Profit, Total Revenue, Total Cost

1
Profit, Total Revenue, Total Cost

• Profit Total Revenue - Total Cost
• Accounting Profit Total Revenue - Explicit
  Costs
• Economic Profit Total Revenue - (explicit and
  implicit cost)
• Normal Profit - A level of profit that is just
  sufficient to maintain ownership.
• Total Cost Explicit Implicit Costs
• Total Cost - explicit payments to the factors of
  production plus the opportunity cost of the
  factors provided by the owner of the firm.
• Remember, total cost includes the owners wage,
  or a normal rate of return to the owner.

2
The Firm Basics

• Historically the firm has been treated as a black
  box.
• Factors of Production gtgtgtgtgtgtgtgt gtgtgtgtgtgtgt Goods
  and Services
• Firm - an economic institution that transforms
  factors of production into goods and services.
• The actions of firms include the following
• Organizes factors of production
• Produces goods
• Sells produced goods to individuals, businesses,
  or government
• Firms replaces the free market with command and
  control.
• Why do Firms Exist?
• The Alchian and Demsetz Answer
• Sum of production of a team of individuals gt Sum
  of independent individuals production (i.e.
  economies of scale)
• Adam Smith and the pin factory

3
Shirking of Workers

• Shirking - the behavior of a worker who is
  putting forth less than the agreed to effort.
• How do firms discourage shirking?
• The role of management. Refer to the next slide.
• Efficiency Wages
• Why would firms pay efficiency wages? In other
  words, why do higher wages elicit higher
  productivity.
• a. The Gift exchange hypothesis
• b. Worker turnover
• c. Worker quality

4
The Role of Management

• How do firms prevent the manager from shirking?
  Make the manager a residual claimant.
• Residual claimant - persons who share in the
  profits of the firm.
• What is the primary role of the manager?
• To prevent shirking, which limits the production
  of the firm.
• In essence, employees employ the manager to raise
  the return to the firm.
• Implications If the manager is poor, employees
  will leave. If the returns of the firm do not
  accrue to the employees, the employees will
  leave.
• Remember, the labor market is like any other
  market. Exchange takes place by both parties
  because benefits exceed the costs.

5
The Objectives of Management

• Managers seek to maximize utility (A.A. Berle and
  Gardner Means)
• Focus of these authors is on the separation of
  ownership and management, which arose due to the
  rise of the corporation.
• How would this impact market behavior? Studies
  have shown that managerial control is less
  profitable than owner control. Managers are
  more risk adverse, due to an inability to
  diversify.
• A related view.... Managers seek to satisfice
  (Richard Cyret, James March and Herbert Simon)
• In this class we assume that firms seek to
  maximize profits. This is a simplification.
• WHY DO WE NEED TO ANSWER THIS QUESTION? We need
  to know the motivation of the people we study.

6
The Short-Run

• Long-run - a firm chooses among all possible
  production techniques
• Short-run - the firm is constrained in regard to
  what production decisions it can make.
• Short run - the longest period of time during
  which at least one of the inputs used in a
  production process cannot be varied.
• Typically a firm can vary labor in the short-run,
  while capital and land are fixed.
• Hence firms are constrained by the Law of
  Diminishing Returns.

7
The Law of Diminishing Returns

• Law of Diminishing Returns - As the amount of a
  variable input is increased, holding all else
  constant, the rate of increase in output will
  eventually decline.
• Law of Diminishing Marginal Productivity - as
  more and more of a variable input is added to an
  existing fixed input, eventually the additional
  output one gets from that individual input is
  going to fall.
• The Law of Diminishing Returns is the foundation
  on which we build our discussion of short-run
  cost and production.

8
The Stages of Production, Marginal Product, and
Average Product

• Stages of Production
• Increasing Returns
• Decreasing Returns
• Negative Returns
• Marginal product - the additional output that
  will be forthcoming from an additional worker,
  other inputs constant.
• The change in total product that occurs in
  response to a unit change in a variable input
  (ceteris paribus).
• The amount of output produced by the last unit of
  the input hired.
• Change in total product / Change in an input
• Slope of the total product curve
• Rate of change in total product
• Average Productivity - output per worker.
• Total product / Inputs hired
• Average Product is Maximized AP MP

9
On the Hiring of Workers

• Why do firms hire workers? Return to Cost-Benefit
  Analysis
• Cost The wage the worker is paid. This is
  generally set in the market, not by the firm.
• Benefit The productivity of the worker
  (marginal product) the value of this
  productivity in the market place (price)
• Value Marginal Product Marginal Product of
  Labor Price of Output
• Relevant when the firm has no control over market
  price.
• Marginal Revenue Product Marginal Product of
  Labor Marginal Revenue of Output
• Relevant when the firm has some control over
  market price.

10
Profit Maximizing Hiring

• If W gt MRP What action should the firm take?
• If W lt MRP What action should the firm take?
• The firm will maximize profits with respect to
  the hiring of workers when W MRP
• In what stage of production, then, do firms
  operate? Only in stage two.
• In stage one, increases in the labor force will
  increase the MRP. If it made sense to hire the
  previous workers, and the next worker offers a
  higher MRP, then it makes sense to hire the next.
  Hence firms will not stop hiring workers in
  Stage One.

11
More History

• History of marginal productivity theory The work
  of J.B. Clark
• J.B. Clark (1847-1938) The first American
  economist to contribute to the history of
  economic thought.
• Ethical implications of Marginal Productivity
  Theory Labor, Capital, and Land are paid
  according to their economic contribution to the
  social product. Therefore analysis contending
  that labor is exploited are naive.
• Critique of Clarks position
• Violation of Humes Dictum That what ought to
  be cannot be derived from what is (i.e.
  normative statements cannot be derived from
  positive statements, or in other words, what a
  person should earn is not relative to what the
  person does earn).
• Conclusion depends upon perfectly competitive
  goods and/or factor markets.
• How do you measure a workers marginal product?

12
Measuring MRP

• Joan Robinson (1933) What is actually meant by
  exploitation is usually that the wage is less
  than the marginal revenue product.
• In most industries the measure of MRP is
  difficult. Sports are the exception.
• The Gerald Scully approach
• i. Estimate the value of a win.
• Revenue f(wins, ...)
• ii. Estimate the value of the players actions in
  terms of wins.
• Wins f(player and team statistics)
• iii. Compare a players estimated MRP to the
  players wage.
• The Anthony Krautman approach
• If the market is competitive..... Salary MRP
• Salary f(player statistics)
• From this we can learn the value of a players
  statistics and thus analyze the value of non-free
  agents.

13
Short Run Total Costs

• Fixed input - an input whose quantity cannot be
  changed as output changes in the short run.
• Variable input - an input whose quantity can be
  changed as output changes in the short-run.
• Total Costs Fixed Costs Variable Costs
• Fixed costs - costs that are spent and cannot be
  changed in the period of time under
  consideration.
• costs of production that do not change as output
  change (i.e. land and capital)
• Variable costs - costs of production that change
  as output changes (i.e. labor and raw materials)

14
Marginal Cost and Average Cost

• Marginal Cost - the increase in total cost
  associated with a one-unit increase in
  production.
• Change in total cost / Change in output
• Slope of the total cost curve
• Rate of change in total cost
• Average Total Cost Total cost / quantity that
  is produced
• Average Total Cost Average Fixed Cost Average
  Variable Cost
• Minimum Average Total Cost represents the
  cheapest (in terms of per-unit costs) point of
  production.
• ATC is minimized ATC MC

15
Summarizing Total Cost

• TC FC VC
• ATC TC/Q
• ATC AFC AVC
• MC change in TC/change in q
• BE ABLE TO COMPLETE COST TABLE!!!
• Production, Total Cost and Marginal Cost
• The Law of Diminishing Returns tells us that as
  labor increases, output will increase eventually
  at a diminishing rate.
• If additional labor is less productive, than
  total cost will be increasing at an increasing
  rate.
• Hence, marginal cost, after diminishing returns
  has set in, increases as output increases.
• We are now able to complete our picture of the
  firm.

16
The Law of Demand
Law of Diminishing Returns

• Total Cost and Output
• Marginal Cost and Average Cost
• AVERAGE COST
• MINIMIZING LEVEL OF
• OUTPUT

• Price and Output
• via Own-Price Elasticity
• Total Revenue and Output
• Marginal Revenue and Output
• REVENU E MAXIMIZING LEVEL
• OF OUTPUT

Profit Total Revenue Total Cost Marginal
Profit Marginal Revenue Marginal Cost PROFIT
MAXIMIZING LEVEL OF OUTPUT
17
Profit Maximization vs. Average Cost Minimization

• The profit maximizing rule gtgtgtgtgt MR MC Why?
• If MR gt MC profit will rise
• If MR lt MC profit will decline
• When MR MC then profit will be maximized.
• What is the elasticity of demand when profit is
  maximized?
• Average cost is minimized when ATC MC.
• What is the significance of the average cost
  minimizing level of output? This is the most
  efficient level of production in the short-run,
  but not necessarily profit maximization.

18
The Long-Run

• How does a firm decide to expand production?
  Profit maximizing output gt average cost
  minimizing output.
• Expanding productive facilities moves the firm
  from the short-run to the long-run.
• Long run - the shortest period of time required
  to alter the amounts of all inputs used in a
  production process.
• A period of time long enough for all inputs to be
  varied.

19
Economies of Scale

• Economies of scale - reductions in the minimum
  average cost that come about through increasing
  plant size.
• specialization of labor.
• more efficient yet larger equipment.
• greater volume of output increase efficiency from
  learning.
• Constant returns to scale - increases in plant
  size do not affect minimum average cost.
• Diseconomies of scale - increases in plant size
  increase minimum average cost.
• supervision of workers more difficult (morale
  declines).
• lengthening of the managerial chain leads to
  disorganization.
• Long run average total cost is a summary of our
  best short-run cost possibilities.

20
Economic Efficiency

• Technical efficiency - as few inputs as possible
  are used to produce a given output.
• Economic efficiency - the method that produces a
  given level of output at the lowest possible
  cost.
• Economic efficiency is achieved when the amount
  of productivity received from each input per
  dollar spent is equal.
• Note The production of many goods does not
  follow a fixed recipe. How does the firm choose
  the inputs to use in production?
• MP1/P1 MP2/P2 ....... MPn/Pn
• WHY IS THIS IMPORTANT? TO MAXIMIZE PROFITS YOU
  MUST COST MINIMIZE.
• HOWEVER, COST MINIMIZATION DOES NOT NECESSARILY
  MEAN PROFIT MAXIMIZATION.