Short Run Long Run
Rules for Profit Maximization
Profit-maximizing rules consist of:
The profit-maximizing level of output occurs where the difference between total revenue (TR) and total cost (TC) is greatest.
The profit-maximizing level of output is also characterized by the condition where Marginal Revenue (MR) equals Marginal Cost (MC).
For perfectly competitive firms, an additional rule applies:
The profit-maximizing level of output is also where Price (P) equals Marginal Cost (MC).
These rules apply universally to all firms, irrespective of the market structure.
Illustrating Profit or Loss on the Cost Curve
To exhibit a firm's profit or loss on a cost curve graph:
Recall that profit is defined as:
Profit = TR - TC
Where Total Revenue (TR) is calculated as Price (P) times Quantity (Q): TR = P × Q
To rewrite the profit formula, manipulate it:
Divide both sides by Q gives: Profit/Q = (P - TC/Q)
Multiply both sides by Q gives: Profit = (P - ATC) × Q
This represents profit graphically as an area of a rectangle with height (P - ATC) and length Q.
Steps to Maximizing Profit
Five Steps for Profit Maximization:
Find where MR = MC.
Determine the optimal quantity (Q).
Establish the optimal price (P).
Calculate the Average Total Cost (ATC).
Compute total profit.
Competitive Firm Earning Profits
The formula for profit is represented as:
Profit = (P - ATC) × Q
Example 3: Amari’s Profit Calculation
Given data for calculation:
Profit = TR - TC
Using the profit formula:
Profit = (P - ATC) × Q
Example: Profit = (20 - 15) × 7
Profit = 5 × 7 = $35
Total Revenue Calculation:
TR = P × Q = 20 × 7 = $140
Total Cost Calculation:
TC = ATC × Q = 15 × 7 = $105
Profit Calculation Recap:
Profit = TR - TC = 140 - 105 = $35
Active Learning 2: Identifying a Firm's Profit
Task: Determine total profit for a given firm.
Steps involved:
Identify Total Revenue (TR) and Total Cost (TC).
Calculate profit or loss from the derived figures.
Visually identify the profit or loss area on a provided graph.
Normal Profits
Definition of normal profits:
Normal profits are equivalent to zero economic profits, occurring when P equals ATC.
Profit Maximization Recap
Formulas and principles regarding profit maximization:
Total Profit = TR - TC
If MR > MC, increase output.
Profit maximization occurs at MR = MC.
Measuring profit per unit: Profit per unit = P - ATC.
Firm’s profit or loss status:
If P > ATC, the firm earns a profit.
If P < ATC, the firm incurs a loss.
Shutdown vs. Exit
Definitions and key differences:
Shutdown: A short-run decision by a firm to cease production due to market conditions but still incurs fixed costs (FC).
Exit: A long-run decision to withdraw from the market, where the firm incurs zero costs.
Firm's Short-run Decision to Shut Down
Analyzing costs associated with shutting down:
Cost of shutting down represented as revenue loss from TR.
Benefit of shutting down reflects cost savings in Variable Costs (VC), while Fixed Costs still incur.
Condition to shut down:
Shut down if TR < VC
Equivalent to:
TR/Q < VC/Q
Decision rule: Shut down if P < AVC.
Firm’s Short-run Supply Curve
Definition and behavior of a firm's short-run supply curve:
The short-run supply curve is the portion of the MC curve above AVC.
Implications based on price thresholds:
If P > AVC, the firm produces where P = MC.
If P < AVC, the firm shuts down (producing Q = 0).
Shutdown Points
Critical price point for shutdown:
When price drops below $65 (the minimum point on AVC), losses exceed fixed costs leading to a shutdown condition.
Short-run Supply Curve Explained
A firm's short-run supply curve is derived from its marginal cost curve above the minimal AVC point.
Market Supply Curve Dynamics
Description of the firm's interaction in the market:
Illustrates how firms interact in the market based on supply dynamics and pricing.
For instance, if there are 1000 identical firms, total market supply at any price is the number of firms multiplied by one firm's quantity at that price.
Firm’s Long-Run Decision to Exit
Costs and considerations for exiting the market:
The exit incurs a revenue loss equating to TR.
The benefit of exit is the cost saving from TC, where zero fixed cost applies in the long run.
Therefore, a firm chooses to exit if TR < TC, reformulated to the decision rule:
Exit if P < ATC.
Long Run Supply Curve Considerations
Assumptions for the long-run supply curve:
All firms have identical costs.
Firms' costs remain unchanged, irrespective of market entry or exit.
Number of firms is fixed in the short run (due to fixed costs) and variable in the long run (thanks to free entry/exit).
Long-term Market Dynamics
Response of market equilibrium to demand shifts:
If demand increases, leading to higher prices, firms may experience short-run profits.
Over time, this may induce new firms to enter the market, increasing supply and consequently reducing prices until long-run equilibrium is restored.
Long-Run Market Supply Dynamics
In the long run, typical firms earn zero economic profit, controlled at the level where price equals minimum ATC:
P = min. ATC
The long-run market supply curve can be depicted as horizontal at this point of price and cost equality.
Long-Run Competitive Equilibrium
Long-run equilibrium is achieved when firms face no incentive to enter or exit due to zero economic profit:
Zero economic profit occurs at the equality of P and ATC.
Since firms produce where P = MR = MC, zero profit condition can be summarized as:
P = MC = ATC at long-run equilibrium, especially where the marginal cost intersects with minimum ATC.
Zero Economic Profit in the Long Run
The phenomenon of zero economic profit in the long run is noted:
Recall that zero economic profit equates to normal profit, which may still encompass substantial accounting profit.
Active Learning Recap
Task for analysis:
For various prices on the graph, identify:
Profit-maximizing quantities.
Indicate if the firm suffers a profit or loss.
Evaluate if the firm should continue production or shut down in the short run.
Identify which price-quantity combination reflects a long-run equilibrium.