• To maximise profit firms should produce up to the level of output where?marginal cost (MC)?=?marginal revenue (MR)

Calculations To Demonstrate the Profit Maximisation Rule

Observations

• With the 7th unit of output,?MC = MR?& no additional profit can be extracted by producing another unit
• Up to the 6th unit of output, MC < MR & additional profit can still be extracted by producing an?additional unit
• From the 8th unit of output, MC > MR & the firm has?gone beyond?the profit maximisation level of output
  • It is making a?marginal loss?on each unit produced?beyond the point where?MC = MR

• When calculating costs, Economists consider both the?explicit?and?implicit?costs of production
  • Explicit costs are the costs which?have to be paid?e.g raw materials, wages etc.
  • Implicit costs are the?opportunity costs?of production
    • This is the cost of the next best alternative to?employing the firm's resources
    • E.g. if an investor puts ￡1m into producing bicycles & they could have put it in the bank to receive 5%?interest, then the 5% represents an?implicit cost
  • Implicit costs must be considered as entrepreneurs will rationally reallocate resources when?greater profits?can be made elsewhere
• Profit = total revenue (TR) - total costs (TC)
  • Total costs include explicit and implicit costs
• Normal profit occurs when TR = TC
  • This is also called breakeven
• Supernormal profit occurs when TR > TC
• A loss occurs when TR < TC

Calculations To Demonstrate Profits

Observations

• Supernormal profit?occurs up to the 6th unit of output
• Normal profits?occur at the 7th unit
• From the 8th unit, the firm is making a?loss

• Firms do not always?make a profit?& may endure losses for a period
  • Entrepreneurs often keep firms going in the hope that?market conditions will change?& demand for their products will increase leading to?profitability
  • This raises the question,?'when is it the best time for a firm to shut down?'
• The?shut-down rule?provides the answer by considering both the long-run & short-run periods

The Short-run Shut Down Point

• In the?short-run, if the selling price?(average revenue) is higher than the average variable cost (AVC), the firm should keep producing (AR > AVC)
  • If the selling price (AR) falls to the AVC it should shut down (AR = AVC)

A firm should shut down in the short-run if the selling price (AR) is unable to cover the AVC

Diagram analysis

• The firm produces at the?profit maximisation level of output (Q)?where MC=MR
• At this level, the P = AVC
  • This means that there is no?contribution?towards the firm's?fixed costs
    • The selling price literally only covers the?cost of the raw materials?used in production
    • There is no point in continuing production &?the firm should shut down

The Long-run Shut Down Point

• In the?long-run, if the?selling price (AR) is higher than the average cost (AC)?the firm should remain open (AR > AC)
  • if the selling price (AR) is equal to or lower than the average cost (AC), the firm should shut down (AR = AC)

A firm should shut down in the long-run if the selling price (AR) is unable to cover the AC

Diagram analysis

• The firm produces at the?profit maximisation level of output (Q)?where MC=MR
• At this level,?P < AC
  • It could continue operating in the?short-run?as the AR > AVC, but in the?long-run?they are making a loss & the firm will shut down