Econ 2 Files
Econ 2 Lecture
Notes
Lecture 18: Profit Maximization, Part 1
 |
Economics 2 |
Lecture 18: Profit Maximization, Part 1
accounting vs. economic profits
demand curve facing the firm
barriers to entry
finding profits graphically
Accounting vs. Economic Profits
Economic Profit = Accounting profit - opportunity costs of capital
Accounting profit consists of the firm's revenues less its input costs (its payments to suppliers of factors of production and intermediate goods). However, the funds and time invested in a firm could have been used in some other business. The foregone return on the entrepreneur's funds that could have been used in another business is the firm's opportunity cost of capital. These opportunity costs are part of the costs of doing business (they are the costs of the firm's equity capital) so we subtract it from accounting profits to get economic profit.
A business can earn an accounting profit yet have zero economic profits. This is a normal profit and simply means that the firm earned as much in this line of business as it could have earned in some other line of business. A firm can earn a positive accounting profit but negative economic profits if it could have earned a greater return in some other line of business. This is called negative economic profits. Positive economic profits (or above-normal profits) result when the business earned a greater return in this line of business than it could have earned elsewhere.
A zero economic profit means that the owners could not use their time or money better in any other business. Zero economic profit is a normal profit. The accounting profits in this business are equal to the level of profit that the owners could get in their next best alternative. There is no reason for firms to enter or exit the industry.
A positive economic profit is an above normal profit and attracts new firms into the industry. Firms exit an industry in which they earn a negative economic profit.
Remember that from now on, costs always include the opportunity costs of capital, the costs of the firm's equity capital, and that profits always means economic profits.
Demand Curve Facing the Firm
Economists assume that the goal of firms is to maximize profit. Recall that economic profits are equal to total revenue minus total costs including the opportunity cost of the owner's time and money.
We assume that firms choose the price and quantity produced so as to maximize profits. A firm's choices for the price and quantity produced depend on the environment in which it operates. One important factor is the demand curve facing the firm.
| With perfectly elastic demand the firm has no control over price. It only chooses the quantity to produce. |  |
 | A firm facing a downward sloping demand curve chooses both the price and quantity produced so as to maximize profits. |
| Facing a perfectly inelastic demand curve, the firm only chooses the price since the quantity is determined by how much consumers want. |  |
Firms would prefer to face the most inelastic demand curves possible. Firms can reduce elasticity by reducing the availability of substitutes. One way is to distinguish or differentiate your product from those of your competitors. Differentiation can occur through advertising, price, service, quality, location, et cetera.
Barriers to Entry
A firm's environment not only depends on the demand for its product but also on the ease of entry into the market.
A barrier to entry is anything that makes it difficult or costly for a firm to enter a market. Some barriers to entry are created by the government: patents and copyrighrs, zoning, and licensing are examples. Other barriers to entry are economic in nature. One such barrier to entry are capital costs. These are sunk costs which must be paid before any output is even produced.
- Airlines have huge fixed costs. An airline must lease planes, gates at airports, and landing rights. They must tie into a computerized reservation system, and so on. These high capital costs make it hard for new firms to enter the market. So airlines may make above-normal profits for a long time and can raise prices without fear of immediate new competition.
- Desktop publishing has low fixed costs: just a computer and a printer. It is easy for new firms to enter the market. Therefore, desktop publishers will not make above-normal profits for long.
Economies of scale are also a barrier to entry. New firms will be forced to enter the market as large firms or else face a huge cost disadvantage. Product differentiation, access to distribution channels, and unique resources can also act as barriers to entry.
Finding Profits Graphically
| TR = P x Q = $3.50 x 12 = $42 TC = ATC x Q = $1.50 x 12 = $18 Profits = TR - TC = $42 - $18 = $24 |  |
 |
David A. Latzko Business and Economics Division Pennsylvania State University, York Campus office: 13 Main Classroom Building voice: (717) 771-4115 fax: (717) 771-4062 e-mail: 
web: www.yk.psu.edu/~dxl31 |
 |