Profits

Unit 7 - Lesson 5
Learning objectives:
● Define terms in orange bold in section 7.2. (AO1)
● Explain cost, revenues and profit concepts. (AO2)
○ Total Revenue (TR), Marginal Revenue (MR) and Average Revenue (AR)
● Explain a rational producers profit maximizing output using:
○ Total Cost and Total Revenue Approach
○ Marginal Cost and Marginal Revenue Approach
● Calculations from data of Total Revenue (TR), Marginal Revenue (MR) and
Average Revenue (AR). (AO4)
Profits
Standard economic theory assumes firms act in a rational manner and attempt to
maximize their profits.

The profit a firm makes is the sum of all revenues earned minus the cost (fixed
plus variable) to produce the good.

Profit = Total Revenue (TR) minus Total Cost (TC)

Profit for an economist is:

Profit = Total Revenue (TR) minus Total Cost (explicit plus implicit costs)
Profit Maximization - Total Revenue/Total Cost Approach

Profit Maximization involves the firm deciding the level of output to produce where the
profit made is as large as possible.

When firms costs are greater than their revenues the firm will make a loss. A firm can
sustain a loss for a period of time before it has to shut-down.

In this case a firm will look to produce an output where the loss made by the firm is the
least - loss minimization.

Two approaches to analyzing profit maximization:

1. Total Revenue - Total Cost Approach

2. Marginal Revenue - Marginal Cost Approach
Profit Maximization - Total Revenue/Total Cost Approach
There is a possibility of three outcomes for a firm:
1. Abnormal (Economic) Profit
a. Abnormal Profit = Total Revenue is greater than Total Cost
2. Normal (Zero Economic) Profit
a. Normal Profit = Total Revenue is equal to Total Cost
3. Economic Loss
a. Economic Loss = Total Revenue is less than Total Cost
Firm’s profit maximizing output is when the vertical distance between total revenue and
total cost is greatest.
Loss minimization level of output is when the vertical distance between total revenue
and total cost is the smallest.
Profit Maximization - Total Revenue/Total Cost Approach
● The graph to the left shows the total
revenue and total cost curves for a
firm with no price making ability (no
market power).
○ We know this because of the linear
total revenue curve.
● Firm’s profit maximizing output is when
the vertical distance between total
revenue and total cost is greatest. .
○ The vertical distance between total
revenue (TR) point A and Total
Cost (TC) point B is the greatest at
Qpm.
○ Qpm is the firm’s profit maximizing
output.
Profit Maximization - Total Revenue/Total Cost Approach
● The graph to the left shows the total
revenue and total cost curves for a firm
with price making ability (market power).
○ We know this because of the shape
of the total revenue curve.
● Firm’s profit maximizing output is when
the vertical distance between total
revenue and total cost is greatest. .
○ The vertical distance between total
revenue (TR) point E and Total Cost
(TC) point F is the greatest at
Qpm.
○ Qpm is the firm’s profit maximizing
output.
Loss Minimization - Total Revenue/Total Cost Approach
● The graph to the left shows the total
revenue and total cost curves for a
firm with no price making ability (no
market power).
○ We know this because of the linear
total revenue curve.
● Firm’s loss minimizing output is when
the vertical distance between total cost
and total revenue is the least. .
○ The vertical distance between total
cost (TC) point C and Total
Revenue (TR) point D is the
smallest at Qlm.
○ Qlm is the firm’s loss minimizing
level of output.
Loss Minimization - Total Revenue/Total Cost Approach
● The graph to the left shows the total
revenue and total cost curves for a firm
with price making ability (market power).
○ We know this because of the shape
of the total revenue curve.
● Firm’s loss minimizing output is when
the vertical distance between total cost
and total revenue is the least. .
○ The vertical distance between total
cost (TC) point G and Total Revenue
(TR) point H is the smallest at Qlm.
○ Qlm is the firm’s loss minimizing
level of output.
Profit Maximization - Marginal Revenue/Marginal Cost

Marginal Revenue
● Additional revenue a firm makes when producing an additional unit of
output.

Marginal Cost
● Additional cost a firm incurs when producing an additional unit of output.

A firm’s profit maximizing output occurs when the marginal cost is equal
to the marginal revenue.
Profit Maximization - MC = MR
Profit Maximization - Marginal Revenue/Marginal Cost
The graph to the right represents a firm
with no market power (ability to influence
price)
● We know this because as output
increases price remains constant.
Point 1:
● Marginal Revenue (MR) is greater
than Marginal Cost (MC)
● For any quantity of output to the left
of point 2 the Marginal Revenue is
greater than the Marginal Cost.
Profit Maximization - Marginal Revenue/Marginal Cost
Point 1:
● When the marginal revenue (MR) is
greater than the marginal cost (MC)
the firm should increase the quantity of
output produced in order to make more
profit.
● Anytime the revenue generated from
an additional unit of output is greater
than the cost to produce it then the
profits of that firm will increase.
● Therefore anytime the marginal
revenue is greater than the marginal
cost the firm should produce more
output to maximize profits.
Profit Maximization - Marginal Revenue/Marginal Cost
Point 3:
● Marginal Revenue (MR) is less than
Marginal Cost (MC)
● For any quantity of output to the right of
point 2 the Marginal Revenue is less than
the Marginal Cost and the firm is making a
loss.
● Any out produced beyond point 2, the firm
is making a loss as the cost to produce an
additional unit of output is greater than the
revenue generated.
● When the marginal revenue (MR) is less
than the marginal cost (MC) the firm should
decrease the quantity of output produced
in order to reduce the amount of loss
incurred from producing additional output.
Profit Maximization - Marginal Revenue/Marginal Cost

Therefore the profit maximizing amount

of output for a firm is at point 2 where the
marginal cost is equal to the marginal
revenue.
● Any quantity to the left of point 2 the
firm is not profit maximizing as the
marginal revenue is greater than the
marginal cost.
● Any point to the right of point 2 the
firm is making a loss when they
produce an additional unit of output.
Profit Maximization - Marginal Revenue/Marginal Cost
The graph to the right represents a firm
with market power (ability to influence
price)
● We know this because as output
increases price decreases.
Point 1:
● Marginal Revenue (MR) is greater
than Marginal Cost (MC)
● For any quantity of output to the left of
point 2 the Marginal Revenue is
greater than the Marginal Cost.
Profit Maximization - Marginal Revenue/Marginal Cost

Point 1:
● When the marginal revenue (MR) is
greater than the marginal cost (MC)
the firm should increase the quantity
of output produced in order to make
more profit.
● Anytime the revenue generated from
an additional unit of output is greater
than the cost to produce it then the
profits of that firm will increase.
● Therefore anytime the marginal
revenue is greater than the marginal
cost the firm should produce more
output to maximize profits.
Profit Maximization - Marginal Revenue/Marginal Cost
Point 3:
● Marginal Revenue (MR) is less than
Marginal Cost (MC)
● For any quantity of output to the right of
point 2 the Marginal Revenue is less than
the Marginal Cost and the firm is making a
loss.
● Any out produced beyond point 2, the firm
is making a loss as the cost to produce an
additional unit of output is greater than the
revenue generated.
● When the marginal revenue (MR) is less
than the marginal cost (MC) the firm should
decrease the quantity of output produced
in order to reduce the amount of loss
incurred from producing additional output.
Profit Maximization - Marginal Revenue/Marginal Cost
Therefore the profit maximizing
amount of output for a firm is at point 2
where the marginal cost is equal to the
marginal revenue.
● Any quantity to the left of point 2 the
firm is not profit maximizing as the
marginal revenue is greater than
the marginal cost.
● Any point to the right of point 2 the
firm is making a loss when they
produce an additional unit of output.
Normal Profit
Normal (Zero Economic) Profit

● Minimum amount of revenue a business must make in order to keep their

business operational.
● Amount of revenue generated must be enough to cover all explicit and
implicit costs associated with the production of the good.
○ Entrepreneurship will also receive a payment as it is a cost associated
with the production of a good.

Therefore if a firm is making normal (zero economic) profit the revenues

generated are enough to cover all explicit and implicit costs associated with
the production of a good including entrepreneurship.