ECON 3 General Economics with TAR

Chapter 7
Analysis of Cost, Profit and Total Revenue

ACCOUNTING VERSUS ECONOMIC COSTS

Economic costs are forward-looking costs, meaning, economists are in tune with future costs because
these costs have major repercussions on the potential profitability of the firm.
Accounting costs tend to be retrospective; they recognize costs only when these are made properly
recorded.

IMPLICIT VERSUS EXPLICIT COSTS

Explicit costs refer to the actual expenses of the firm in purchasing or hiring the inputs it need, such
as, when a firm purchases a machine worth one million pesos or rents a building worth one hundred
thousand pesos per month.
Implicit costs refer to the value of inputs being owned by the firm and used in its own production
process.

SHORT-RUN COST ANALYSIS

To analyze the short-run costs, it is essential to fix the level of capital and study the changes in the
quantity of labor hired. The following are the types of short-run costs:
1. Total fixed costs (TFC). Costs that do not vary with output.
2. Total variable costs (TVC). Costs that vary with output.
3. Total costs (TC). The sum of total fixed costs and total variable costs.
TC = TFC + TVC
4. Average fixed costs (AFC). Total fixed costs divided by the number of output produced (Q).
AFC = TFC/Q
5. Average variable costs (AVC). Total variable costs divided by the number of output produced (Q).
AVC = TVC/Q
6. Average total costs (ATC). Total costs divided by the number of output produced (Q). Also defined
as the cost per unit of output.
ATC = ATC/Q
7. Marginal costs (MC). Changes in total costs divided by the change in output produced (Q). It is
also the additional cost incurred from producing additional unit of output.
MC = TC
Q

Table 10
Hypothetical Cost Schedule
Q TFC TVC TC AFC AVC ATC MC
0 30 0 30 .. .. .. ..
1 30 15 45 30 15 45 15
2 30 20 50 15 10 25 5
3 30 22.5 52.5 10 7.5 17.5 2.5
4 30 27.5 57.5 7.5 6.9 14.38 5
5 30 37.5 67.5 6 7.5 13.5 10
6 30 60 90 5 10 15 22.5

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 ECON 3 General Economics with TAR

Figure 38. Total Fixed Cost, Total Variable Cost and Total Cost Curve

Figure 39. Average Fixed Cost, Average Variable Cost, Average Fixed Cost
and Marginal Cost Curve

LONG-RUN COST ANALYSIS (LAC)

The long-run average total cost (LAC) of producing a given level of output is always the lowest point
of the short-run average total cost of producing that output.

LONG-RUN MARGINAL COST (LMC)

The long-run marginal cost measures the change in long-run total cost from a given point in output.

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 ECON 3 General Economics with TAR

PROFIT ANALYSIS

Business Profit versus Economic Profit

Business profit refers to the difference between total revenue and explicit cost, while economic profit
is the difference between total revenue and both explicit and implicit costs.

Point of Maximum Profit

By definition, profit (π) equals total revenue (TR) less total cost (TC). Whereas, total revenue is equal
to price (P) multiplied by quantity (Q). In symbols:
TR = P x Q
π = TR –TC
The rule is simple: if TR > TC, the firm incurs profit, if TR < TC, the firm incurs loss and if TR = TC, the
firm experiences break-even condition.
Table 11
Hypothetical Data of the Firm’s
Total Cost and Total Revenue
Total Revenue
Points Quantity (Q) Total Cost (TC) Profit (π)
(TR)
A 0 1600 0 -1600
B 100 4000 1600 -2400
C 200 4600 3200 -1400
D 300 4800 4800 0
E 400 5048 6400 1352
F 500 5550 8000 2450
G 600 6400 9600 3200
H 700 8000 11200 3200
I 800 12800 12800 0

Figure 40. Total Cost and Total Revenue Curve

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The Profit of the Firm in the Short-run

Price is greater than marginal cost (P > ATC)

In Figure 21, the optimum output of the firm is given by Q0, where P = MC. We use ATC to find the
total cost in order to compute for the profit. In this case, the firm is earning profits because price is greater
than the cost (ATC) given by the shaded region. Profit is greater than cost.

Figure 41. Optimum Output in the Short-run

Price is equal to ATC (P = ATC)

Figure 42 shows the case where a firm is either experiencing profits or losses. As shown in the grap,
price is equal to marginal cost denoting the best level of output. But since price equals ATC, the firm is at a
break-even (TR = TC). Profit is zero.

Figure 42. Firm is neither experiencing profit nor loss

Price is greater than AVC (P > AVC)

Even if the price is below ATC, the firm may continue operating in the short-run as long as price is
greater than AVC (P > AVC). In figure 43, price intersects marginal cost indicating the best level of output, but
is above the AVC curve which means that the firm should not shut down even though the profits are negative,
because total revenue is greater than total variable costs, and shutting down the business will eliminate this
extra revenue.

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Figure 43. Profits are negative but P > AVC

(Do not shut down)

The Shutdown Point

The firm should shut down if any of the following occurs, P = AVC or P < AVC. Figure 44 shows that
price is equal to its marginal cost and average variable cost. It is no longer practical to continue to do business
because revenue is just enough to cover the variable cost of the firm, and there is no excess revenue to cover
fixed costs.
If P < AVC, the decision is to shut down also because total revenue is insufficient to pay variable costs
as shown in Figure 45.

Figure 44. P = AVC (Shut down point) Figure 45. Profits are negative and P < AVC
(Shut down point)

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