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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.

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.

     D. The special case of horizontal perfectly elastic demand will be explored in chapter 23.
        

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.

 

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.

 

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.

 

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/unit X 30,000 units - ($100,000 + $2 X 30,000 units)

                        = $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

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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