Eco 101

Lecture Notes

           Revenue, Costs, and Profit
Marginal Analysis of Revenue and Costs

Economic Profit

Profit = Total Revenue - Total Costs
          =    TR  -  TC
Total Revenue  =  Price  x  Quantity Sold
                TR    =   P x Q
Total Costs = Opportunity costs of all factors of production: land, capital, labor and other inputs supplied by the firmís owner(s)

Economic Profit versus Business Profit
Economic Costs =Explicit costs + Implicit Costs

Economic Profit = T. Revenue -T. Economic Costs
                           =TR- Explicit Costs-Implicit Costs

Business Profit = T. Revenue -Explicit Costs

=>We expect:  Bus. Profit > Economic Profit

Total Revenue and Demand Curve
Consider the following two cases:

Note that in the diagram on the left with a horizontal demand curve the revenue increases at a constant rate (price) as the output increases. In the case of a downward-sloping demand curve, however, as the quantity increases, total revenue increases first reaches a maximum and then starts falling.


Recall that we defined a firmís short-run total costs as:

     Total Cost = TFC + TVC

Now we can define economic profit:

    Profit = Total Revenue - Total Cost
    Profit =      TR     -      TC

Total Revenue and Total Costs

         The Case of a Horizontal Demand Curve        The Case of a Downward-Sloping Demand Curve

The vertical (linear) spread between the TC curve and the TR curve measures the profit.

Profit Determination: A Marginal Approach
As a firm increases its output, both its revenue and costs increase. That will result in changes in its profit.
Change in Profit = Change in Revenue + Change in Costs
If the firm changes its output one unit at a time,
Change in Profit =  Marginal Revenue - Marginal Cost
Marginal Revenue(MR): Change in total revenue resulting from producing one additional unit of output.
Marginal Cost(MC): Change in total cost resulting from producing one additional unit of output
Profit: A Marginal Approach
If  change in total revenue > change in total cost,
                      MR       >         MC

==>  Change in profit will be positive

==> Profit will increase

==> The firm will stop increasing output when
                       MR    =      MC
Marginal Revenue and Marginal cost

Note that on the left side of the crossing between marginal revenue and marginal cost MR>MC.
That means increases in the output will increase the profit. On the right side of the crossing between MR and MC, MR<MC; increases in the output will result in reductions in the profit.

Revenue, Costs, and Profit
Profit = TR - TC            Profit= Q(P-ATC)
In the table below, assuming a horizontal demand curve (fixed price), a firm's profits have been calculated for different levels of output.


Revenue, Costs, and Profit: The Case of a Downward-Sloping Demand Curve

The case of downward-sloping demand curve:     Marginal Revenue, ATC, AVC, MC

The case of downward-sloping demand curve:     Marginal Revenue, ATC, AVC, MC


The Firm Under Perfect Competition

Perfect Competition
Many firms and many buyers
A homogenous product
Free entry and exit
Perfect information

=>The demand curve facing the firm under perfect
     competition is horizontal: perfectly elastic.
=>A perfectly competitive firm is a price taker.
Profit Maximization Under Perfect Competition
Profit Maximization in the Short Run
                       MC = P = MR (=AR)
         TR    P . Q
Recall: AR = -------  =  ---------  =   P
         Q               Q
   Under perfect competition a firm is a price taker:
   To maximize its profit in the short run a perfectly competitive firm (facing a given market price) sets its short-run marginal cost  equal to the price.

Revenue, Costs, and Profit
Short-Run Equilibrium

The Shutdown Price

Marginal Cost and the Supply Curve
A firm's short-run supply curve: The segment of the marginal cost above AVC.

The Industryís Supply Curve


Profit under Competitive Conditions


The Long-Run Behavior of a Firm Under Competition


Long-Run Equilibrium under Competition