2. PROFIT THEORY
• How economist's measure profit is different to
accountants, because of the issue of opportunity
cost.
• For example, a person might be making $80,000 a
year profit from running their business, but they
were making $80,000 a year as marketing
manager before they started to run their own
business. Running a business may involve more
stress, and higher levels of uncertainty.
3. PROFIT THEORY
How do economists measure profit?
Total Profit = Total revenue - total cost
(fixed, variable and
opportunity cost)
4. Normal Profit
° If total revenue is equal to total cost,the firm is
making normal profit.
Abnormal Profit
° If total revenue is greater than the total cost,the
firm is making abnormal profit.
Losses
• If total revenue is less than total cost, then the
firm is making losses.
PROFIT THEORY
6. Table Analysis —Firm A
• Afirm is making an abnormal profit of
$20,000.
• This means that the revenue earned by the
firm is not only covering all the costs, but it is
in fact $20,000 more.
• This will make the entrepreneur happy, as
he/she was expecting to cover her
opportunity cost of$60,000 and in fact gets
$80,000.
7. Table Analysis Firm
• Firm B is making normal profit.
• The revenue earned by the firm exactly covers
all the costs.
• The entrepreneur will be satisfied.
8. Table Analysis —Firm C
• Firm C is making losses.
• Although an accountant would say that the
firm is making a profit of $40,000 (S200,000-
$160,000) the entrepreneur will not be happy.
• Fixed and variable costs are covered, but
opportunity cost is not covered.
• The entrepreneur should close down the firm,
moving to the entrepreneur's next best
occupation.
9. Which one of the following firms is making
abnormal profit, normal profits and losses?
10. Profit Theory
Beyond the issue of opportunity cost,
firms must also consider the following:
1. The Shout down point
2. The break even point
3. The profit maximizing level of output
11. Shut Down Point
• is not unusual to see firms
continue to operate, in the short run,
even ifthey are making a loss.
• is also not unusual to see firms
shut down for a short period of time
and then open u again.
12. Shut Down Point
Temporary Shut Down
• The firm may close down temporarily inthe
short run and produce nothing.
• It will only lose its total fixed costs —the costs
that are unavoidable such as rent or the
interest payments on loans.
• Temporarily closing may be better than
producing and not getting enough revenue to
cover the variable costs.
14. Shut Down Point Example:
Archie
• Archie would be better not producing at all in
the short turn and closing down temporarily.
• Revenue gained has failed to cover all the
variable costs.
• By producing, Archie has costs of $120,000
not covered by revenue, but he only loses
$100,000 of fixed costs ifhe did not produce.
15. Shut Down Point Example: Batcat
• Total revenue of $120,000 means the variable
costs of$120,000 are just covered.
° They will lose $100,000 of fixed cost whether
they produce or not produce.
• In this situation it is likely that Batcat will
continue to produce in order to maintain the
continuity of production, thus pleasing customers
and to maintain the employment of workers and
the usage of inputs. This will please unions and
suppliers.
16. Shut Down Point Example: Charlie
• Charlie loses $90,000 by producing, since their
total revenue covers their variable costs and
also contributes $10,000 towards their fixed
costs.
• If they did not produce then Charlie would
lose their fixed costs of $100,000.
• Therefore Charlie will produce in the short
run.
17. Short Run Losses
• Firms making losses in the short run cannot do
this forever.
• Whether they produce or not in the short run,
the firms need to plan ahead in the long run in
order to change their combination of factors
and to devise a situation where they are able
to cover all their costs and make normal
profits.If they cannot do this, they will have
to close permanently.
18. Shut Down Point —Definition.
• The Shut Down price is the level of price
(revenue) that enables a firm to cover its variable
costs in the short run
• It is the price where price = the average variable
costs in the short run.
• If price (revenue) does not cover average variable
costs, then the firm will shut down in the short
run.
19.
20. Real Worid Exampies -
Shut Down Point
• Many businesses open and close on a
seasonable basis in very hot and cold climates.
• For example an ice cream in store in Vienna
shuts down in October and re opens again in
April.
• The act of temporarily closing down, because
it cannot cover its variable costs is a good
example of afirm that is not reaching its shut
down price in the short run.
21. THE BREAK EVEN POINT
• The break-even price is the price at which a firm
is able to make normal profit in the long run.
° This means that it will break even, covering all of
its costs, including opportunity cost.
• The break even price is the level of price that
enables a firm to cover all its costs in the long
run:- the price where price = average total costs.
° If the price does not cover average total costs in
the long run, then the firm will shut down for
good.
25. Break Even Point
What is the break even price? At$5,the price is too cheap
and we will not break even.
26. Break Even Quantity
Break Even Quantity = fixed costs
contribution per unit
Contribution per unit =
price —variable cost per unit.
Average Variable Costs:
• Simple add up to the total variable cost and then determine
the average.
• This will not be the most accurate answer.
• Naturally we can determine the break even quantity when
each different labor combination.
