DEMAND AND SUPPLY ANALYSIS: THE FIRM 1 2. OBJECTIVES OF THE FIRM Profit = Total revenue Total cost Total Revenue: Amount received by a firm from sale of its output. Total Cost: Market value of the inputs that are used by a firm in its production. Level of output Firm s efficiency Resource price Profit depends on: Characteristics of the product market & Characteristic of resource market Output profit TR > TC Output profit TR < TC 2.1 Types of Profit Measures Accounting Profit (Net Income): AP = TR Explicit cost (Accounting Cost). AP < 0 Accounting loss. Economic Profit: EP = TR Explicit cost Implicit cost. (or) EP = Accounting Profit Implicit cost (or) EP = TR Total economic Cost (EP is also called Abnormal or Supernormal profit). Explicit Cost: It refers to payments made to non-owner parties for the services or resources provided by them. Implicit Cost: It doesn t require cash outlay. Normal profit: it s the difference b/w accounting profit & economic profit. Normal Profit = Accounting Profit Economic Profit. Positive Economic Profit: Firm is able to generate greater than opportunity cost of resources. Negative Economic Profit: Firm is not able to generate enough profits to cover opportunity costs of the resources. Economic loss: Economic profit is less than zero. Economic rent: Extra amount of earnings that a factor earns over and above its opportunity cost necessary to keep a resource in its current use.
2 2.2 Comparison of Profit Measures Relationship between Accounting Profit and Normal Profit Accounting profit > Normal profit Accounting profit = Normal profit Accounting < Normal profit Economic Profit Economic profit > 0 and firm is able to protect economic profit over the long run Economic profit = 0 Economic profit < 0 implies economic loss Firm s Market value of Equity Positive effect No effect Negative effect 3. ANALYSIS OF REVENUE, COSTS, AND PROFITS Revenue Total Revenue = Price Quantity = / Marginal Revenue = TR / Q Cost Total Cost = Sum of all costs incurred by a firm. TC = TVC + TFC Avg. Total Cost = TC/Q ATC curve is U shaped. Efficient Scale: quantity at which ATC is minimized. Marginal Cost (MC): increase in total cost from producing one more unit = It exhibits J-shaped pattern. MC < MR, Q profit Fixed Cost: Any cost that doesn t depend on firms level of output. Quasi-fixed Cost: Fixed cost that changes when production moves beyond certain range. Avg. Fixed Cost (AFC): = Q AFC Variable Cost: Cost that varies with the quantity produced TVC = VC/unit Q At Q =0, TVC = 0. Avg. Variable Cost (AVC) = Initially Q AVC later Q AVC Relationship between MC, ATC & AVC. MC < ATC ATC is declining. MC > ATC ATC is increasing. Same relationship holds for MC & AVC. Rising MC curve intersects ATC & AVC curve at their minimum points.
3 3.1 Profit Maximization Functions of Profit Motivate firms Promote efficient allocation of resources Promote economic welfare & standard of living. To create wealth for investors Promote innovation & development Simulate business investment & increase economic growth. Approaches for Determining Profit Maximizing Level of Output Total Revenue Total cost Approach: Based on the fact that TR TC = Profit Q TC & TR EP EP reach maximum & than falls down. Profit in maximized at output level where (TR TC) = max. Marginal revenue-marginal cost Approach: Based on comparison between MR & MC. Q MC MR > MC Q profit. Profits is maximized at point where MR = MC Per unit revenue - Per unit cost Approach: Profit is maximized when per-unit revenue = per-unit cost. Per-unit revenue > per-unit cost profit Per-unit revenue < per-unit cost profit. 3.1.1 Total, Average and Marginal Revenue In perfect competition (an individual firms is a small seller in the industry). Firm faces an infinitely elastic demand curve. Price is determined by the market supply and demand which implies that shift in supply curve of a single firm doesn t affect market price. Total quantity supplied & demanded is mainly determined by price. TR increases by a constant amount. MR = AR = Price = Demand. MR, AR & Price only changes when there is a shift in demand and / or supply factors creating price changes. 3.1.2 Factor of Production Land: Site location of the business. Labor: Physical & Mental human effort used in production. Capital: Building, Machinery & Equipment used in production. Material: Any good that firm buys as input to produce goods/services Production function: It represents the relationship between the quantity of input used to produce a good & the quantity of output of that good.
4 3.1.6 Short-Run versus Long-Run Profit Maximization Short Run In Short-run, two conditions exist: Fixed scale of production. Firms can neither enter nor exit from industry. Profit is maximized at the output level where MR = MC. MC curve of a perfectly competitive profitmaximizing firm represents the firm s short-run supply curve. Loss: If P< ATC firm incurs losses. MR > MC Q Profit. MR = MC profit is max. MR < MC Q profit. Breakeven price: Price at which economic profit is zero i.e. P = ATC is known breakeven price. It s the output level at which P = AR = MR = ATC or TR = TC TR > TVC but TR < TVC + TFC. SR: firms will continue operating. LR: if situation persists, firms will exit. Revenue < Variable cost i.e. P < AVC, firms incur operating losses & Total losses > Fixed cost, hence, to minimize losses firms will: SR: Shut-Down LR: Exit. Long Run All inputs are variable. Firm s are able to or production scale. New firms can enter or exit the industry. Entry & Exit from the Industry Effects of Entry: when P > ATC Firms earn Economic Profit incentive for new firms to enter Supply P profit. Effects of Exit: When P < ATC firms incur economic losses incentive for existing firm to exit Supply P losses. Long Run v/s Short Run Long-run industry supply curve exhibits the relationship between quantities supplied & output prices for an industry when firms can enter or exit the industry. In the long-run (under perfect competition), profit is max. Firm will operate at the minimum efficient scale point on its LRATC. In the short-run, supply curve of a competitive firm is that part of MC curve that remains above the AVC curve.
5 Effects of Change in Demand Demand P firms earn economic profit new firm enter no. of firms in LR firms earn normal profit. Demand P firm incur economic losses firms exit no. of firms market supply P. Effects of Change in Technology Use of new technology Cost of production market supply (keeping demand constant) Price. Due to lower cost of production, firms earn economic profit. Opposite is true for firms with old technology. Long-run average cost (LRAC) Profits Losses Losses FIRMS DECISIONS IN THE SHORT AND LONG RUN Short Run Condition Total Revenue (TR) Total Cost (TC) Operating profit (TR > Variable Cost) but TR < TFC + TVC Operating Loss (TR < Variable Cost) Short Run Decision P = MC and firm will continue operating P = MC and losses fixed costs firm will continue operating Shut down and losses fixed costs firm will Shut down. Long Run Decision Existing firms stay in the market. Expand: New firms will enter the industry Contract: Existing firms exist the Industry. Contract: Existing firms exist the Industry.
6 Economies of scale or increasing return to scale: Occurs when; % in output > % in inputs e.g. 20% increase in factor inputs 35% rise in output. Diseconomies of scale or Decreasing return to scale Occurs when; % in output < % in inputs. e.g. 50% rise in inputs leads to 25% rise in output. Constant return to scale: It occurs when; % in output = % in input. e.g. 20% rise in inputs leads to 20% rise in output. 3.2 Productivity It refers to average output produced per unit of input. Profit is maximized when productivity is maximized. Effects of increase in Productivity: Production cost. Profitability. Investment value. Synergies are created. Strengthen firm s competitive position in the long-run. Effects of decrease in productivity: Production cost. Profit ability. Firms or industry become less competitive over time. 3.2.1 Productivity Measures Total product: Total quantity of a good produced in a given period from using all inputs. Greater the TP of a firm, greater the market share. Average product: AP = Total product / Total quantity of input used to produce product. Greater the AP of a firm, more efficient it is. Marginal Product (MP): Additional output that can be produced by employing one more unit of a specific input. = = Flaw: Difficult to measure individual worker s productivity when work is performed collectively. In this care, Average product is a preferred measure.
7 Relationships MP & AP When MP > AP; AP curve is increasing. When MP < AP, AP curve is decreasing. When MP = AP, AP curve is at maximum. MP & MC When, MP MC. When MP MC. When MP is at maximum MC is at its minimum. MC & AVC MC < AVC; AVC is decreasing. MC > AVC; AVC is increasing. 3.2.2 Marginal Returns & Productivity Increasing marginal return occur when. with L units. > Diminishing marginal product or law of diminishing marginal productivity: All else constant, Marginal product of an input declines when additional units of a variable input are added to fixed inputs. Profit maximization guideline: profit is maximum where = Least-cost optimization rule: = If > employ more labor. If > employ more physical capital. In short, firms prefer to use input with higher ratio to the input with lower ratio, when it increases production. Level of output at which profit is maximized: Profit is maximized when: = (or) MRP = MP of an input unit Price of the product. When; MRP > cost of an input, firm earns profit. MRP < cost of an input, firm incurs loss. Surplus value or contribution = MRP cost of an input.