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Chapter 22 Understanding Profit
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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 

   E. The special case of horizontal 
       perfectly elastic demand will 
       be explored in chapter 23.
 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
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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III. Maximizing profit using marginal analysis
        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
           TR and TC is the longest.

 

 

V. Minimizing a short-run loss versus a short-run
     close down

     A. TR1 is making a profit.

     B. TR2 is paying all variable costs and making some 
          contribution to fixed costs. Cash flow may be 
          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 
          contributing to fixed costs. This situation requires 
          that the firm shut down very quickly in the short run
          as each unit produced adds to total loss.

Econ Concepts Video in in 60 Seconds,
 The Shut Down Rule

Editors Note: Video uses marginal analysis while this analysis uses total analysis.

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VI. Economies and diseconomies of scale affect profit.
      A. Companies try to maximize profits by designing 
           production facilities that increase the number of 
           units produced before the diseconomies of scale
           begin to rapidly increase costs.

      B. Flexible production lines, designed by the 
          Japanese and being used by companies such as
          General Motors, allow for producing different 
          product models and even different products 
          without substantially changing a production 
          line's configuration. These procedures have
          become a popular method of increasing a
          plant's economies of scale.

 

  

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VII. Long-run costs Long-run average total costs are the horizontal summation         of ever larger short-run average total costs.

 

 

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. 		B.  Total Profit 

      = Total Revenue - Total Costs

      = P x Q - ( TFC + TVC)

      = P x Q - TFC + VC/unit X Q

      = ($7/u) X 30,000u - ($100,000 + $2 X 30,000u) 

      = $210,000 - ($100,000 + $60,000) = $50,000
         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

     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

$5Q/unit = $100,000 dividing $5/unit into both sides

Q = 20,000 units

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IX. After reviewing cost definitions, this Break-even calculator is a good application of this analysis.

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