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Chapter 22
Understanding Profit
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Editors Notes: A.
McConnell Economics Books, including the
18th edition,
B.
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I. Introduction
A. Profit equals total revenue minus total
costs.
B. Understanding profit
requires bringing revenue and costs together.
C. Total profit and profit on the
margin will be analyzed.
II. Demand determines marginal revenue.
A.
Marginal
revenue (MR) is the change in total revenue which
is received from selling one more unit.
B. Demand may be thought of
as average revenue with what is happening on the margin an
indication of
what is happening to the average.
C. When product
demand is downsloping, marginal revenue is below demand indicating
the average
price received falls as quantity increases.
D.
Econ Concepts in 60 Seconds Video on Imperfect Competition MR Less Than
Demand
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Demand Schedule | |||
| Price | Quantity | Total Revenue | Marginal Revenue | |
| 5 | 0 | 0 | ||
| 4 | 1 | 4 | 4 | |
| 3 | 2 | 6 | 2 | |
| 2 | 3 | 6 | 0 | |
| 1 | 4 | 4 | -2 | |
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At high prices, demand is inelastic, lowering
price increases total revenue as marginal revenue is positive.
At medium prices, unitary elasticity means no change in total revenue as price is changed. At low prices, demand is elastic, lowering price decreases total revenue as marginal revenue is negative. |
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D. The special case of horizontal perfectly elastic
demand will be explored in chapter 23.
III. Maximizing profit using marginal analysis
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A. Selling quantity Q will maximize profit. B. At quantities below optimum point Q, MR exceeds MC and increasing quantity sold will increase total profit. C. At quantities above point Q, MC exceeds MR and an increase in quantity sold will decrease total profit. D. Maximum profit results when MR = MC E. To find total revenue (TR) draw a perpendicular line from the intersection of MR and MC to the quantity axis. Then extend the line up to the demand curve and over to the y-axis. The resulting rectangle is P x Q which equals total revenue. F. To find TC draw a line from the intersection of the perpendicular and ATC to the y-axis. The resulting rectangle is ATC x Q which is total costs. G. The resulting top rectangle is TR-TC. It is total profit. |
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IV. Maximizing profit using total analysis
of revenue and cost
A. Total Revenue = Price x Quantity B. Total Costs = Total Fixed Costs + Total Variable Costs C. Total Profit = Total Revenue - Total Costs D. Maximum profit is where the vertical distance
between |
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V. Minimizing a short-run loss versus a short-run close down
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A. TR1 is making a profit. B. TR2 is paying all variable costs and making some positive as fixed costs such as depreciation, though an expense, have been paid. This level of total revenue is all that is necessary to continue in business during the short run. C. TR3 is not covering all variable costs and not
Econ Concepts Video in in 60 Seconds,
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VI. Economies and diseconomies of scale affect profit.
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A. Companies try to maximize profits by designing units produced before the diseconomies of scale begin to rapidly increase costs. B. Flexible production lines, designed by the
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VII. Long-run costs
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Long-run average total costs
are the horizontal summation of ever larger short-run average total costs.
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VIII. Predicting profit with break-even analysis
| A. Darin Jones has decided to open a
fully-automated car wash with Linda Smith, a friend
from college. Speedy Car Wash would be fully automated with annual fixed
charges for costs such as depreciation and rent amounting to $100,000.
Variable costs such as labor were expected to be
$2.00 per vehicle washed. Price was expected to average $7.00 per vehicle
and they plan to wash 30,000 cars per year. The
expected first-year profit for Speedy Car Wash would be calculated as
follows.
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B. Total Profit = Total Revenue - Total Costs
= P x Q - ( TFC + TVC) = P x Q - TFC + VC/unit X Q = $7/unit X 30,000 units - ($100,000 + $2 X 30,000 units) = $210,000 - ($100,000 + $60,000) = $50,000 |
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C. A graph can also be used
to estimate profit.
Calculations for 30,000 cars: TR = $7 X 30,000 = $210,000 TFC = $100,000 TVC = $2 x 30,000 = $ 60,000 TC = $100,000+ $60,000 = $160,000 P = TR - TC = $210,000 - $160,000 = $50,000
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| D. The break-even point
can be calculated using the concept of contribution to margin. Contribution to margin (C) = price - variable cost/unit
Note: C first goes to pay for TFC and then goes to profit. At 30,000 units there were 20,000 units to pay fixed costs and 10,000 units for profit at $5/unit or $50,000. |
E. An algebraic
approach can also be used to calculate the break-even point. TR = P/unit x Q and TC = TFC + VC/unit X Q At breakeven TR = TC and by substituting P/unit x Q = TFC + VC/unit x Q and by substituting $7Q/unit = $100,000 + $2/unit x Q $7Q/unit = $100,000 + $2Q/unit Q = 20,000 units |
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IX. After reviewing cost definitions, this Break-Even Calculator is a good application of this analysis.
| Last Chapter | Proceed to Part II Product and Factor Markets |
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| Chapter 22 Class Discussion Questions | Table of Contents | |
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