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Microeconomics: Profit

Profit: total revenue minus total cost.

Accounting profit: it exists when the total revenue is greater than the explicit costs of production. Explicit costs are payments made by the firms to others for factors of productions not owned by the firm. 
  • For example, workers are not owned by the firm, and thus, their wages are part of the explicit costs. However, as you have seen, often in economics we include the variable r for rent for capital (machines) even if the machines are owned by the business owner(s). In this case the variable 'r' would not be counted in as being part of the explicit cost.

Economic profit: the amount of revenue is greater than both the explicit and implicit costs of production.
  • One way to find the economic profit is to simply take the accounting profit and subtract the opportunity cost. The opportunity cost is the value of the resources owned by the business owner(s) that they chose to assign to a specific task instead of another. For example, using our previous example, machines could have been sold or rented to another firm instead of producing goods for the firm.
In economics, we say that a firm is earning a normal profit when its economic profit is equal to zero
  • A normal profit for a firm producing good X indicates that other business owners are neither leaving or entering the market for this particular good.
As previously noted, an economic profit is important for signal for other firms to  enter and compete with other firms in the market.
  • if a firm is earning a negative economic profit (economic loss), then the firm will exit the market in the long run.
  • Note that economic graphs show economic profit, not accounting profit. Then, if it appears (on the graph) that the firm is breaking even, it simply indicates that the firm is making a normal profit . 
Profit Maximization:

A firm maximizes its profit when its marginal revenue is equal to its marginal cost. Given that the MC>0 and MR<0 . In general, the TR curve is convex, as the demand is a decreasing curve and the TC curve increases overtime.


Graph:
  • As you can see, as when the firm produces quantity Q0, and Q2 its total revenue is equal to its total cost. Then, at these levels of quantity, the firm is earning a normal economic profit, the firm is breaking even. 
  • As the firm increases its output from Q0 to Q1, the firm is able to maximize the distance between its total revenue and cost. Therefore,  the firm has maximized its profit. Also notice that at this point, the slope of the total revenue curve is equal to the slope of the total cost curve.
It is possible for some firms to not make any profit or break even, under this condition, the firm would try to minimize its losses by making its total revenue and total cost as similar as possible.

Reference: Mayer,David. AP Microeconomics Crash Course. Research & Education Association (2014). p 87-90. 

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