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Profit Maximization & Economies of Scale

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Profit Maximization & Economies of Scale Presentation #8: Profit Maximization & Economies of Scale 3 Minute Video on Calculating Profit Maximization 3 minute Video on Economies of Scale Q: If every unit can be sold for $10. Which unit maximizes profit? A: FOUR Q: Why should you should never produce 5 units? A: It costs you more to make the 5th unit (and 6th, 7th, 8th, etc…) than you make selling it Marginal Price Cost $12 Marginal $10 Revenue $8 $6 1 2 3 4 5 Quantity Short-Run Profit Maximization Q: What is the goal of every business? A: To Maximize Profit!!!!!! To maximum profit firms must make the right amount of output Firms should continue to produce until the additional revenue (MR) from each new output is greater than or equals the additional cost (MC). Example: Assume the price is still $10 (MR = $10) Should you produce… if the additional cost of another unit is $5 (MC=$5) 10 > 5…YES if the additional cost of another unit is $9 (MC=$9) 10 > 9…YES if the additional cost of another unit is $11 (MC=$11) 10 < 11…NO Profit Maximizing Rule: MR = MC Short Run Profit Maximization Review Marginal Revenue (MR) = Marginal Cost (MC) = amount received selling one more unit cost of making one more unit Profit Maximization Graph Maximize profit where MR = MC Explained in 5 minutes by Khan Academy Assume a firm can sell any quantity produced at $10 per unit Firm sets quantity of output where MC = MR & produces that quantity to maximize profit. D = MR WHY? $10 -------------------------------- Economic Profit ------------------------------------ Since MC is rising company will “break even” on the last unit sold. That means you make economic profit on all previous units sold (MC < MR for all previous units) If P > ATC, firm is earning economic profit! Economies of Scale Why do economies of scale occur? Firms that produce more can better use Techniques like Mass Production and Specialization Example: A car company that makes 50 cars a day will have a very high average cost per car. A car company that can produce 100,000 cars a day will have a very low average cost per car. Using specialization & mass production will cause Total Cost to be higher (Assembly lines & Robots are expensive) But the Average Cost for each car would be significantly lower (because factory can crank out so many cars) Total Cost of Making 1 Car is VERY High High fixed/“Start Up” costs for all equipment & training Costs MC1 ATC1 $9,900,000 $50,000 $6,000 $3,000 0 1 100 1,000 100,000 1,000,0000 Quantity Cars Cost of making 100 cars falls because Specialization increases efficiency…Economies of Scale is kicking in Costs MC1 ATC1 MC2 $9,900,000 ATC2 $50,000 $6,000 $3,000 0 1 100 1,000 100,000 1,000,0000 Quantity Cars Cost of making 1,000 cars continues to fall because mass production techniques further increase efficiency as Economies of Scale increase Costs MC1 . ATC1 MC2 $9,900,000 MC3 ATC2 $50,000 ATC3 $6,000 $3,000 0 1 100 1,000 100,000 1,000,0000 Quantity Cars At some point, the long-run average total cost will get as low as it can get…in this case 100,000 cars. Production has reached Constant Returns to Scale Costs MC1 ATC1 MC2 $9,900,000 MC3 MC4 ATC2 $50,000 ATC3 ATC4 $6,000 $3,000 0 1 100 1,000 100,000 1,000,0000 Quantity Cars Eventually, operation grows too large. The difficulty of managing an increasingly large workforce and possible overcrowding effect within an organization leads to growing costs. Production has reached Diseconomies of Scale This means that the Long Run Average Total Costs are increasing Costs MC1 ATC1 MC2 $9,900,000 MC5 MC3 MC4 ATC5 ATC2 $50,000 ATC3 ATC4 $6,000 $3,000 0 1 100 1,000 100,000 1,000,0000 Quantity Cars The RED LINE shows the Long Run ATC as it moves from Economies of Scale to Constant Returns to Scale to Diseconomies of Scale Costs MC1 ATC1 MC2 $9,900,000 MC5 MC3 MC4 ATC5 ATC2 $50,000 ATC3 ATC4 $6,000 $3,000 0 1 100 1,000 100,000 1,000,0000 Quantity Cars Long Run ATC Simplified Long Run Average Total Cost Explained in 8 Minutes by Khan Academy Economies of Scale & Diseconomies of Scale Explained in 3 Minutes By Khan Academy Costs Economies of Constant Diseconomies Scale Returns to Scale of Scale Long Run Average Cost Curve Quantity 1 2 3 Watch video linked below (and all videos in this presentation) as review Then take practice quiz to check for understanding 11 Minute Crash Course Economics Video that puts a lot of these ideas together.
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