8. Profits Students Should Be Able To

8. Profits Students should be able to:

• Understand the distinction between normal and supernormal profit • Explain and illustrate the concept of profit maximisation using marginal cost and marginal revenue

The Nature of Profit • Profit measures the return to risk when committing scarce resources to a market or industry • Entrepreneurs organise factors of production and take risks for which they require an adequate rate of return. • The higher the market risk and the longer they expect to have to wait to earn a positive return, the greater will be the minimum return that an entrepreneur will demand to participate in the market • There are different types of profit: 1. Normal profit • Normal profit is the minimum profit needed to keep factor inputs in their current use in the long run. • Normal profits reflect the opportunity cost of using funds to finance a business. If you put £200,000 of savings into a new business, those funds could have earned a low-risk rate of return by being saved in a bank account. You might use the rate of interest on that £200,000 as the minimum rate of return that you need to make from your investment

• Because we treat normal profit as an opportunity cost of investing financial capital in a business, we include an estimate for normal profit in the average total cost curve, thus, if the firm covers its AC then it is making normal profits. 2. Sub-normal profit – is profit less than normal (Price per unit < average cost) 3. Supernormal profits • Profit achieved in excess of normal profit (known as abnormal profit). When firms are making abnormal profits, there is incentive for other producers to enter a market to acquire some of this profit. • Supernormal profits are made when price > AC • Abnormal profit persists in the long run in imperfectly competitive markets such as oligopoly and monopoly where firms successfully block the entry of new firms

Calculating Economic Profit The data below is for an owner-managed firm for a given year

• Total revenue £320,000 • Raw material costs £30,000 • Wages and salaries £85,000 • Interest paid on bank loan £30,000 • Salary the owner could have earned elsewhere £32,000 • Interest forgone on capital invested in the business £20,000 In a simple accounting sense, the business has total revenue of £320,000 and costs of £145,000 giving an accounting profit of £175,000. But profit according to an economist should take into account the opportunity cost of the capital invested and the income that the owner could have earned elsewhere.

Taking these two items into account we find that the economic profit is £123,000.

The Difference between Accounting Profit and Economic Profit

Economic Profit = abnormal Profit

Normal Profit = Accounting Profit Opportunity Cost

Total Revenue

Economic Cost Accounting Cost Accounting Cost

Short Run Profit Maximisation The profit maximisation rule: Profits are maximised when marginal revenue = marginal cost

Price Per Unit (AR) Demand / Total Marginal Total Marginal Profit Output Revenue (TR) Revenue (MR) Cost (TC) Cost (MC) (£) (Units) (£) (£) (£) (£) (£) 50 33 1650 2000 -350 48 39 1872 37 2120 20 -248 46 45 2070 33 2222 17 -152 44 51 2244 29 2312 15 -68 42 57 2394 25 2384 12 10 40 63 2520 21 2444 10 76 38 69 2622 17 2480 6 142 36 75 2700 13 2534 9 166 34 81 2754 9 2612 13 142

• As price per unit declines, so demand expands. Total revenue rises but at a decreasing rate as shown by the column showing marginal revenue. Initially the firm is making a loss because total cost exceeds total revenue. • The firm moves into profit at an output level of 57 units. • Thereafter profit is increasing because the marginal revenue from selling units is greater than the marginal cost of producing them. • Consider the rise in output from 69 to 75 units. The MR is £13 per unit, whereas marginal cost is £9 per unit. Profits increase from £142 to £166. • But once marginal cost is greater than marginal revenue, total profits are falling

Showing profit maximisation in a diagram

Revenue Marginal profit: the Marginal Cost And Cost increase in profit when one more unit is sold or the difference between MR and MC

Profits are increasing when MR > MC

Profits are decreasing when MR < MC

Q1 Marginal Revenue Output (Q)

As long as marginal revenue > marginal cost, total profits will be increasing (or losses decreasing). The profit maximisation output occurs when marginal revenue = marginal cost. In the next diagram we introduce average revenue and average cost curves into the diagram so that, having found the profit maximising output (where MR=MC), we can then find (i) the profit maximising price (using the demand curve) and then (ii) the cost per unit.

• The difference between price and average cost marks the profit margin per unit of output

• Total profit is shown by the shaded area and equals the profit margin multiplied by output

Costs Supernormal profits at Price Revenue P1 and output Q1

Normal profit at Q2 where SRAC AR = AC

P1 SRMC

AC1

AC2

AR (Demand)

Q1 Q2 MR Output (Q)

Short Run Supply Decision - The Shut Down Price • A business needs to make at least normal profit in the long run to justify remaining in an industry but in the short run a firm will continue to produce as long as total revenue covers total variable costs or price per unit > or equal to average variable cost (AR = AVC). • This is called the short-run shutdown price. The reason for this is as follows. A business’s fixed costs must be paid regardless of the level of output. If we make an assumption that these costs cannot be recovered if the firm shuts down then the loss per unit would be greater if the firm were to shut down, provided variable costs are covered.

MC ATC Costs, P1 is below average variable cost -

Revenues staying in production means that losses would increase.

AVC A AC1

B P2 P1 C

Q1 Output (Q)

• Average revenue (AR) and marginal revenue curves (MR) lies below average cost, so whatever output produced, the business faces making a loss i.e. P

Many pubs have been shutting-down in the UK in recent years. Partly this is the result of a shift in spending towards lower-priced alcohol from supermarkets. The decline has gathered pace following the last recession. Shutting down - Total number of pubs in the United Kingdom (UK) from 2000 to 2013

60.8 60.7 60.1 59.4 59 60 58.6 58.2 56.8 54.8 55 52.5 51.2 50.4 49.4 50 48

Number of pubs in thousands 45

40 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

Many small independent petrol retailers have closed down because profits have not been enough to remain commercially viable. The petrol retail industry is dominated by the multinational oil companies and also by the leading supermarkets.

Number of petrol stations sites in the United Kingdom (UK) in 2014, by brand

Number of open petrol station sites 0 200 400 600 800 1000 1200 1400 BP 1,163 Shell 1,019 Esso 1,009 Certas Energy * 999 Texaco 783 Unbranded 724 Tesco 503 Murco 463 Morrisons 332 Jet 303 Sainsbury's 299 Minor brands 243 Asda 236 Harvest Energy 106 Maxol 103

Analysis: Using Diagrams to show the effects of Changes in Demand and Supply Conditions

• A change in demand and/or costs will lead to a change in the profit maximising price and output. • In the diagram below we see the effects of an outward shift of demand from AR1 to AR2 short run costs of production remain unchanged).

A rise in demand (causing an outward shift in AR and MR) causes an expansion of supply, a higher profit maximising price and an increase in supernormal profits

Profit Max at Price P2 Costs Profit Max at Price P1

P2 AC

P1 MC

AC1 AC2 AR2

AR1 (Demand) MR2

Q1 Q2 MR1 Output (Q)

What are the Key Functions of Profit in a Market Economy? Leading airline groups worldwide in 2014, based on net profit (in billion U.S. dollars)

Net profit in billion U.S. dollars 0 0.5 1 1.5 2 2.5 3 3.5

American Airlines 2.9 Emirates 1.5 Japan Airlines 1.3 IAG 1.3 Southwest Airlines 1.1 United-Continental Holdings 1.1 Ryanair 1.1 Turkish Airlines 0.8 EasyJet 0.7 Air China 0.7

Profits serve a variety of purposes in a market economy: 1. Finance for investment Retained profits are source of finance for companies undertaking investment. The alternatives such as issuing new shares (equity) or bonds may not be attractive depending on the state of the financial markets especially in the aftermath of the credit crunch. 2. Market entry: Rising profits send signals to other producers within a market. When existing firms are earning supernormal profits, this signals that profitable entry may be possible. In contestable markets, we would see a rise in market supply and lower prices. But in a monopoly, the dominant firm(s) can protect their position through barriers to entry. 3. Demand for factor resources: Factor resources flow where the expected rate of return or profit is highest. In an industry where demand is strong, more land, labour and capital are then committed to that sector. 4. Signals about the health of the economy: Profits made by businesses throughout the economy provide important signals about the health of the macro economy. Rising profits might reflect improvements in supply-side performance (e.g. higher productivity or lower costs through innovation). Strong profits are also the result of high levels of demand. Annual profit for Apple.Inc ($ billion)

45 41.73 39.51 40 37.04 35

30 25.92 25 20 14.01 15 8.24 10 6.12

Net income in billion U.S. dollars 3.5 5 1.33 1.99 0 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 Fiscal years

Key Factors Affecting Profitability of Businesses

1. Rate of growth of market demand and the average price that sellers can achieve 2. Changes in business operating costs e.g. wages, prices of essential raw materials and components 3. Changes in the efficiency of factor resources – e.g. improvements in labour productivity lead to lower unit costs and therefore higher profits for a given selling price 4. The effects of economies of scale to lower unit costs in the long run and therefore increase profitability 5. Impact of intervention in markets by the government that can affect profability e.g. environmental taxes such as a minimum carbon price, the congestion charge 6. The cost of meeting government regulations such as EU health and safety legislation 7. Impact of government subsidies / tax relief / investment allowances and other forms of financial help 8. Strategic behaviour by other firms in the market e.g. price wars might lead to a cut in total profits 9. The effects of changes in exchange rates affecting the profitability of exporting and the relative prices of competing goods and services from overseas

Case Study: Pricing Models in the Fast-Changing App Industry

Number of available apps in the Apple App Store from July 2008 to June 2015

1600000

1400000

1200000

1000000

800000

600000

Number of available apps 400000

200000

0 Jul Sep Apr Jul Nov Mar Jun Oct Jan Jun Oct Mar Jun Sep Jan May Jun Oct Jun Sep Jan Jun '08 '08 '09 '09 '09 '10 '10 '10 '11 '11 '11 '12 '12 '12 '13 '13 '13 '13 '14 '14 '15 '15

The global app economy is an industry experiencing rapid growth with over 1.5 million apps available in the Apple App Store in the summer of 2015. But there is also considerable upheaval and disruption as many new app developers arrive and pricing models for different apps appear to change with increasing frequency.

Worldwide app category revenue distribution in the Apple App Store in February 2014, by business model

Free apps with in-app purchases Paid apps without in-app purchases Paid apps with in-app purchases

Share of revenue 0.0% 10.0% 20.0% 30.0% 40.0% 50.0% 60.0% 70.0% 80.0% 90.0% 100.0% Catalogs

Entertainment

Food & Drink

Health & Fitness

Medical

Navigation

Photo & Video

Developers of apps have offered different price points and business models in this contestable market: 1. Free app to download and free to use 2. Free to download + in-app purchases (typically in-game items, more functions or features, ad free) 3. Paid-for using upfront payment only

4. Paid-for using upfront payment + optional in-app purchases • The 3rd and 4th examples described above are called "Freemium apps" and have become increasingly popular as a pricing model well beyond the realms of the app industry. • Games in particular rely heavily on Freemium models. News category apps tend to focus more on upfront payments only with few extras. • Many factors have to be taken into account when setting the pricing model and price point for an app. These include the prices charged by competitor products, the social and economic background of the user base and also consumer sensitivity to price changes both for upfront charges and in-app purchases. • For many app developers, frequent testing of different prices enables them to find an equilibrium that meets their financial targets. But too many price changes risks confusing and alienating customers.

Most popular Apple App Store categories in June 2015, by share of available apps

Share of active apps 0.0% 5.0% 10.0% 15.0% 20.0% 25.0% Games 21.8% Business 10.33% Education 9.79% Lifestyle 8.57% Entertainment 6.6% Utilities 5.05% Travel 4.42% Books 3.67% Music 3.05% Health and Fitness 2.81% Productivity 2.81% Sports 2.6% Food and Drink 2.5% Photo and Video 2.43% Finance 2.36%

Most popular global mobile messenger apps as of August 2015, based on number of monthly active users

Monthly active users in millions 0 100 200 300 400 500 600 700 800 900

WhatsApp 800 Facebook Messenger 700 QQ Mobile 603 WeChat 600 Skype* 300 Viber* 249 LINE 211 Kik* 200 BlackBerry Messenger 91 KakaoTalk 48

Case Study: Revenues and Profits in the UK Cinema Industry UK cinemas have seen rising profits in recent years helped by total box office revenues that have surpassed £1 billion a year in each of the last four years. Revenue growth tailed off in 2013 and 2014 but overall the cinema industry looks in good financial health especially as the sector attempts to broaden their sources of revenues.

Cinema box office revenue in the United Kingdom from 2001 to 2014 1200 1,099 1,083 1,040 1,058 988 1000 944 821 850 770 770 762 800 755 742 645 600

400 Revenue in million £

200

0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

What factors help to explain the rising profitability of the cinema industry?

Firstly, there is the issue of market power. The UK cinema sector is highly concentrated. In 2014 the leading five cinema chains accounted for over 70% of all ticket sales. Increasing market power allows firms to increase prices. Furthermore, once cinemagoers have their tickets, the cinema has monopoly power over the supply of food and drinks such as popcorn. Regular popcorn and a drink at Vue now cost on average over £8. The typical mark-up on popcorn made fresh from popcorn kernels is around 2000%.

Average annual cinema ticket price in the United Kingdom (UK) from 2000 to 2014 8

6.72 7 6.37 6.53 5.95 6.06 6 5.44 5.05 5.2 4.71 4.87 5 4.4 4.44 4.49 4.14 4.29 4 Price in £ 3

0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Another way in which cinema chains boost their profits is by cutting their costs, and they are well known for being one of the main types of employer employing staff on zero hours contracts. These casual contracts allow cinema chains to employ staff with no guarantee of work, and employees only work as and when they are needed. Typically busy peak times for cinemas are school-holidays and weekend evenings, so this is when most staff is employed. Younger staff tends not to be unionised, and so wages may be lower. With around 20% of revenue for cinemas being spent on staff, cutting these costs will have a strong effect on profits.

Large chains have seen an increase in some costs as they have installed the technology needed for 3D viewing of films. With new digital projectors costing around £85,000 per screen, small independents are at a real disadvantage. Larger chains are also able to benefit from economies of scale in the renting of films from distributors – cinema chains normally spend 40%-60% of their revenue on this area, so economies of scale can make a large impact.

A final way in which cinemas have been able to boost profits is through greater use of product differentiation. More are offering ‘premium’ services, with luxury reclining seating and specialist at-seat’ food services. The mark-up on these offerings is high, and is starting to make an impact on the bottom line for cinemas.

Cinema admissions annually in the United Kingdom (UK) from 2007 to 2014 200 173.5 171.6 172.5 180 164.2 169.2 165.5 162.5 157.5 160 140 120 100 80 60

Individuals admitted in millions 40 20 0 2007 2008 2009 2010 2011 2012 2013 2014

Cinemas are also looking to grow their ancillary revenues by making more extensive use of their facilities. Cinemas such as Vue have been successful in expanding their conference and events business ranging from thousands of students attending revision days through to the rapidly-expanding e-sports industry with customers willing to pay high prices for tickets to watch some of the world’s most accomplished video games players.

The UK has less than 1% of the world population yet is the third largest consumer of film, with the average Briton watching 87 films a year (admittedly not all of them at the cinema). Prices seem set to rise for consumers, whether or not mergers between chains continue. The ever-higher fees commanded by movie stars and the escalating cost of production and marketing by distributors means that distributors are keen to extract as much revenue from cinema chains as possible. If these costs continue to rise, then the end user, the cinema-goer, will be the one facing the higher prices as chains pass on these costs in order to maintain their margins (the effect of “sequential oligopolies”). If cinemagoers are prepared to go to independent cinemas to watch alternative films, then they may find that the cost of a night out falls. Source: Adapted from Ruth Tarrant, EconoMax magazine 2013