Theory of The Firm – Profit Maximization

Marginal revenue displays the added revenue from each product sold, the reason the line has a negative gradient is the factor that as there is a greater quantity supplied there is a lower price, as the product is less scarce. When marginal revenue crosses the x-axis in a graph it can be noted that every product produced from that point on-wards takes away from revenue.
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Through the understanding of the nature of marginal revenue, we can produce a model curve for a firm’s total revenue. It can be noted that the x-intercept of the marginal revenue graph represents the point at which the total revenue graph is at the peak.

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Marginal cost displays the added cost from each product sold due to the factors of production being employed such as labour, materials, etc. Marginal cost represents all of the variable costs of the firm, and how there is an increase in cost when more is produced. However, average total cost allows us to see what the firm should actually pay for production.

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Average total cost involves the average variable and fixed costs. The curve displayed above is of the average total cost in the short term. The curve is in a negative gradient as long as marginal costs do not exceed the average total cost, the initial negative gradient can be explained as average fixed costs declines as quantity produced increase, as factors such as the factory are becoming more efficient. The reason the gradient increases is because of the greater increase in marginal cost whereas average fixed cost does not radically change to counteract. This is further explained by the law of diminishing marginal returns.

The understanding of average total cost allows us to use the profit maximization point of marginal cost and marginal revenue graph to analyse what the total revenue is and what the total cost is, enabling the actual portion of profit from production.

There are two examples below, the first one display’s firms operating at point of profit making, and the second an example of loss making. Notice the distinct difference between them as the gradient of average revenue or the position of average total cost. As there are a variety of factors present in the positioning and gradients of each curve and line, it is important to look at what are the points to look at for profit maximization The average revenue line is used as it represents the demand curve, and the average total cost curve is used as it represents the operating costs of the term when a given quantity is supplied. This allows revenue to be worked out through price x quantity, where the quantity at profit maximization meets the average revenue line and average total cost curve.

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Introduction to Theory of The Firm

Fixed Costs → do not vary with output
Variable Costs → vary with output

Revenue of a firm is always dependent on the output.

Materials         → Variable Cost (leather, stitching, etc.)
Capital             → Fixed Cost (sewing machines, leather tanner, etc.)
Labour             → Fixed/Variable Cost (depends on type and payment)
Transport         → Fixed Cost (short term)
Marketing        → Fixed Cost (does not vary with output)
Factory            → Fixed Cost (same size, does not vary with output)

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Short Term: The length of time in which one factor of production is fixed (factory determines whether or not the firm operates in the short term or the long term).

Long Term: The length of time over which at least one factor of production becomes variable (i.e. need a new factory to increase output).

The Law of Diminishing Marginal Returns:

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This graph shows how output increases over the initial short term, but in the long term output decreases. This can be explained by several factors, such as there are only so many facilities, employees waiting to use machines, rate of productivity declines as employees may begin chatting to each other or the machinery is now inefficient.

The classic example is “too many cooks in the kitchen”, if the oven is used by one cook the other cook cannot use it, if one cook used all the fish the other cook cannot use it, etc. The limitation of output increases over time due to inherent problems.

If this graph meets the x-axis and goes below it, it identifies the result of less productivity. As at any point below the x-axis adding a greater amount of a factor of production subtracts from the total output.

As a consequence of The Law of Diminishing Marginal Returns:

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Shown above is the example of how adding a unit of labour increases the costs involved in production. The reason marginal cost is at the trough while marginal productivity is at the peak is because the cost of introducing more labour was small in comparison to the increased output. Therefore it can be stated that the cost is counteracted by the increase in output.

This is evident if the following example is given, at one unit of labour 100 baseballs are outputted, as there is an additional unit of labour introduced there is an additional 150 baseballs outputted, this counteracts the cost of hiring the additional unit of labour as the output has increased by 150%.

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For Marginal Revenue it can be noted that as price decreases, quantity increases. This is because for the producer to sell the next good they will have to reduce the price of their good, in the sense of revenue you have to lower the price to sell more. As there is more supply the price drops as the good is less scarce.

Profit Maximisation: This is where Marginal Revenue is equal to Marginal Cost (MR=MC, Q-P)

At point Q1 there is greater marginal revenue then marginal cost, this is still a point of profit but if you stop at point Q1 you forsake possible profit and this is highlighted by the blue triangle. This is why it is worthwhile for the producer to increase one of the factors of production to increase the marginal cost with the goal of reaching the point of profit maximisation.

At point Q2 there is a greater marginal cost whereas, there is less marginal revenue. This point can be seen as equally inefficient as point Q1, as again there is loss represented by the green triangle. However it can be argued that it is better to be on this side as through this you achieve a greater market share, which is a long term interest.

Notes:

Every firm will attempt to reach the point of profit maximisation, the price of the product does not matter to the firm, and the interest is in profit.

Definitions:

Marginal Revenue: The extra revenue that an additional unit of product will bring.

Marginal Cost: The extra cost that an additional unit of product will bring.

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The introduction of average revenue allows the producer to see where the price of the good should be in order for the firm to maximize profit. The average revenue can be identified as demand, and while it is in the interest of the firm to maximize profit the accurate pricing of the good is essential.

Average Revenue: Total revenue per unit of output. When all output is sold at the same price, average revenue will be the same as price.

 

Supply & Demand Review

1. Why does the demand curve slope down from left to right?

The reason the normal demand curve slopes down from left to right, is due to the inversely proportional relationship that price & demand have. The slope exists as it follows the “Law of Demand”, this is because as the price of a product or commodity decreases then the demand increases. There are only two exceptions for the normal demand curve, and they are Giffen Goods & Veblen Goods.

2. Why does the supply curve slope up from right to left?

There is no law that determines that the supply curve should slope up from right to left. The regular supply curve does show a positive relationship between quantity of supply and price. However in accordance to theory as the quantity of supply increases so does the demand. This works because in theory a manufacturer would want to make more of their product if it was to be sold at a higher price, as there can be an increase in the profit margin.

3. Explain, using a diagram, what happens to the demand for ice cream as we move from summer to winter?

In regards to supply, the supply curve will shift to the left as prices will remain the same but the quantity of supply will be reduced. In regards to demand the curve will shift to the left as the changed in demand is due to the seasons changing and ice cream becoming less favourable during the winter. In the diagram below the shift of the equilibrium can be noticed.

 

4. People have a rise in incomes explain with a diagram what will happen to the demand for restaurant meals?

Due to a rise of income, people have a greater effective demand to go out for restaurant meals. The supply will stay the same, as the restaurants won’t necessarily react to a rise of incomes. The demand however will increase, and the price will be similar or higher than before, as people are now able to afford eating in restaurants and the price increase is a reaction to the newly generated demand.

 

 

5. There is an increase in the price of cinema tickets. Using a diagram explain what will happen.

Due to the prices of cinema tickets increasing, there will be excess supply. This is because there is not a given factor to change the supply or demand but the price has been changed. The market will naturally want to go back to the original equilibrium, if there is not another factor introduced to justify the change in price.