Section 10: Profits, Production, and CostsModule 52:

Defining Profit

Understanding Profit

• The primary goal of most firms is to maximize profits• Firm’s profit equals total

revenue

• Profit=Total Revenue-Total Cost• π = (PxQ)-cost of inputs

Accountants vs. Economists

Accounting

ProfitTotal

RevenueAccounting Costs

(Explicit Only)

Accountants look at only EXPLICIT COSTS

•Explicit costs (out of pocket costs) are payments

paid by firms for using the resources of others.

•Example: Rent, Wages, Materials, Electricity Bills

Economists examine both the EXPLICIT COSTS and

the IMPLICIT COSTS

•Implicit costs are the opportunity costs that firms

“pay” for using their own resources

•Example: Forgone Wage, Forgone Rent, Time

Economic

Profit

Total

RevenueEconomic Costs

(Explicit + Implicit)

Accountants vs. Economists

Accounting

ProfitTotal

RevenueAccounting Costs

(Explicit Only)

Accountants look at only EXPLICIT COSTS

•Explicit costs (out of pocket costs) are payments

paid by firms for using the resources of others.

•Example: Rent, Wages, Materials, Electricity Bills

Economists examine both the EXPLICIT COSTS and

the IMPLICIT COSTS

•Implicit costs are the opportunity costs that firms

“pay” for using their own resources

•Example: Forgone Wage, Forgone Rent, Time

Economic

Profit

Total

RevenueEconomic Costs

(Explicit + Implicit)

From now on, all costs

we discuss will be

ECONOMIC COSTS

Opportunity of an additional years of school

Explicit Costs Implicit Costs

Tuition $17,000 Forgone Salary $35,000

Books and Supplies

$1,000

Computer $1,500

Total Explicit Costs

$19,500 Total Implicit Costs

$35,000

Total Opportunity Cost

Total Explicit Cost + Total Implicit Costs$19,500 + $35,000=$54,500

Accounting Profit vs. Economic Profit

Accounting Profit=

Total Revenue - Explicit Costs -Depreciation

• Depreciation (Reduction of Value) is also calculated here• This occurs because

some input wear out over time and need to be replaced

• Depreciation is calculated yearly

Economic Profit=

Total Revenue – Opportunity Costs

• When economists refer to profit (π), they mean economic profit

Profit at a Coffee Shop

Case 1 Case 2

Revenue $100,000 $100,000

Explicit Cost -$60,000 -$60,000

Depreciation -$5,000 -$5,000

Accounting Profit $35,000 $35,000

Implicit Costs of Business

(Implicit Cost of Capital)Income which could have been earned on capital used in the best way

-$3,000 (Sell equipment for $5o,ooo and earn $3,000 on interest)

-$3,000 (Sell equipment for $5o,ooo and earn $3,000 on interest)

Income which could have been earned as a barista in someone’s else’s shop

-$34,000 (Could have earned $34,000 working for someone else)

-$30,000 (Could have earned $30,000 working for someone else)

Economic Profit -$2,000 +$2,000

Economic Profit

• Economic Profits signal the best uses of resources

• Positive profit signals the best use of resources

• Negative profit indicates better alternative use of resources

Economic Profit Equals Zero

• Earning zero profit is not a bad thing

• A firm could not do any better than what it is doing• This is called Normal

Profit

• A firm earning a normal profit is earning just enough to keep using its resources

Section 10: Profits, Production, and CostsModule 53:

Profit Maximization

Maximizing Profit

• What quantity of output would maximize the producers profit?• 1st Calculate the total

profit at each quantity

• 2nd use marginal analysis to determine the optimal output rule

Optimal Output Rule

• Profit is maximized by producing the quantity of output at which:• Marginal revenue at the

last unit produced is equal to its marginal cost

• Producer should produce up until marginal benefit equals marginal cost

Short-Run Profit Maximization

What is the goal of every business?

To Maximize Profit!!!!!!

•To maximum profit firms must make the right

output

•Firms should continue to produce until the

additional revenue from each new output

equals the additional cost.

Example (Assume the price is $10)

• Should you produce…

…if the additional cost of another unit is $5

…if the additional cost of another unit is $9

…if the additional cost of another unit is $1113

Profit Maximizing Rule

MR=MC

Profit for Jennifer and Jason’s FarmMarket Price=$18

Quantity of Tomatoes (Bushels)

Total Revenue (TR)TR=PxQ

Total Cost (TC)

Cost of Inputs

Profit(TR-TC)

0 $0 $14 -$14

1 $18 $30 -$12

2 $36 $36 0

3 $54 $44 $10

4 $72 $56 $16

5 $90 $72 $18

6 $108 $92 $16

7 $126 $116 $10

Marginal Revenue Curve

MR=P

• Marginal Revenue varies as output varies

• Stays the same because we assume market revenue is constant

Marginal Cost Curve

MC

• Shows how the cost of producing one more unit depends on the quantity that has already been produced

$12

$10

$8

$6

1 2 3 4 5

Marginal

Cost

1. Assume every unit can be sold for $10. Which

unit maximizes profit?

2. Use marginal analysis to explain why you

should never produce 5 units

Marginal

Revenue

Quantity

Price

Short-Run Profit Maximization

What is the goal of every business?

To Maximize Profit!!!!!!

•To maximum profit firms must make the right

output

•Firms should continue to produce until the

additional revenue from each new output

equals the additional cost.

Example (Assume the price is $10)

• Should you produce…

…if the additional cost of another unit is $5

…if the additional cost of another unit is $9

…if the additional cost of another unit is $11

Short-Run Costs for Jennifer and Jason’s FarmMarket Price=$18

Quantity of Tomatoes (Bushels)

Total Cost (TC)

Cost of Inputs

Marginal Cost(MC=^TC/^Q)

Marginal Revenue

(MR)

Net Gain of Bushel

(MR-MC)

0 $14

1 $30 $18 $2

2 $36 $18 $12

3 $44 $18 $10

4 $56 $18 $6

5 $72 $18 $2

6 $92 $18 -$2

7 $116 $18 -$6

+$16

+$6

+$8

+$12

+$16

+$20

+$24

Section 10: Profits, Production, and CostsModule 54:

Production Function

Production = Converting inputs into output

Inputs and Outputs• To earn profit, firms must make products (output)

• Inputs are the resources used to make outputs.

• Input resources are also called FACTORS.

Marginal Product =Change in Total Product

Change in Inputs

•Marginal Product (MP)- the additional output

generated by additional inputs (workers).

•Total Physical Product (TP)- total output or quantity

produced

•Average Product (AP)- the output per unit of input

Average Product =Total Product

Units of Labor

The Production Function

• A firm produces goods and services for sale• They transform input into

output

• The quantity of input determines the quantity of outputs• This is the production

function

• Shows the quantity of output depending in the quantity of:• Variable input for a fixed

input

Total Production Curve

• Shows the quantity of output depending in the quantity of:• Variable input for a

fixed input

• In the case of the pizzeria:• The changing of output

is dependent on the variable cost of labor• Marginal Product of

labor (MPL)

Production Analysis•What happens to marginal product as you hire

more workers?

•Why does this happens?

The Law of Diminishing Marginal ReturnsAs variable resources (workers) are added to

fixed resources (ovens, machinery, tool, etc.), the

additional output produced from each additional

worker will eventually fall.

Too many cooks in

the kitchen!

Diminishing Returns

• There is an increase in the quantity of the variable input• Fixed input stays the

same

• Each worker has a smaller and smaller share of product responsibility

Marginal Product of Labor

• The additional output of using on more unit of labor• Adding one

more worker

Quantity of Labor

(Workers)

Quantity of Pizzas

MPLMPL=^Q/^L

0 01917

151311

975

1 19

2 36

3 51

4 64

5 75

6 84

7 91

8 96

Production Function and Total Product Curve

0

20

40

60

80

100

120

1 2 3 4 5 6 7 8

Total Product

Total Product

Adding the 2nd

worker leads to an increase in 17

Quantity of Labor

Adding the 7th worker leads to an increase in output of only 7 pizzas

Total Quantity of Output

Production Function and Total Product Curve (Diminishing Returns)

0

2

4

6

8

10

12

14

16

18

20

1 2 3 4 5 6 7 8

Total Product

Total Product

Marginal Product of Labor

Quantity of Labor

Notice that as you hire

more workers the

additional links each

additional worker

creates begins to

decrease

This is because of the

fixed resources and the

Law of Diminishing

Marginal Returns

Graphing Production

Three Stages of Returns

Total

Product

Quantity of Labor

Marginal

and

Average

Product

Quantity of Labor

Total

Product

Stage I: Increasing Marginal Returns

MP rising. TP increasing at an increasing rate.

Why? Specialization.

Average Product

Marginal Product

Three Stages of Returns

Total

Product

Quantity of Labor

Marginal

and

Average

Product

Quantity of Labor

Total

Product

Stage II: Decreasing Marginal Returns

MP Falling. TP increasing at a decreasing rate.

Why? Fixed Resources. Each worker adds less and less.

Average Product

Marginal Product

Total

Product

Quantity of Labor

Marginal

and

Average

Product

Quantity of Labor

Total

Product

Stage III: Negative Marginal Returns

MP is negative. TP decreasing.

Workers get in each others way

Marginal Product

Average Product

34

Three Stages of Returns

Copyright

ACDC Leadership 2015

With your partner calculate MP and AP then discuss

what the graphs for TP, MP, and AP look like.

Remember quantity of workers goes on the x-axis.

# of Workers

(Input)

Total Product(TP)

PIZZAS

Marginal

Product(MP)

Average

Product(AP)

0 0

1 10

2 25

3 45

4 60

5 70

6 75

7 75

8 70

# of Workers

(Input)

Total Product(TP)

PIZZAS

Marginal

Product(MP)

Average

Product(AP)

0 0 - -

1 10 10

2 25 15

3 45 20

4 60 15

5 70 10

6 75 5

7 75 0

8 70 -5

With your partner calculate MP and AP then discuss

what the graphs for TP, MP, and AP look like.

Remember quantity of workers goes on the x-axis.

# of Workers

(Input)

Total Product(TP)

PIZZAS

Marginal

Product(MP)

Average

Product(AP)

0 0 - -

1 10 10 10

2 25 15 12.5

3 45 20 15

4 60 15 15

5 70 10 14

6 75 5 12.5

7 75 0 10.71

8 70 -5 8.75

With your partner calculate MP and AP then discuss

what the graphs for TP, MP, and AP look like.

Remember quantity of workers goes on the x-axis.

37

Section 10: Profits, Production, and CostsModule 55: Firm Costs

Definition of the “Short-Run”• We will look at both short-run and long-run production

costs.

• Short-run is NOT a set specific amount of time.

• The short-run is a period in which at least one resource is fixed.• Plant capacity/size is NOT changeable

• In the long-run ALL resources are variable• NO fixed resources

• Plant capacity/size is changeable

Today we will examine short-run costs

Costs Of ProductionFixed Costs

• A fixed cost is a cost that does not change, regardless of how much of a good is produced.• rent and salaries

Jets Pizza Fixed Cost

Costs Of ProductionVariable Costs

• Variable costs are costs that rise or fall depending on how much is produced. • costs of raw materials

• some labor costs.

Jets Pizza Variable Cost

Costs Of ProductionTotal Cost

• The total cost equals:• fixed costs plus variable costs. • TC=FC+VC

• Prices are set above this cost to make a profit

Jet’s PizzaTotal cost

Total Cost Curve• Curve which shows how total cost depends on the

quantity of output

Point Quantity of Labor

Quantity of Wheat

Variable Cost

Fixed Costs Total Cost

A 0 0 $0 $400 $400

B 1 19 200 400 600

C 2 36 400 400 800

D 3 51 600 400 1,000

E 4 64 800 400 1,200

F 5 75 1,000 400 1,400

G 6 84 1,200 400 1,600

H 7 91 1,400 400 1,800

I 8 96 1,600 400 2,000

Total Cost Curve

400600

8001,000

1,2001,400

1,6001,800

2,000

0

500

1000

1500

2000

2500

0 19 36 51 64 75 84 91 96

Cost

Quantity of Wheat

Total Cost

Total Cost

Costs Of ProductionMarginal Cost• The marginal cost is

the cost of producing one more unit of a good.

Jet’s PizzaMarginal cost

Costs of Pizza

Quantity of Pizza

Fixed Cost Variable Cost Total Cost Marginal CostMC=^TC/^Q

0 $108 $0 $108$123660

84108132

156180204

228

1 $108 12 120

2 $108 48 156

3 $108 108 216

4 $108 192 300

5 $108 300 408

6 $108 432 540

7 $108 588 696

8 $108 768 876

9 $108 972 1,080

10 $108 1,200 1,308

Total Costs

FC = Total Fixed Costs

VC = Total Variable Costs

TC = Total Costs

Per Unit Costs

AFC = Average Fixed Costs

AVC = Average Variable Costs

ATC = Average Total Costs

MC = Marginal Cost

Different Economic Costs

Calculating Costs

OutputVariable

Cost

Fixed

Cost

TotalCost

MarginalCost

0 $0 $10 -

1 $10

2 $17

3 $25

4 $40

5 $60

6 $110

Fill out the chart then

calculate:

1. The AVC of

each

2. The AFC of

each

3. The ATC of

each

$10

$10

$10

$10

$10

$10

$10

$20

$27

$35

$50

$70

$120

-

$10

$7

$8

$15

$20

$50

Calculating Costs

OutputVariable

Cost

Fixed

Cost

TotalCost

MarginalCost

0 $0 $10 $10 -

1 $10 $10 $20 $10

2 $17 $10 $27 $7

3 $25 $10 $35 $8

4 $40 $10 $50 $15

5 $60 $10 $70 $20

6 $110 $10 $120 $50

Notice that the AVC + AFC = ATC

AVC AFC ATC

- - -

$10 $10 $20

$8.50 $5 $13.50

$8.33 $3.33 $11.66

$10 $2.50 $12.50

$12 $2 $14

$18.33 $1.67 $20

Calculating Costs

AVC AFC ATC

- - -

$10 $10 $20

$8.50 $5 $13.50

$8.33 $3.33 $11.66

$10 $2.50 $12.50

$12 $2 $14

$18.33 $1.67 $20

AVC

ATC$20

$18

$16

$14

$12

$10

$8

$6

$4

$2

1 2 3 4 5 6

MC

55

Costs

AFC

Average

Fixed Cost

ATC and AVC get

closer and closer but

NEVER touch

Quantity

Section 10: Profits, Production, and CostsModule 56:

Long-Run Costs and Economies of Scale

Definition of the “Short-Run”• We will look at both short-run and long-run production

costs.

• Short-run is NOT a set specific amount of time.

• The short-run is a period in which at least one resource is fixed.• Plant capacity/size is NOT changeable

• In the long-run ALL resources are variable• NO fixed resources

• Plant capacity/size is changeable

Today we will examine LONG-run costs.

In the long run all resources are variable. Plant capacity/size can change.

Definition and Purpose of the Long Run

Why is this important?

The Long-Run is used for planning. Firms use to identify

which plant size results in the lowest per unit cost.

Ex: Assume a firm is producing 100 bikes with a fixed

number of resources (workers, machines, etc.).

If this firm decides to DOUBLE the number of

resources, what will happen to the number of bikes it

can produce?

There are only three possible outcomes:1. Number of bikes will double (constant returns to scale)

2. Bikes will more than double (increasing returns to scale)

3. Bikes will less than double (decreasing returns to scale)

Returns to Scale• The long-run average cost

curve for a firm is “U-shaped” like the short-run average cost curves –but for a different reason.

• The long-run average total cost curve (LRATC) is the relationship between output and average total cost when fixed cost has been chosen to minimize average total cost for each level of output.

Long Run ATCWhat happens to the average total costs of a

product when a firm increases its plant capacity?

Example of various plant sizes:

•I make looms out of my garage with one saw

•I rent out building, buy 5 saws, hire 3 workers

•I rent a factor, buy 20 saws and hire 40 workers

•I build my own plant and use robots to build looms.

•I create plants in every major city in the U.S.

Long Run ATC curve is made up of all the

different short run ATC curves of various plant

sizes.

Long Run AVERAGE Total Cost

Quantity Cars

Costs

ATC1

MC1

0 1 100 1,000 100,000 1,000,0000

$9,900,000

$50,000

$6,000

$3,000

Long Run AVERAGE Total Cost

Quantity Cars

Costs

ATC1

MC1

MC2

0 1 100 1,000 100,000 1,000,0000

$9,900,000

ATC2

Economies of Scale- Long

Run Average Cost falls

because mass production

techniques are used.

$50,000

$6,000

$3,000

Long Run AVERAGE Total Cost

Quantity Cars

Costs

ATC1

MC1

ATC2

MC2

ATC3

MC3

0 1 100 1,000 100,000 1,000,0000

$9,900,000

$50,000

$6,000

$3,000

Economies of Scale- Long

Run Average Cost falls

because mass production

techniques are used.

Long Run AVERAGE Total Cost

Quantity Cars

Costs

ATC1

MC1

ATC2

MC2

ATC3

MC3

0 1 100 1,000 100,000 1,000,0000

$9,900,000

$50,000

$6,000

$3,000

Constant Returns to Scale-

The long-run average total

cost is as low as it can get.

MC4

ATC4

Long Run AVERAGE Total Cost

Quantity Cars

Costs

ATC1

MC1

ATC2

MC2

ATC3

MC3

MC5

0 1 100 1,000 100,000 1,000,0000

$9,900,000

MC4 ATC5

$6,000

$3,000

ATC4

Diseconomies of Scale-

Long run average costs

increase as the firm gets too

big and difficult to manage.

$50,000

Long Run AVERAGE Total Cost

Quantity Cars

Costs

ATC1

MC1

ATC2

MC2

ATC3

MC3

MC5

0 1 100 1,000 100,000 1,000,0000

$9,900,000

MC4 ATC5

$6,000

$3,000

ATC4

These are all short run

average costs curves.

Where is the Long Run

Average Cost Curve?

$50,000

Long Run AVERAGE Total Cost

Quantity Cars

Costs

0 1 100 1,000 100,000 1,000,0000

Long Run

Average Cost

Curve

Economies of

Scale

Constant

Returns to

Scale

Diseconomies

of Scale

LRATC Simplified

Quantity

Costs

Long Run

Average Cost

Curve

Economies of

Scale

Constant

Returns to Scale

Diseconomies

of Scale

The law of diminishing marginal returns doesn’t apply in

the long run because there are no FIXED RESOURCES.

Economies and Diseconomies of Scale

• Economies of Scale: the LRATC is falling as the firm expands.

• Diseconomies of Scale: the LRATC is rising as the firm expands.

Economies of Scale

• A firm will enjoy an economies of scale if• start-up costs are high• average costs fall for

each additional unit produced

• An industry that enjoys economies of scale can easily become a natural monopoly.• Public water

Diseconomies of Scale• The firm is not benefiting from

expansion due to decreasing returns to scale.

• This simply means that output is increasing at a slower rate than production costs. • You might imagine a firm that

increases total costs by 100% but this allows the firm to increase output by only 50%.

• Problems with coordination and communication. • Vast firms have offices and

subsidiaries spread across the globe. • It takes time, effort, and money to

coordinate production, marketing, and sales activities within large firms.

• At some point, the firm becomes so large that per-unit costs actually begin to rise.

Sunk Costs

• A sunk cost is a cost that has been incurred in the past and cannot be recovered.

• Sunk costs don’t matter in decision-making!

• Suppose you have purchased a concert ticket for $100 and accidentally drop the ticket in a storm drain, losing it forever. Should you buy another ticket or sit at home and sulk?

• Economists would say that the loss of the first ticket is a moot point. • You can’t get your $100 back, it is

gone. • Whether or not you buy another

ticket depends upon whether you can afford another $100.

• The first $100 is a sunk cost. Sunk costs don’t factor into decision-making because they can not be recovered and therefore don’t affect marginal values.

Section 10: Profits, Production, and CostsModule 57:

Introduction to Market Structure

To Find Market Structures

• Sometimes economists can look at the number of sellers to sell what type of market structure it is.

• Other times they will use:• Concentration ratios

• Herfindahl-Hirschman Index

Use of Measures

• Concentration Ratios• Measures the

percentage of industry sales accounted for by the largest firms

• Used in the 4 or 8 firm model• Add together the

percentage of sales from all firms

• Larger number means more concentrated

• Smaller number means more spread out

• Example:

• 4 Firms• 25%, 20%, 15%, and

10%• 25+20+15+10=70

• 8 Firms (Add 4 more to the list)• 9%, 8%, 6%, 2%

• 70+(9+8+6+2)=95

Use of Measures

• Herfindahl-Hirschman Index• Look at the square of

each firm’s share of the market sales• Larger number means a

few firms dominate the industry

• Smaller number means numerous firms of equal size

• A 3 frim industry• 60%, 25%, 15%

• HHI=60(60)+25(25)+15(15)=4,450

• The higher number shows a smaller concentration of firms and thus an Oligopolistic industry

COMPARISON OF MARKET STRUCTURES

PERFECTECONOMY

MONOPOLISTIC COMPETITION

OLIGOPOLY MONOPOLY

Number of Firms

Many Many A Few Dominate One

Variety of Goods

None Some Some None

Control over Prices

None Little Some Complete

Barriers to Entry

None Low High Complete

Examples Wheat, Shares of Stock

Jeans, Books Cars, Movie Studios

Public Water

What prevents any one firm from raising its prices?

Perfect Competition

Number of Firms: MANY

Variety of Goods: NONE

Barriers to Entry: NONE Control Over Prices: NONE

When do firms in monopolistic competition have some control over prices?

Number of Firms: MANY Variety of Goods: SOME

Barriers to entry: LOW Control over Prices: LITTLE

Monopolistic Competition

Why is public water a monopoly?

Number of Firms: ONE Variety of Goods: None

Barriers to Entry: Complete Control Over Prices: Complete

PUBLIC WATER

Why are high barriers to entry an important part of oligopoly?

Number of Firms: FEW Variety of Goods: SOME

Barriers to entry: HIGH Control over Prices: SOME

Oligopoly