Home Page Econ 14 Files Econ 14 Lecture Notes Lecture 20: Profit Maximization

|  Search

Economics 14

Lecture 20 - Profit Maximization

accounting vs. economic profit
demand curve facing the firm
barriers to entry

Accounting vs. Economic Profit

Assume that firms behave so as to maximize profits. Profits are equal to the firm's total revenue minus its total costs. Total cost includes the opporunity cost of capital.

Economic Profit = Accounting profit - opportunity cost of capital

Accounting profit consists of the firm's revenues less its direct, out-of-pocket costs. However, the funds 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 called the opportunity cost of capital. This opportunity cost is part of the costs of doing business 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 called 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.

Remember that from now on, costs always include the opportunity costs of capital and that profits always means economic profits.

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.

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. One barrier to entry is fixed or sunk costs. These are costs which must be paid before any output is even produced.

• Airlines have huge fixed costs. An airline must lease planes, gtes at airports, and landing rights. They must tie into a computerized reservation system, and so on. These high fixed 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.

David A. Latzko Business and Economics Division Pennsylvania State University, York Campus office: 13 Main Classroom Building phone: (717) 771-4115 fax: (717) 771-4062 DXL31@psu.edu www.yk.psu.edu/~dxl31