Total Revenue, Total Cost, Profit by kpg20724

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									                                                             Total Revenue, Total Cost, Profit
                                                           We assume that the firm’s goal is to maximize
                                                            profit.
  Professor Sumner La Croix
                                                              Profit = Total revenue – Total cost
  University of Hawai′i-Mānoa
  Econ 130(3)
                                                                          the amount a            the market
  November 6 & 9, 2009                                                    firm receives           value of the
                                                                          from the sale           inputs a firm
                                                                          of its output           uses in
                                                                                                  production


                                                     0   THE COSTS OF PRODUCTION                                   1




        Costs: Explicit vs. Implicit                       Explicit vs. Implicit Costs: An Example
                                                         You need $100,000 to start your business.
  Explicit costs require an outlay of money,
                                                           The interest rate is 5%.
   e.g., paying wages to workers.
  Implicit costs do not require a cash outlay,            Case 1: borrow $100,000
   e.g., the opportunity cost of the owner’s time.             explicit cost = $5000 interest on loan
  The cost of something is the highest value              Case 2: use $40,000 of your savings,
   opportunity foregone.                                    borrow the other $60,000
                                                               explicit cost = $3000 (5%) interest on the loan
  This is true whether the costs are implicit or              implicit cost = $2000 (5%) foregone interest you
   explicit. Both matter for firms’ decisions.                  could have earned on your $40,000.

                                                           In both cases, total (exp + imp) costs are $5000.
THE COSTS OF PRODUCTION                              2   THE COSTS OF PRODUCTION                                   3




Economic Profit vs. Accounting Profit                                 The Production Function
  Accounting profit                                       A production function shows the relationship
   = total revenue minus total explicit costs               between the quantity of inputs used to produce a
                                                            good and the quantity of output of that good.
  Economic profit
   = total revenue minus total costs (including            It can be represented by a table, equation, or
     explicit and implicit costs)                           graph.

  Accounting profit ignores implicit costs,               Example 1:
   so it’s higher than economic profit.                       Farmer Akira grows wheat.
                                                              He has 5 acres of land.
                                                              He can hire as many workers as he wants.

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                                                                                                                       1
 Ex 1: Farmer Akira’s Production Function                                                                   Marginal Product
                                                                                             If Akira hires one more worker, his output rises
   L         Q
 (no. of (bushels
                                                3,000                                         by the marginal product of labor.
workers) of wheat)                              2,500
                                                                                             The marginal product of any input is the
                           Quantity of output
   0          0                                 2,000                                         increase in output arising from an additional unit
                                                                                              of that input, holding all other inputs constant.
   1      1000                                  1,500
                                                                                             Notation:
   2      1800                                  1,000
                                                                                                ∆ (delta) = “change in…”
   3      2400                                   500                                          Examples:
   4      2800                                     0                                          ∆Q = change in output, ∆L = change in labor
                                                        0   1     2    3    4    5                                              ∆Q
   5      3000
                                                                No. of workers               Marginal product of labor (MPL) =
                                                                                                                                ∆L
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             Why MPL Is Important                                                                        Why MPL Diminishes
   Because rational owners of firms think at the                                            Farmer Akira’s output rises by a smaller and
   margin!                                                                                   smaller amount for each additional worker. Why?
   When Farmer Akira hires an extra worker,                                                 As Akira adds workers, the average worker has
      his costs rise by the wage he pays the worker                                         less land to work with and will be less productive.
      his output rises by MPL                                                               In general, MPL diminishes as L rises
   Comparing them helps Akira decide whether he                                             whether the fixed input is land or capital
   would benefit from hiring the worker.                                                     (equipment, machines, etc.).
                                                                                             Diminishing marginal product:
                                                                                             the marginal product of an input declines as the
                                                                                             quantity of the input increases (other things equal)

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                     Marginal Cost                                                           EXAMPLE 1: Total and Marginal Cost
  Marginal Cost (MC)                                                                                     Q
   is the increase in Total Cost from                                                                             Total                  Marginal
                                                                                                      (bushels
                                                                                                                  Cost                   Cost (MC)
   producing one more unit:                                                                           of wheat)

                                                                                                            0     $1,000
                     ∆TC                                                                  ∆Q = 1000                        ∆TC = $2000    $2.00
           MC =
                     ∆Q                                                                                 1000      $3,000
                                                                                           ∆Q = 800                        ∆TC = $2000    $2.50
                                                                                                        1800      $5,000
                                                                                           ∆Q = 600                        ∆TC = $2000    $3.33
                                                                                                        2400      $7,000
                                                                                          ∆Q = 400                         ∆TC = $2000    $5.00
                                                                                                        2800      $9,000
                                                                                           ∆Q = 200                        ∆TC = $2000   $10.00
                                                                                                        3000 $11,000

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                                                                                                                                                          2
     EXAMPLE 1: The Marginal Cost Curve                                                           Why MC Is Important
    Q                                                                                  Farmer Akira is rational and wants to maximize
(bushels      TC       MC                                                                 his profit. To increase profit, should he produce
                                              MC usually rises
of wheat)                                     as Q rises,
                                                                                          more or less wheat?
        0    $1,000                           as in this example.                      To find the answer, Farmer Akira needs to
                       $2.00                                                              “think at the margin.”
  1000       $3,000
                       $2.50                                                           If the cost of additional wheat (MC) is less than
  1800       $5,000
                       $3.33
                                                                                          the revenue he would get from selling it,
  2400       $7,000                                                                       then Akira’s profits rise if he produces more.
                       $5.00
  2800       $9,000
                      $10.00
  3000 $11,000

THE COSTS OF PRODUCTION                                                        12   THE COSTS OF PRODUCTION                                     13




              Fixed and Variable Costs                                                                    EXAMPLE 2
   Fixed costs (FC) do not vary with the quantity of                                 Our second example is more general,
      output produced.                                                                 applies to any type of firm
         For Farmer Akira, FC = $1000 for his land                                    producing any good with any types of inputs.
         Other examples:
          cost of equipment, loan payments, rent
   Variable costs (VC) vary with the quantity
      produced.
         For Farmer Akira, VC = wages he pays workers
         Other example: cost of materials
   Total cost (TC) = FC + VC

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EXAMPLE 2: Costs                                                                    EXAMPLE 2: Marginal Cost
                                       $800               FC
 Q      FC    VC      TC               $700               VC                         Q      TC    MC        Recall, Marginal Cost (MC)
                                                          TC
  0 $100        $0 $100                $600                                                                 is the change in total cost from
                                                                                      0 $100
  1     100     70    170                                                                         $70       producing one more unit:
                                       $500                                           1     170
                                                                                                   50                       ∆TC
                               Costs




  2     100 120       220              $400                                                                          MC =
                                                                                      2     220                             ∆Q
  3     100 160       260                                                                          40
                                       $300                                           3     260             Usually, MC rises as Q rises, due
  4     100 210       310                                                                          50       to diminishing marginal product.
                                       $200                                           4     310
  5     100 280       380                                                                          70       Sometimes (as here), MC falls
                                       $100                                           5     380
  6     100 380       480                                                                         100       before rising.
                                        $0                                            6     480
  7     100 520       620                     0   1   2   3    4   5   6   7                      140       (In other examples, MC may be
                                                                                      7     620             constant.)
                                                               Q
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                                                                                                                                                     3
EXAMPLE 2: Average Fixed Cost                                                        EXAMPLE 2: Average Variable Cost

 Q    FC     AFC             Average fixed cost (AFC)                                 Q    VC       AVC        Average variable cost (AVC)
  0 $100         n/a
                             is fixed cost divided by the                                                      is variable cost divided by the
                                                                                       0    $0        n/a
                             quantity of output:                                                               quantity of output:
  1   100    $100                                                                      1    70       $70
                                 AFC = FC/Q                                                                         AVC = VC/Q
  2   100         50                                                                   2   120        60
  3   100 33.33                                                                        3   160      53.33
                             Notice that AFC falls as Q rises:                                                As Q rises, AVC may fall initially.
  4   100         25         The firm is spreading its fixed                           4   210      52.50     In most cases, AVC will
  5   100         20         costs over a larger and larger                                                   eventually rise as output rises.
                                                                                       5   280      56.00
                             number of units.
  6   100 16.67                                                                        6   380      63.33
  7   100 14.29                                                                        7   520      74.29

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EXAMPLE 2: Average Total Cost                                                        EXAMPLE 2: Average Total Cost

 Q    TC    ATC        AFC       AVC            Average total cost                    Q    TC    ATC                $200
                                                (ATC) equals total                                                  Usually, as in this example,
                                                                                                                    $175
  0 $100         n/a    n/a         n/a                                                0 $100        n/a
                                                cost divided by the                                                 the ATC curve is U-shaped.
                                                                                                                    $150
  1   170    $170      $100        $70          quantity of output:                    1   170   $170
                                                                                                                    $125



                                                                                                            Costs
  2   220     110        50         60           ATC = TC/Q                            2   220      110
                                                                                                                    $100
  3   260 86.67 33.33            53.33                                                 3   260 86.67
                                                Also,                                                                $75
  4   310 77.50          25      52.50                                                 4   310 77.50                 $50
                                                 ATC = AFC + AVC
  5   380        76      20      56.00                                                 5   380       76              $25
  6   480        80 16.67        63.33                                                 6   480       80               $0
                                                                                                                           0   1   2   3       4   5   6   7
  7   620 88.57 14.29            74.29                                                 7   620 88.57
                                                                                                                                           Q
THE COSTS OF PRODUCTION                                                         20   THE COSTS OF PRODUCTION                                                   21




 EXAMPLE 2: The Various Cost Curves Together                                         EXAMPLE 2: Why ATC Is Usually U-Shaped

                                 $200                                                 As Q rises:                   $200

                                 $175                                                 Initially,                    $175
                                 $150                                                 falling AFC                   $150
           ATC                                                                        pulls ATC down.
                                 $125                                                                               $125
                         Costs




                                                                                                            Costs




           AVC
                                 $100                                                 Eventually,                   $100
           AFC
                                 $75                                                  rising AVC                     $75
           MC
                                                                                      pulls ATC up.
                                 $50                                                                                 $50

                                 $25                                                  Efficient scale:               $25
                                  $0
                                                                                      The quantity that               $0
                                        0   1    2      3       4   5   6   7         minimizes ATC.                       0   1   2   3       4   5   6   7
                                                            Q                                                                              Q
THE COSTS OF PRODUCTION                                                         22   THE COSTS OF PRODUCTION                                                   23




                                                                                                                                                                    4
              EXAMPLE 2: ATC and MC                                                 Costs in the Short Run & Long Run
When MC < ATC,                  $200                   ATC                           Short run:
ATC is falling.                                        MC                             Some inputs are fixed (e.g., factories, land).
                                $175
When MC > ATC,                  $150                                                  The costs of these inputs are FC.
ATC is rising.                  $125                                                 Long run:
                        Costs


The MC curve                    $100                                                  All inputs are variable
crosses the                     $75                                                   (e.g., firms can build more factories,
ATC curve at                    $50                                                   or sell existing ones).
the ATC curve’s
                                $25                                                  In the long run, ATC at any Q is cost per unit
minimum.
                                 $0                                                   using the most efficient mix of inputs for that Q
                                       0   1   2   3       4    5     6   7           (e.g., the factory size with the lowest ATC).
                                                       Q
THE COSTS OF PRODUCTION                                                       24   THE COSTS OF PRODUCTION                                    25




    EXAMPLE 3: LRATC with 3 factory Sizes                                              EXAMPLE 3: LRATC with 3 factory Sizes
Firm can choose                                                                    To produce less
from 3 factory         Avg                                                         than QA, firm will    Avg
sizes: S, M, L.       Total                                                        choose size S        Total
                      Cost                     ATCS            ATCM                in the long run.     Cost            ATCS    ATCM
Each size has its                                                     ATCL                                                             ATCL
own SRATC curve.                                                                   To produce
                                                                                   between QA
The firm can                                                                       and QB, firm will                                   LRATC
change to a                                                                        choose size M
different factory                                                                  in the long run.
size in the long
                                                                          Q        To produce more                                        Q
run, but not in the                                                                                                QA          QB
                                                                                   than QB, firm will
short run.
                                                                                   choose size L
                                                                                   in the long run.
THE COSTS OF PRODUCTION                                                       26   THE COSTS OF PRODUCTION                                    27




             A Typical LRATC Curve                                                              How ATC Changes as
                                                                                           the Scale of Production Changes
In the real world,
                           ATC                                                     Economies of              ATC
factories come in
many sizes,                                                                        scale: ATC falls
each with its own                                                                  as Q increases.
                                                                    LRATC                                                           LRATC
SRATC curve.                                                                       Constant returns
So a typical                                                                       to scale: ATC
LRATC curve                                                                        stays the same
looks like this:                                                                   as Q increases.

                                                                          Q        Diseconomies of                                        Q
                                                                                   scale: ATC rises
                                                                                   as Q increases.

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                                                                                                                                                   5
             How ATC Changes as
        the Scale of Production Changes
  Economies of scale occur when increasing
   production allows greater specialization:
   workers more efficient when focusing on a
   narrow task.
      More common when Q is low.
  Diseconomies of scale are due to coordination
   problems in large organizations.
   E.g., management becomes stretched, can’t
   control costs.
      More common when Q is high.
THE COSTS OF PRODUCTION                            30




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