8. Profits
Studentsshouldbeableto:
•
Understandthedistinctionbetweennormalandsupernormalprofit
•
Explainandillustratetheconceptofprofitmaximisationusingmarginalcostandmarginalrevenue
TheNatureofProfit
•
Profitmeasuresthereturntoriskwhencommittingscarceresourcestoamarketorindustry
•
Entrepreneursorganisefactorsofproductionandtakerisksforwhichtheyrequireanadequaterate
ofreturn.
•
Thehigherthemarketriskandthelongertheyexpecttohavetowaittoearnapositivereturn,the
greaterwillbetheminimumreturnthatanentrepreneurwilldemandtoparticipateinthemarket
•
Therearedifferenttypesofprofit:
1. Normalprofit
•
Normalprofitistheminimumprofitneededtokeepfactorinputsintheircurrentuseinthelongrun.
•
Normalprofitsreflecttheopportunitycostofusingfundstofinanceabusiness.Ifyouput£200,000of
savingsintoanewbusiness,thosefundscouldhaveearnedalow-riskrateofreturnbybeingsavedina
bankaccount.Youmightusetherateofinterestonthat£200,000astheminimumrateofreturnthat
youneedtomakefromyourinvestment
•
Becausewetreatnormalprofitasanopportunitycostofinvestingfinancialcapitalinabusiness,we
includeanestimatefornormalprofitintheaveragetotalcostcurve,thus,ifthefirmcoversitsACthenit
ismakingnormalprofits.
2.
Sub-normalprofit–isprofitlessthannormal(Priceperunit<averagecost)
3. Supernormalprofits
•
Profitachievedinexcessofnormalprofit(knownasabnormalprofit).Whenfirmsaremaking
abnormalprofits,thereisincentiveforotherproducerstoenteramarkettoacquiresomeofthisprofit.
•
Supernormalprofitsaremadewhenprice>AC
•
Abnormalprofitpersistsinthelongruninimperfectlycompetitivemarketssuchasoligopolyand
monopolywherefirmssuccessfullyblocktheentryofnewfirms
CalculatingEconomicProfit
Thedatabelowisforanowner-managedfirmforagivenyear
•
Totalrevenue£320,000
•
Rawmaterialcosts£30,000
•
Wagesandsalaries£85,000
•
Interestpaidonbankloan£30,000
•
Salarytheownercouldhaveearnedelsewhere£32,000
•
Interestforgoneoncapitalinvestedinthebusiness£20,000
Inasimpleaccountingsense,thebusinesshastotalrevenueof£320,000andcostsof£145,000givingan
accountingprofitof£175,000.
Butprofitaccordingtoaneconomistshouldtakeintoaccounttheopportunitycostofthecapitalinvestedand
theincomethattheownercouldhaveearnedelsewhere.
Takingthesetwoitemsintoaccountwefindthattheeconomicprofitis£123,000.
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TheDifferencebetweenAccountingProfitandEconomicProfit
EconomicProfit=
abnormalProfit
NormalProfit=
OpportunityCost
AccountingProfit
AccountingCost
AccountingCost
Economic
Cost
Total
Revenue
ShortRunProfitMaximisation
Theprofitmaximisationrule:Profitsaremaximisedwhenmarginalrevenue=marginalcost
PricePerUnit(AR)
(£)
Demand/
Output
(Units)
Total
Revenue(TR)
(£)
Marginal
Revenue(MR)
(£)
Total
Cost(TC)
(£)
Marginal
Cost(MC)
(£)
Profit
(£)
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
•
Aspriceperunitdeclines,sodemandexpands.Totalrevenuerisesbutatadecreasingrateasshownby
thecolumnshowingmarginalrevenue.Initiallythefirmismakingalossbecausetotalcostexceedstotal
revenue.
•
Thefirmmovesintoprofitatanoutputlevelof57units.
•
Thereafterprofitisincreasingbecausethemarginalrevenuefromsellingunitsisgreaterthanthe
marginalcostofproducingthem.
•
Considertheriseinoutputfrom69to75units.TheMRis£13perunit,whereasmarginalcostis£9per
unit.Profitsincreasefrom£142to£166.
•
Butoncemarginalcostisgreaterthanmarginalrevenue,totalprofitsarefalling
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Showingprofitmaximisationinadiagram
Revenue
MarginalCost
Marginalprofit:the
increaseinprofitwhenone
moreunitissoldorthe
differencebetweenMRand
MC
AndCost
Profitsare
increasingwhen
MR>MC
Profitsare
decreasingwhen
MR<MC
Q1
Output(Q)
MarginalRevenue
Aslongasmarginalrevenue>marginalcost,totalprofitswillbeincreasing(orlossesdecreasing).Theprofit
maximisationoutputoccurswhenmarginalrevenue=marginalcost.
Inthenextdiagramweintroduceaveragerevenueandaveragecostcurvesintothediagramsothat,having
foundtheprofitmaximisingoutput(whereMR=MC),wecanthenfind(i)theprofitmaximisingprice(usingthe
demandcurve)andthen(ii)thecostperunit.
•
Thedifferencebetweenpriceandaveragecostmarkstheprofitmarginperunitofoutput
•
Totalprofitisshownbytheshadedareaandequalstheprofitmarginmultipliedbyoutput
Costs
Revenue
SupernormalprofitsatPrice
P1andoutputQ1
NormalprofitatQ2where
AR=AC
SRAC
SRMC
P1
AC1
AC2
AR
(Demand)
Q1
MR
Q2
Output(Q)
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ShortRunSupplyDecision-TheShutDownPrice
•
Abusinessneedstomakeatleastnormalprofitinthelongruntojustifyremaininginanindustrybut
intheshortrunafirmwillcontinuetoproduceaslongastotalrevenuecoverstotalvariablecostsor
priceperunit>orequaltoaveragevariablecost(AR=AVC).
•
Thisiscalledtheshort-runshutdownprice.
Thereasonforthisisasfollows.
Abusiness’sfixedcostsmustbepaidregardlessofthelevelofoutput.Ifwemakeanassumptionthatthesecosts
cannotberecoveredifthefirmshutsdownthenthelossperunitwouldbegreaterifthefirmweretoshutdown,
providedvariablecostsarecovered.
ATC
MC
Costs,
Revenues
P1isbelowaveragevariablecost-
stayinginproductionmeansthat
losseswouldincrease.
AVC
A
AC1
P2
B
P1
C
AR
MR
Output(Q)
Q1
•
Averagerevenue(AR)andmarginalrevenuecurves(MR)liesbelowaveragecost,sowhateveroutput
produced,thebusinessfacesmakingalossi.e.P<AC
•
AtpriceP1andoutputQ1(whereMR=MC),thefirmwouldshutdown,aspriceislessthanAVC.Theloss
perunitofproducingisdistanceAC.Nocontributionismadetofixedcosts
•
IfthefirmshutsdownproductionthelossperunitwillequalthefixedcostperunitAB.
•
Intheshort-run,providedthatthepriceisgreaterthanorequaltoP2,thebusinesscanjustify
continuingtoproduce
•
InthelongruntheshutdownpriceiswhereAVC=Pbecauseallcostarevariable
Analysis:DerivingtheFirm’sShort-RunSupplyCurve
1.
Intheshortrun,thesupplycurveforabusinessoperatinginacompetitivemarketisthemarginalcost
curveaboveaveragevariablecost.
2.
Inthelongrun,afirmmustmakeanormalprofit,sowhenprice=averagecost,thisisthebreak-even
point.Itwillthereforeshutdownatanypricebelowthisinthelongrun.
3.
Asaresultthelongrunsupplycurvewillbethemarginalcostcurveaboveaveragetotalcost.
Theconceptofa‘supplycurve’isinappropriatewhendealingwithmonopolybecauseamonopolyisapricemaker,nota“passive”price-taker,andcanthusselectthepriceandoutputcombinationonthedemandcurveso
astomaximiseprofitswheremarginalrevenue=marginalcost.
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Manypubshavebeenshutting-downintheUKinrecentyears.Partlythisistheresultofashiftinspending
towardslower-pricedalcoholfromsupermarkets.Thedeclinehasgatheredpacefollowingthelastrecession.
Shuttingdown-TotalnumberofpubsintheUnitedKingdom(UK)from2000to2013
65
Numberofpubsinthousands
60.8
60.7
60.1
60
59.4
59
58.6
58.2
56.8
54.8
55
52.5
51.2
50.4
49.4
50
48
45
40
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013
Manysmallindependentpetrolretailershavecloseddownbecauseprofitshavenotbeenenoughtoremain
commerciallyviable.Thepetrolretailindustryisdominatedbythemultinationaloilcompaniesandalsobythe
leadingsupermarkets.
NumberofpetrolstationssitesintheUnitedKingdom(UK)in2014,bybrand
Numberofopenpetrolstationsites
0
BP
Shell
Esso
CertasEnergy*
Texaco
Unbranded
Tesco
Murco
Morrisons
Jet
Sainsbury's
Minorbrands
Asda
HarvestEnergy
Maxol
200
400
600
800
1000
1200
1400
1,163
1,019
1,009
999
783
724
503
463
332
303
299
243
236
106
103
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Analysis:UsingDiagramstoshowtheeffectsofChangesinDemandandSupplyConditions
•
Achangeindemandand/orcostswillleadtoachangeintheprofitmaximisingpriceandoutput.
•
InthediagrambelowweseetheeffectsofanoutwardshiftofdemandfromAR1toAR2shortruncosts
ofproductionremainunchanged).
Ariseindemand(causinganoutwardshiftinARandMR)causesanexpansionofsupply,ahigherprofit
maximisingpriceandanincreaseinsupernormalprofits
ProfitMaxatPriceP2
Costs
ProfitMaxatPriceP1
AC
P2
P1
MC
AC1
AC2
AR2
AR1
(Demand)
MR2
Q1
Q2
Output(Q)
MR1
WhataretheKeyFunctionsofProfitinaMarketEconomy?
Leadingairlinegroupsworldwidein2014,basedonnetprofit(inbillionU.S.dollars)
NetprofitinbillionU.S.dollars
0
0.5
1
1.5
2
AmericanAirlines
3
3.5
2.9
Emirates
1.5
JapanAirlines
1.3
IAG
1.3
SouthwestAirlines
1.1
United-ContinentalHoldings
1.1
Ryanair
1.1
TurkishAirlines
2.5
0.8
EasyJet
0.7
AirChina
0.7
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Profitsserveavarietyofpurposesinamarketeconomy:
1.
FinanceforinvestmentRetainedprofitsaresourceoffinanceforcompaniesundertakinginvestment.
Thealternativessuchasissuingnewshares(equity)orbondsmaynotbeattractivedependingonthe
stateofthefinancialmarketsespeciallyintheaftermathofthecreditcrunch.
2.
Marketentry:Risingprofitssendsignalstootherproducerswithinamarket.Whenexistingfirmsare
earningsupernormalprofits,thissignalsthatprofitableentrymaybepossible.Incontestablemarkets,
wewouldseeariseinmarketsupplyandlowerprices.Butinamonopoly,thedominantfirm(s)can
protecttheirpositionthroughbarrierstoentry.
3.
Demandforfactorresources:Factorresourcesflowwheretheexpectedrateofreturnorprofitis
highest.Inanindustrywheredemandisstrong,moreland,labourandcapitalarethencommittedtothat
sector.
4.
Signalsaboutthehealthoftheeconomy:Profitsmadebybusinessesthroughouttheeconomyprovide
importantsignalsaboutthehealthofthemacroeconomy.Risingprofitsmightreflectimprovementsin
supply-sideperformance(e.g.higherproductivityorlowercoststhroughinnovation).Strongprofitsare
alsotheresultofhighlevelsofdemand.
AnnualprofitforApple.Inc($billion)
NetincomeinbillionU.S.dollars
45
41.73
37.04
40
39.51
35
30
25.92
25
20
14.01
15
10
5
1.33
1.99
2005
2006
3.5
6.12
8.24
0
2007
2008
2009
2010
2011
2012
2013
2014
Fiscalyears
KeyFactorsAffectingProfitabilityofBusinesses
1.
2.
3.
4.
5.
6.
7.
8.
9.
Rateofgrowthofmarketdemandandtheaveragepricethatsellerscanachieve
Changesinbusinessoperatingcostse.g.wages,pricesofessentialrawmaterialsandcomponents
Changesintheefficiencyoffactorresources–e.g.improvementsinlabourproductivityleadtolower
unitcostsandthereforehigherprofitsforagivensellingprice
Theeffectsofeconomiesofscaletolowerunitcostsinthelongrunandthereforeincreaseprofitability
Impactofinterventioninmarketsbythegovernmentthatcanaffectprofabilitye.g.environmentaltaxes
suchasaminimumcarbonprice,thecongestioncharge
ThecostofmeetinggovernmentregulationssuchasEUhealthandsafetylegislation
Impactofgovernmentsubsidies/taxrelief/investmentallowancesandotherformsoffinancialhelp
Strategicbehaviourbyotherfirmsinthemarkete.g.pricewarsmightleadtoacutintotalprofits
Theeffectsofchangesinexchangeratesaffectingtheprofitabilityofexportingandtherelativeprices
ofcompetinggoodsandservicesfromoverseas
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CaseStudy:PricingModelsintheFast-ChangingAppIndustry
NumberofavailableappsintheAppleAppStorefromJuly2008toJune2015
1600000
Numberofavailableapps
1400000
1200000
1000000
800000
600000
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
Theglobalappeconomyisanindustryexperiencingrapidgrowthwithover1.5millionappsavailableinthe
AppleAppStoreinthesummerof2015.Butthereisalsoconsiderableupheavalanddisruptionasmanynewapp
developersarriveandpricingmodelsfordifferentappsappeartochangewithincreasingfrequency.
WorldwideappcategoryrevenuedistributionintheAppleAppStoreinFebruary2014,bybusinessmodel
Freeappswithin-apppurchases
Paidappswithoutin-apppurchases
Paidappswithin-apppurchases
Shareofrevenue
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
Developersofappshaveoffereddifferentpricepointsandbusinessmodelsinthiscontestablemarket:
1. Freeapptodownloadandfreetouse
2.
Freetodownload+in-apppurchases(typicallyin-gameitems,morefunctionsorfeatures,adfree)
3.
Paid-forusingupfrontpaymentonly
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4.
Paid-forusingupfrontpayment+optionalin-apppurchases
•
The3rdand4thexamplesdescribedabovearecalled"Freemiumapps"andhavebecomeincreasingly
popularasapricingmodelwellbeyondtherealmsoftheappindustry.
GamesinparticularrelyheavilyonFreemiummodels.Newscategoryappstendtofocusmoreon
upfrontpaymentsonlywithfewextras.
Manyfactorshavetobetakenintoaccountwhensettingthepricingmodelandpricepointforanapp.
Theseincludethepriceschargedbycompetitorproducts,thesocialandeconomicbackgroundofthe
userbaseandalsoconsumersensitivitytopricechangesbothforupfrontchargesandin-apppurchases.
Formanyappdevelopers,frequenttestingofdifferentpricesenablesthemtofindanequilibriumthat
meetstheirfinancialtargets.Buttoomanypricechangesrisksconfusingandalienatingcustomers.
•
•
•
MostpopularAppleAppStorecategoriesinJune2015,byshareofavailableapps
Shareofactiveapps
0.0%
5.0%
Games
Business
Education
Lifestyle
Entertainment
Utilities
Travel
Books
Music
HealthandFitness
Productivity
Sports
FoodandDrink
PhotoandVideo
Finance
10.0%
15.0%
20.0%
21.8%
10.33%
9.79%
8.57%
6.6%
5.05%
4.42%
3.67%
3.05%
2.81%
2.81%
2.6%
2.5%
2.43%
2.36%
25.0%
MostpopularglobalmobilemessengerappsasofAugust2015,basedonnumberofmonthlyactiveusers
Monthlyactiveusersinmillions
0
100
200
300
400
500
600
700
WhatsApp
700
QQMobile
603
WeChat
600
Skype*
300
Viber*
249
LINE
211
Kik*
200
BlackBerryMessenger
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900
800
FacebookMessenger
KakaoTalk
800
91
48
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CaseStudy:RevenuesandProfitsintheUKCinemaIndustry
UKcinemashaveseenrisingprofitsinrecentyearshelpedbytotalboxofficerevenuesthathavesurpassed£1
billionayearineachofthelastfouryears.Revenuegrowthtailedoffin2013and2014butoverallthecinema
industrylooksingoodfinancialhealthespeciallyasthesectorattemptstobroadentheirsourcesofrevenues.
CinemaboxofficerevenueintheUnitedKingdomfrom2001to2014
1200
944
Revenueinmillion£
1000
755
800
742
770
770
762
821
988
1,040
1,099 1,083
1,058
850
645
600
400
200
0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Whatfactorshelptoexplaintherisingprofitabilityofthecinemaindustry?
Firstly,thereistheissueofmarketpower.TheUKcinemasectorishighlyconcentrated.In2014theleadingfive
cinemachainsaccountedforover70%ofallticketsales.Increasingmarketpowerallowsfirmstoincrease
prices.Furthermore,oncecinemagoershavetheirtickets,thecinemahasmonopolypoweroverthesupplyof
foodanddrinkssuchaspopcorn.RegularpopcornandadrinkatVuenowcostonaverageover£8.Thetypical
mark-uponpopcornmadefreshfrompopcornkernelsisaround2000%.
AverageannualcinematicketpriceintheUnitedKingdom(UK)from2000to2014
8
7
5.95 6.06
Pricein£
6
5
4.4
4.44 4.49
4.14 4.29
5.05
4.71 4.87
5.2
6.72
6.37 6.53
5.44
4
3
2
1
0
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
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Anotherwayinwhichcinemachainsboosttheirprofitsisbycuttingtheircosts,andtheyarewellknownfor
beingoneofthemaintypesofemployeremployingstaffonzerohourscontracts.Thesecasualcontractsallow
cinemachainstoemploystaffwithnoguaranteeofwork,andemployeesonlyworkasandwhentheyare
needed.Typicallybusypeaktimesforcinemasareschool-holidaysandweekendevenings,sothisiswhenmost
staffisemployed.Youngerstafftendsnottobeunionised,andsowagesmaybelower.Witharound20%of
revenueforcinemasbeingspentonstaff,cuttingthesecostswillhaveastrongeffectonprofits.
Largechainshaveseenanincreaseinsomecostsastheyhaveinstalledthetechnologyneededfor3Dviewingof
films.Withnewdigitalprojectorscostingaround£85,000perscreen,smallindependentsareatareal
disadvantage.Largerchainsarealsoabletobenefitfromeconomiesofscaleintherentingoffilmsfrom
distributors–cinemachainsnormallyspend40%-60%oftheirrevenueonthisarea,soeconomiesofscalecan
makealargeimpact.
Afinalwayinwhichcinemashavebeenabletoboostprofitsisthroughgreateruseofproductdifferentiation.
Moreareoffering‘premium’services,withluxuryrecliningseatingandspecialistat-seat’foodservices.The
mark-upontheseofferingsishigh,andisstartingtomakeanimpactonthebottomlineforcinemas.
CinemaadmissionsannuallyintheUnitedKingdom(UK)from2007to2014
200
Individualsadmittedinmillions
180
162.5
164.2
2007
2008
173.5
169.2
171.6
2010
2011
172.5
165.5
160
157.5
140
120
100
80
60
40
20
0
2009
2012
2013
2014
Cinemasarealsolookingtogrowtheirancillaryrevenuesbymakingmoreextensiveuseoftheirfacilities.
CinemassuchasVuehavebeensuccessfulinexpandingtheirconferenceandeventsbusinessrangingfrom
thousandsofstudentsattendingrevisiondaysthroughtotherapidly-expandinge-sportsindustrywith
customerswillingtopayhighpricesforticketstowatchsomeoftheworld’smostaccomplishedvideogames
players.
TheUKhaslessthan1%oftheworldpopulationyetisthethirdlargestconsumeroffilm,withtheaverage
Britonwatching87filmsayear(admittedlynotallofthematthecinema).Pricesseemsettoriseforconsumers,
whetherornotmergersbetweenchainscontinue.Theever-higherfeescommandedbymoviestarsandthe
escalatingcostofproductionandmarketingbydistributorsmeansthatdistributorsarekeentoextractasmuch
revenuefromcinemachainsaspossible.Ifthesecostscontinuetorise,thentheenduser,thecinema-goer,will
betheonefacingthehigherpricesaschainspassonthesecostsinordertomaintaintheirmargins(theeffectof
“sequentialoligopolies”).Ifcinemagoersarepreparedtogotoindependentcinemastowatchalternativefilms,
thentheymayfindthatthecostofanightoutfalls.
Source:AdaptedfromRuthTarrant,EconoMaxmagazine2013
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