PRINCIPLE OF ECONOMIC
6 EDITION
KARL CASE, RAY FAIR
PRENTICE HALL BUSINESS PUBLISHING
COPY RIGHT 2002
The Concept of Profit
•
Profit
is the difference between total revenue and total cost.
•
The economic concept of profit takes
into account the opportunity cost of capital.
•
Total economic cost includes a normal
rate of return. A normal rate of
return is the rate that is just sufficient to keep current investors
interested in the industry.
•
Breaking even
is a situation in which a firm is earning exactly a normal rate of return.
Maximizing Profit–An Example
•
If Blue Velvet washes 800 cars each
week, it takes in revenues of $4,000.
•
This revenue is sufficient to cover both
fixed costs of $2,000 and variable costs of $1,600, leaving a positive economic
profit of $400 per week.
Firm Earning Positive Profits in the Short Run
•
To maximize profit, the firm sets the
level of output where marginal revenue equals marginal cost.
Firm Earning Positive Profits in the Short Run
•
Profit is the difference between total
revenue and total cost.
Minimizing Losses
•
Operating profit (or loss)
or net operating revenue equals total revenue minus total
variable cost (TR – TVC).
•
If revenues exceed variable costs,
operating profit is positive and can be used to offset fixed costs and reduce
losses, and it will pay the firm to keep operating.
•
Operating profit (or loss)
or net operating revenue equals total revenue minus total variable
cost (TR – TVC).
•
If revenues are smaller than variable
costs, the firm suffers operating losses that push total losses above fixed
costs. In this case, the firm can
minimize its losses by shutting down.
Long-Run Costs:
Economies and Diseconomies of Scale
•
Increasing returns to scale,
or economies of scale, refers to an increase in a firm’s scale of
production, which leads to lower average costs per unit produced.
•
Constant returns to scale
refers to an increase in a firm’s scale of production, which has no effect
on average costs per unit produced.
•
Decreasing returns to scale
refers to an increase in a firm’s scale of production, which leads to higher
average costs per unit produced.
The Long-Run Average Cost Curve
•
The long-run average cost curve
(LRAC) is a graph that shows the different scales on which a firm can
choose to operate in the long-run. Each
scale of operation defines a different short-run.
Short-Run Profits: Expansion to Equilibrium
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The existence of positive profits will
attract new entrants to an industry.
•
As capital flows into the industry, the
supply curve shifts to the right, and price falls.
•
Firms will continue to expand as long as
there are economies of scale to be realized, and new firms will continue to
enter as long as positive profits are being earned.
Short-Run Profits: Contraction to Equilibrium
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As long as losses are being sustained in
an industry, firms will shut down and leave the industry, thus reducing supply.
•
As this happens, price rises.
•
This gradual price rise reduces losses
for firms remaining in the industry until those losses are ultimately
eliminated.
Long-Run Equilibrium in Perfectly Competitive Output
Markets
•
Whether we begin with an industry in
which firms are earning profits or suffering losses, the final long-run
competitive equilibrium condition is the same.
•
In the long-run, equilibrium price (P*)
is equal to long-run average cost, short-run marginal cost, and short-run
average cost. Profits are driven to
zero.
The Long-Run Adjustment Mechanism
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The central idea in our discussion of
entry, exit, expansion, and contraction is this:
•
In efficient markets, investment capital
flows toward profit opportunities.
•
The actual process is complex and varies
from industry to industry.
•
The central idea in our discussion of
entry, exit, expansion, and contraction is this:
•
Investment—in the form of new firms and
expanding old firms—will over time tend to favor those industries in which
profits are being made, and over time industries in which firms are suffering
losses will gradually contract from disinvestment.
Internal Versus External Economies of Scale
•
Economies of scale that are found within
the individual firm are called internal economies of scale.
•
External economies of scale
describe economies or diseconomies of scale on an industry-wide basis.
The Long-Run Industry Supply Curve
•
The long-run industry supply curve
(LRIS) traces output over time as the industry expands.
•
When an industry enjoys external
economies, its long-run supply curve slopes down. Such an industry is called a decreasing-cost
industry.
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