|
Profit is
very simply revenue minus costs. It's very important to remember that
economists calculate costs in a different way to accountants - we include the
opportunity cost of the economic resources employed in the total cost.
You run
your own firm and total revenues are £40,000 and total costs are £20,000.
You could work for a large firm and earn £30,000.
Accounting
Profit = Total revenue - Total costs
£20,000 = £40,000 - £20,000
Economic
Profit = Total revenue - Total costs - Opportunity cost
-£10,000 = £40,000 - £20,000 - £30,000
This
example shows that you are in effect losing money by owning your own company,
as your labour would be better employed with the large firm. This does ignore
the benefits of working for yourself.
It
is possible to highlight another example using capital. If you invest £10,000
into a business venture that yields a 10% accounting profit. In order to work
out the economic profit the opportunity cost has to be taken away from the £1,000
accounting profit. It is possible to invest the £10,000 in a high interest
account and earn 7.5%, which equals £750. The economic profit is therefore
£250 (£1,000 - £750).
Profit Maximising Level of Output
It
is possible to find the profit maximising level of output by drawing the
revenue and cost curves. Finding
the maximum profit level using total curves
is
done by finding the output where the difference between TR and TC is
greatest; in this case it occurs at an output of 3.
Economists
assume that the objective of most firms is to maximize profits. It is
possible to prove that if a firm wishes to profit maximize it must produce
where the marginal cost is equal to the marginal revenue (MC=MR).
If the quantity is below 3, the marginal cost of an
extra unit is less than the marginal revenue, therefore it makes sense to
increase output as it will lead to greater profit. If production continues
past 3, the marginal cost is greater than the marginal revenue, therefore any
increases in the quantity will lead to a fall in profit.
If
we add AC and AR curves to the above diagram it is possible for us to
calculate the total profit the firm will earn.
If the firm produces at the profit maximising level of output (3), it
will receive an AR (the price of the good) of £6.
It costs £4.50 (the AC) to produce each unit, therefore the firm will
make a profit of £1.50 on each unit sold.
To calculate the total profit we multiply the profit per unit by the
quantity sold, £1.50 ´
3 = £4.50, which is equal to the shaded area in the diagram below.
Normal
and abnormal profit
An
economic profit of zero is described as being a normal profit (remember
accounting profits are still being earned), i.e., normal profit is the same
as what could be earned by investing the factors of production in the next
best alternative (AR=AC).
Abnormal
profits occur when the economic profit is greater than zero, i.e., it earns
more money than it could by investing in the next best option (AR>AC).
An
economic profit indicates that the factors of production could be used in a
more profitable way (AR less than AC).
A Loss Making Firm
A
firm who is making a loss in the short run may in fact continue to trade.
If it were to close it would still have to pay the fixed costs,
therefore if it is able to make a contribution to the fixed costs it will be
losing less money by continuing to operate; this is known as loss minimising.
If the price a firm receives is above the AVC, it will stay open.
Selling where P=AVC in the short run is a more favourable scenario
than closing down.
In
the long run a firm will shutdown if it is making an economic loss, unless it
has an objective other than making a profit, e.g., schools and hospitals.
A firm in the long run is able to loss minimise by producing where
MC=MR.
Notes on the
Internet
Profits
Produced by Geoff Riley at RGS Newcastle
Profit Maximisation PowerPoint Model
Profit Maximisation PowerPoint Presentation
Profit
Profit Maximisation Worksheet
|
