONG-RUN
CONDITION DECISION DECISION
Profits TR > TC P = MC: operate Expand: new firms enter
Losses 1. With operating profit P = MC: operate Contract: firms exit
(TR ≥ TVC) (losses < fixed costs)
2. With operating losses Shut down: Contract: firms exit
(TR < TVC) losses = fixed costs

• In the short-run, firms have to decide how much to
produce in the current scale of plant.
• In the long-run, firms have to choose among many
potential scales of plant.


Long-Run Costs: Economies and
Diseconomies of Scale

• Increasing returns to scale, or
economies of scale, refers to an
increase in a firm’s scale of
production, which leads to lower
average costs per unit produced.



• Constant returns to scale refers to
an increase in a firm’s scale of
production, which has no effect on



• Decreasing returns to scale refers
to an increase in a firm’s scale of
production, which leads to higher


The Long-Run Average Cost Curve

• The long-run average cost
curve (LRAC) is a graph that
shows the different scales on
which a firm can choose to
operate in the long-run. Each
scale of operation defines a
different short-run.


The Long-Run Average Cost Curve

• The long run average cost curve of a firm
exhibiting economies of scale is downward-
sloping.


Weekly Costs Showing Economies of
Scale in Egg Production
JONES FARM TOTAL WEEKLY COSTS
15 hours of labor (implicit value $8 per hour) $120
Feed, other variable costs 25
Transport costs 15
Land and capital costs attributable to egg production 17
$177
Total output 2,400 eggs
Average cost $.074 per egg

CHICKEN LITTLE EGG FARMS INC. TOTAL WEEKLY COSTS
Labor $ 5,128
Feed, other variable costs 4,115
Transport costs 2,431
Land and capital costs 19,230
$30,904
Total output 1,600,000 eggs
Average cost $.019 per egg


A Firm Exhibiting Economies and
• The long-run average cost curve of a firm
that eventually exhibits diseconomies of
scale becomes upward-sloping.


Optimal Scale of Plant

• The optimal scale of plant is the scale that
minimizes average cost.


Long-Run Adjustments to
Short-Run Conditions
• Firms expand in the long-run when
increasing returns to scale are available.


Long-Run Adjustments to
Short-Run Conditions
• Prices will be driven down to the minimum
point on the LRAC curve.


Short-Run Profits:
Expansion to Equilibrium
• The existence of positive profits will attract
new entrants to an industry.
• As capital flows into the industry, the supply
curve shifts to the right, and price falls.
• Firms will continue to expand as long as
there are economies of scale to be realized,
and new firms will continue to enter as long
as positive profits are being earned.


Short-Run Losses:
Contraction to Equilibrium
• When firms in an industry suffer losses,
there is an incentive for them to exit.


Short-Run Losses:
• As firms exit, the supply curve shifts from
S to S’, driving price up to P*.


Short-Run Losses:
• The industry eventually returns to long-run
equilibrium and losses are eliminated.


Short-Run Profits:
• As long as losses are being sustained in an
industry, firms will shut down and leave the
industry, thus reducing supply.

• As this happens, price rises.

• This gradual price rise reduces losses for firms
remaining in the industry until those losses are
ultimately eliminated.


Long-Run Equilibrium in Perfectly
Competitive Output Markets
• Whether we begin with an industry in which
firms are earning profits or suffering losses,
the final long-run competitive equilibrium
condition is the same.
• In the long-run, equilibrium price ( P*) is equal
to long-run average cost, short-run marginal
cost, and short-run average cost. Profits are
driven to zero.


The Long-Run Adjustment Mechanism

• The central idea in our discussion of entry,
exit, expansion, and contraction is this:
• In efficient markets, investment capital flows
toward profit opportunities.
• The actual process is complex and varies from
industry to industry.


The Long-Run Adjustment Mechanism

• The central idea in our discussion of entry,
exit, expansion, and contraction is this:
• Investment—in the form of new firms and
expanding old firms—will over time tend to favor
those industries in which profits are being made,
and over time industries in which firms are
suffering losses will gradually contract from
disinvestment.


Internal Versus External
Economies of Scale

• Economies of scale that are found
within the individual firm are called
internal economies of scale.

• External economies of scale
describe economies or diseconomies
of scale on an industry-wide basis.


The Long-Run Industry Supply Curve

• The long-run industry supply curve
(LRIS) traces output over time as the
industry expands.

• When an industry enjoys external
economies, its long-run supply curve
slopes down. Such an industry is
called a decreasing-cost industry.


A Decreasing-Cost Industry:
External Economies

• In a decreasing cost industry, costs decline as a
result of industry expansion, and the LRIS is
downward-sloping.

An Increasing-Cost Industry:
External Diseconomies

• In an increasing cost industry, costs rise as a
result of industry expansion, and the LRIS is
upward-sloping.

An Increasing-Cost Industry: External
Diseconomies
Construction Activity and the Price of Lumber
Products, 1991 - 1994
MONTHLY PERCENTAGE PERCENTAGE
AVERAGE, NEW INCREASE CHANGE IN THE PERCENTAGE
HOUSING OVER THE PRICE OF CHANGE IN
PERMITS PREVIOUS LUMBER CONSUMER
YEAR YEAR PRODUCTS PRICES

1991 79,500 - - -

1992 92,167 + 15.9 + 14.7 + 3.0

1993 100,917 + 9.5 + 24.6 + 3.0

1994 111,000 + 10.0 NA + 2.1
Sources: Federal Reserve Bank of Boston, New England Economic Indicators, July, 1994, p. 21;
Statistical Abstract of the United States , 1994, Tables 754, 755.


Ch08

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