ENT 112 12/03/2024

Microeconomics

COST AND PROFIT

ECONOMICS
ENT 112 | LESSON 5

intended ✓Differentiate the types of costs

learning ✓Illustrate the firm’s short-run and

long-run cost curves;

outcomes ✓Analyze the profit structure of the

firm through cases evident in the
community.

The Production Process

Behavior of profit-maximizing firms
All firms must make several basic decisions to achieve what
we assume to be their primary objective—maximum profits.

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DECISIONS How much
output to
Which production
technology
How much of
each input to
supply to use demand

are based on

The price of Techniques of The price of inputs

INFORMATION output production
available

The Three Decisions That All Firms Must Make

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The Production Process

Behavior of profit-maximizing firms
Price of output Production techniques Input prices

Determines Determine total cost

total revenue and optimal
method of production

Total revenue
−Total cost with optimal method
= Total profit

Determining the Optimal Method of Production

optimal method of production The production method

that minimizes cost.

The Production Process

Behavior of profit-maximizing firms
Profit and economic costs
profit (economic profit) The difference between total revenue
and total cost.
profit = total revenue - total cost

total revenue The amount received from the sale of the product
(q x P).

The Production Process

Behavior of profit-maximizing firms
Profit and economic costs
total cost (total economic cost) The total of (1) out-of-pocket
costs, (2) normal rate of return on capital, and (3) opportunity
cost of each factor of production.
The term profit will from here on refer to economic profit. So, whenever we
say profit = total revenue - total cost, what we really mean is

economic profit = total revenue - total economic cost

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The Production Process

Behavior of profit-maximizing firms
Profit and economic costs
normal rate of return A rate of return on capital that is just sufficient to keep
owners and investors satisfied. For relatively risk-free firms, it should be
nearly the same as the interest rate on risk-free government bonds.
Calculating Total Revenue, Total Cost, and Profit
INITIAL INVESTMENT: $20,000
MARKET INTEREST RATE AVAILABLE: 0.10 OR 10%
Total revenue (3,000 units x $10 each) $30,000
Costs
Unit cost from Supplier 15,000
Labor cost 14,000
Normal return/Opportunity Cost of Capital ($20,000 x 0.10) 2,000
Total Cost $31,000
Profit = total revenue - total cost −1,000

The Production Process

Behavior of profit-maximizing firms
Short-run vs Long-run Decisions
short run The period of time for which two conditions hold: The
firm is operating under a fixed scale (fixed factor) of production,
and firms can neither enter nor exit an industry.
long run That period of time for which there are no fixed factors
of production: Firms can increase or decrease the scale of
operation, and new firms can enter and existing firms can exit
the industry.

Cost in the Short-run

fixed cost Any cost that does not depend on the

firm’s level of output. These costs are incurred even
if the firm is producing nothing. There are no fixed
costs in the long run.
variable cost A cost that depends on the level of
production chosen.
total cost Fixed costs plus variable costs.

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Cost in the Short-run

Total fixed cost (TFC) or overhead The total of all costs that do
not change with output, even if output is zero.

Short-Run Fixed Cost (Total and Average) of a

Hypothetical Firm
(1) (2) (3)
Q TFC AFC (TFC/Q)

0 $1,000 $ −
1 $1,000 1,000
2 $1,000 500
3 $1,000 333
4 $1,000 250
5 $1,000 200

Firms have no control over fixed costs in the short run. For this reason,
fixed costs are sometimes called sunk costs.

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Cost in the Short-run

Average fixed cost (AFC) Total fixed cost divided by the number
of units of output; a per-unit measure of fixed costs.

Short-Run Fixed Cost (Total and Average) of a Hypothetical Firm

spreading overhead The process of dividing total fixed costs by more

units of output. Average fixed cost declines as quantity rises.

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Cost in the Short-run

Total variable cost (TVC) The total of all costs that

vary with output in the short run.
Total variable cost (TVC) curve A graph that shows
the relationship between total variable cost and the
level of a firm’s output.

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Cost in the Short-run

The total variable cost curve
embodies information about both
factor, or input, prices and technology.
It shows the cost of production using
the best available technique at each
output level given current factor
prices.

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Cost in the Short-run

Marginal cost The increase in total cost that results from
producing one more unit of output. Marginal costs reflect
changes in variable costs.

Derivation of Marginal Cost from Total Variable Cost

UNITS OF OUTPUT TOTAL VARIABLE COSTS ($) MARGINAL COSTS ($)

0 0 0
1 10 10
2 18 8
3 24 6

Although the easiest way to derive marginal cost is to look at total variable cost and subtract, do not lose
sight of the fact that when a firm increases its output level, it hires or demands more inputs. Marginal
cost measures the additional cost of inputs required to produce each successive unit of output.

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Cost in the Short-run

The shape of the marginal cost curve in the short-run

Declining Marginal Product Implies That Marginal Cost Will Eventually Rise with Output

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Cost in the Short-run

The shape of the marginal cost curve in the short-run

In the short run, every firm is constrained by some fixed input

that (1) leads to diminishing returns to variable inputs and (2)
limits its capacity to produce. As a firm approaches that
capacity, it becomes increasingly costly to produce successively
higher levels of output. Marginal costs ultimately increase with
output in the short run.

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Cost in the Short-run

Graphing total variable costs and marginal costs

TVC TVC
slope of TVC = = = TVC = MC
Δq 1

Total Variable Cost and Marginal Cost for a

Typical Firm

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Cost in the Short-run

Average variable cost (AVC) The total of all costs
that vary with output in the short run.
Short-Run Costs of a Hypothetical Firm
(3) (4) (6) (7) (8)
(1) (2) MC AVC (5) TC AFC ATC
q TVC ( TVC) (TVC/q) TFC (TVC + TFC) (TFC/q) (TC/q or AFC + AVC)
0 $ 0 $ − $ − $1,000 $ 1,000 $ − $ −
1 10 10 10 1,000 1,010 1,000 1,010
2 18 8 9 1,000 1,018 500 509
3 24 6 8 1,000 1,024 333 341
4 32 8 8 1,000 1,032 250 258
5 42 10 8.4 1,000 1,042 200 208.4
− − − − − − − −
− − − − − − − −
− − − − − − − −
500 8,000 20 16 1,000 9,000 2 18

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Cost in the Short-run

Graphing average variable costs and marginal costs

Marginal cost intersects average variable cost at the lowest, or minimum, point of AVC.

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Cost in the Short-run

Total cost curves

Total Cost = Total Fixed Cost + Total Variable Cost

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Cost in the Short-run

Graphing other cost curves

Average Total Cost = Average Variable Cost + Average Fixed Cost

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Cost in the Short-run

The relationship between average total
cost and marginal cost

If marginal cost is below average total cost,

average total cost will decline toward marginal
cost. If marginal cost is above average total
cost, average total cost will increase. As a
result, marginal cost intersects average total
cost at ATC’s minimum point, for the same
reason that it intersects the average variable
cost curve at its minimum point.
Average Total Cost = Average Variable Cost + Average Fixed Cost

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Output Decisions in the Short-run

total revenue (TR) The total amount that a firm takes in from
the sale of its product: the price per unit times the quantity of
output the firm decides to produce (P x q).
total revenue = price x quantity
TR = P x q

marginal revenue (TR) The additional revenue that a firm

takes in when it increases output by one additional unit. In
perfect competition, P = MR.

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Output Decisions in the Short-run

Demand Facing a Typical Firm in a Perfectly Competitive Market

In the short run, a competitive firm faces a demand curve that is simply a horizontal line at the market
equilibrium price. In other words, competitive firms face perfectly elastic demand in the short run.

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Output Decisions in the Short-run

The profit-maximizing level of output

The Profit-Maximizing Level of Output for a Perfectly Competitive Firm

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Output Decisions in the Short-run

The profit-maximizing level of output
As long as marginal revenue is greater than marginal cost, even though the difference
between the two is getting smaller, added output means added profit. Whenever
marginal revenue exceeds marginal cost, the revenue gained by increasing output by
one unit per period exceeds the cost incurred by doing so.

The profit-maximizing perfectly competitive firm will produce up to the point where
the price of its output is just equal to short-run marginal cost—the level of output at
which P* = MC.

The profit-maximizing output level for all firms is the output level where MR = MC.

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Output Decisions in the Short-run

The profit-maximizing level of output

Keep in mind that the marginal cost curve carries information

about both input prices and technology.

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THANKS
Any questions?

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