Production & Profits. Production and Profits Jennifer and Jason run an organic tomato farm Jennifer and Jason run an organic tomato farm The market price.

Production & Profits

Production and Profits• Jennifer and Jason run an organic

tomato farm• The market price of organic tomatoes is

$18 per bushel • Jennifer and Jason are price takers –

they can sell as much as they like at that price

• What is there profit-maximizing level of output by direct calculation?

Production and Profit• Total Revenue = P x Q• Profit = TR – TC• Profit is maximized at an output of 5

bushels, where profit is equal to $18

Marginal Analysis & Profit-Maximizing Quantity of Output

• Marginal Analysis is when the optimal amount of an activity is the level at which marginal benefit is equal to marginal cost

• To apply to profit-maximization: considering the effect on a producer’s profit of increasing output by one unit

• Marginal revenue is the change in total revenue generated by an additional unit of output


• Marginal revenue formula:

MR = ∆TR/∆Q


• Jennifer and Jason can maximize their profit by producing bushels up to the point at which the marginal revenue is equal to marginal cost

• Producer’s optimal output rule: profit is maximized by producing the quantity at which the MR of the last unit produced is equal to its marginal costMR = MC at the optimal quantity of output



• The net gain being negative in the 6th and 7th bushels illustrates another rule:

• Price-taking firm’s optimal output rule – a price taking firm’s profit is maximized by producing the quantity of out put at which the market price is equal to the marginal cost of the last unit produced

• P = MC at the price-taking firm’s optimal quantity of output


• Really, the price-taking firm’s optimal output rule is just an application of the optimal output rule to the case of a price-taking firm

• WHY?• In the case of a price-taking firm,

marginal revenue is equal to the market price

The Price-Taking Firm’s Profit-Maximizing Quantity of Output

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Price, cost of bushel

Quantity of tomatoes (bushels)

MC

MR = PE

Profit-maximizing quantity

Optimal point

Market price

The marginal revenue curve shows how marginal revenue

varies as output varies


• Are all price-taking firm’s production decision summed up as “produce up to the point where marginal cost of production is equal to the price?”

• NO!• Before you apply Marginal Analysis to

determine how much to produce, a producer must answer an “either-or” question—should it produce at all?

When is Production Profitable?

• Economic profit is the measure based on the opportunity cost of resources used in the business

• To calculate economic profit, a firm’s total cost incorporates the implicit cost (benefits forgone in the next best use of the firm’s resources) as well as explicit cost incurred by the firm


• What determines if Jennifer and Jason’s farm earns a profit or generates a loss?• Whether the market price of organic

tomatoes is more or less than the farm’s minimum average total cost

Calculation of short-run AVC and short-run ATC**short-run due to all variables are

fixed costs**

Costs and Production in the Short Run

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$30

18

14

MC

ATC

MR = PCBreak

even price

Minimum-cost output



Minimum average total cost


• Profit is equal to total revenue minus total cost, TR-TC:

• If TR > TC, the firm is profitable.

• If TR = TC, the firm breaks even.

• If TR < TC, the firm incurs a loss.

When is Production Profitable?• Also can express this in terms of revenue and

cost per unit of output• Divide profit by number of units of output, Q:

Profit/Q = TR/Q – TC/Q• TR/Q is average revenue (market price)• TC/Q is average total cost

Profitability and the Market Price

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MC

Profit ATCMR= P

C Z

E

Market Price = $18

1414.40

$18




Break even price

Area of the shaded rectangle shows Jennifer and Jason’s total profit when market price is $18. Can be expressed:

Profit = TR – TC = (TR/Q – TC/Q) x QOr

Profit = (P – ATC) x Q


76543210

MC

Loss

ATC

MR = PC

A

Y

Market Price = $10

14

10

$14.67




Break even price


• How does a producer know, in general, whether or not its business will be profitable?

• Need to compare the market price to the producer’s minimum average total cost


76543210

MC

Loss

ATC

MR = PC

A

Y

Market Price = $10

14

10

$14.67




Break even price

For Jennifer and Jason, minimum average total cost ($14) occurs at an output quantity of 4 bushels.

Whenever market price exceeds minimum average total cost, the producer can find some output level for which

the average total cost is less than the market price.

If the market price is less than minimum average total cost, there is not output level at which price exceeds

average total cost. Due to this, the firm will be unprofitable at any quantity of output.


• Minimum average total cost of a price-taking firm is its break-even price–The price at which it earns zero profit

(called economic profit)–At firm will earn positive profit when the

market price is above the break-even price and it will suffer losses when the market price is below the break-even price

Profitability and the Market Price • Rules determining whether a producer of a good is

profitable depends on a comparison of the market price of the good to the producer’s break-even price:

1. Whenever market price exceeds minimum average total cost, the producer is profitable.

2. Whenever the market price equals minimum average total cost, the producer breaks even.

3. Whenever market price is less than minimum average total cost, the producer is unprofitable.

Production & Profits Notes

Production and Profit• Total Revenue =• Profit =• Profit is maximized at an output of 5

bushels, where profit is equal to $18


• Marginal Analysis is

• To apply to profit-maximization: considering the effect on a producer’s profit of increasing output by one unit

• Marginal revenue is the change in total revenue generated by an additional unit of output


• Marginal revenue formula:


• Jennifer and Jason can maximize their profit by producing bushels up to the point at which the marginal revenue is equal to marginal cost

• Producer’s optimal output rule:



• The net gain being negative in the 6th and 7th bushels illustrates another rule:

• Price-taking firm’s optimal output rule –

• P = MC at the price-taking firm’s optimal quantity of output


• Really, the price-taking firm’s optimal output rule is just an application of the optimal output rule to the case of a price-taking firm

• WHY?• In the case of a price-taking firm,

marginal revenue is equal to the market price

The Price-Taking Firm’s Profit-Maximizing Quantity of Output

76543210

$24

201816

12

86



MC

MR = PE

Profit-maximizing quantity

Optimal point

Market price


• Are all price-taking firm’s production decision summed up as “produce up to the point where marginal cost of production is equal to the price?”

• NO!• Before you apply Marginal Analysis to

determine how much to produce, a producer must answer an “either-or” question—should it produce at all?


• Economic profit is the measure based on the opportunity cost of resources used in the business

• To calculate economic profit,


• What determines if Jennifer and Jason’s farm earns a profit or generates a loss?• Whether the market price of organic

tomatoes is more or less than the farm’s minimum average total cost

Calculation of short-run AVC and short-run ATC**short-run due to all variables are

fixed costs**

Costs and Production in the Short Run

76543210

$30

18

14

MC

ATC

MR = PCBreak

even price

Minimum-cost output





• Profit is equal to total revenue minus total cost, TR-TC:

• If TR > TC,

• If TR = TC,

• If TR < TC,

When is Production Profitable?• Also can express this in terms of revenue and

cost per unit of output• Divide profit by number of units of output, Q:

• TR/Q is average revenue (market price)• TC/Q is average total cost


76543210

MC

ATCMR= P

C Z

E

Market Price = $18

1414.40

$18




Break even price


76543210

MC

ATC

MR = PC

A

Y

Market Price = $10

14

10

$14.67




Break even price


• How does a producer know, in general, whether or not its business will be profitable?

• Need to compare the market price to the producer’s minimum average total cost


76543210

MC

ATC

MR = PC

A

Y

Market Price = $10

14

10

$14.67




• Minimum average total cost of a price-taking firm is its break-even price–The price at which it earns zero profit

–At firm will earn positive profit when the market price is above the break-even price and it will suffer losses when the market price is below the break-even price

Profitability and the Market Price • Rules determining whether a producer of a good is

profitable depends on a comparison of the market price of the good to the producer’s break-even price:

1. Whenever market price exceeds minimum average total cost,

2. Whenever the market price equals minimum average total cost,

3. Whenever market price is less than minimum average total cost,

Production & Profits. Production and Profits Jennifer and Jason run an organic tomato farm Jennifer and Jason run an organic tomato farm The market price.

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