CHAPTER 6
THEORY OF COST AND PROFIT
At the end of this chapter, the students should be able to:
a. Identify the different costs of producing a product and its behavior in relation to
output levels.
b. Analyze the behavior of costs in the short-run and in the long-run.
c. Differentiate between economic and business profits and when break-even points are
attained.
d. Describe and explain the economies and diseconomies of scale in production.
Cost is one of the most essential considerations in production. A certain producer, for
instance, will not jump into a particular investment by simply looking at the potential revenue of
the business. The producer, to be able to maximize profits, must be able to manage its various
costs associated with creating a product by finding the least cash outlays in expanding output
thereby maintaining or increasing profits. In this chapter, we will look into the different costs and
analyze profits and revenues incurred in the short-run and the benefits of producing in mass in
terms of costs and profits in the long-run.
COST CONCEPT
Cost of production refers to the total payment by a firm to the owners of the factors of
production.
Factors of Production Factor Payment
Land Rent
Labor Wage or Salary
Capital Interest
Entrepreneurship Profit
The price of the resources is measured in terms of opportunity cost. Opportunity cost is
the value of the foregone opportunity or alternative benefits. This means that in order for a
business firm to secure the services or resources, it must pay an amount equal to what these
resources can earn in other alternative resources. For instance, a skilled worker earning P1000 in
Company A has an opportunity cost equal to P1000. That is the worth of the skill provided by the
worker. If company B wishes to hire the services of the said skilled worker, then company B has
to pay P1000 (the opportunity cost).
Important cost concepts include:
A. Explicit vs. Implicit Costs
Explicit cost (Visible Cost). It is the actual (explicit) expenditures made by the firm
(that is usually thought of as its only expenses).
Implicit cost (Invisible cost). It is the cost of self-owned, self-employed resources
frequently overlooked in computing the expenses of the firm.
B. Short run and Long run viewpoints
Short run. It is the planning period of the firm so short that some resources can be
classified as fixed while some are considered as variable.
Long run. It is the planning period of the firm so long that all resources eventually
become variable.
42
SHORT-RUN COST ANALYSIS
In the short run, the total costs of a firm depend on the firm’s size and on the level (or
volume) of production. The component parts of Total Costs (TC) are Total Fixed Costs (TFC) and
Total Variable Costs (TVC).
TC = TFC + TVC
Fixed Cost. It is the kind of cost which remains constant regardless of the level (or volume) of
production. The summation of all the fixed costs incurred by a firm in its production is
the Total Fixed Cost (TFC).
Variable Cost. It is the kind of cost which changes in proportion to the level (or volume) of
production. Total Variable Cost (TVC) is the totality of all the variable costs spent by the
firm in its production.
Using the example on input-output data in Chapter 5, the following costs (Total and
Averages) are derived. Additional assumptions are: 1) There is only one variable input (X) which
costs P50 each; and 2) The fixed input values at P150, regardless of the output.
Table 6.1. Costs and Output Schedules
X TP MP AP TVC TFC TC AVC AFC AC MC
0 0 - 0 150 150 - - -
6 8.33
1 6 6.0 50 150 200 8.33 25.00 33.33
10 5.00
2 16 8.0 100 150 250 6.25 9.38 15.63
13 3.85
3 29 9.7 150 150 300 5.17 5.17 10.34
15 3.33
4 44 11.0 200 150 350 4.55 3.41 7.95
11 4.55
5 55 11.0 250 150 400 4.55 2.73 7.27
5 10.00
6 60 10.0 300 150 450 5.00 2.50 7.50
2 25.00
7 62 8.9 350 150 500 5.65 2.42 8.06
Costs
550
TC
500
450
400
TVC
350
300
250
200
150 TFC
100
50
0 Output (Q)
0 6 16 29 44 55 60 62
Figure 6.1. Cost Curves
Average and Marginal Cost Curves
Average cost is also called unit cost. These curves show the same kind of information as
the total cost curves in a different form. The average cost curves include the Average Cost (AC),
Average Fixed Cost (AFC) and the Average Variable Cost (AVC).
43
Average Fixed Cost (AFC) refers to the fixed cost per unit at various levels of output. This
is obtained by dividing the TFC by the output (Q).
TFC
AFC=
Q
Average Variable Cost (AVC) is the variable cost per unit of output. This can be obtained
in two ways:
TC
AC=
Q
AC= AFC + AVC
Marginal Cost is the additional or extra cost brought about by producing one additional
unit of output. Also, this is known as the slope of the TC. It is obtained by dividing the change in
the total cost by the change in the output.
∆ TC Change∈Total Cost
MC= =
∆Q Change∈Output
Costs
35
30
MC
25
20
15
10 A
C
5 AV
C
AFC
0
0 6 16 29 44 55 60 62 Q
Figure 6.2. Average and Marginal Cost Curves
PROFIT CONCEPT
Total and Marginal Revenue
Total revenue (TR) is the payment for the output by the firm. This represents the income
of the firm. It is obtained by multiplying the price (P) and the output (Q) produced.
TR = P x Q
Marginal Revenue (MR) is the additional income of a firm obtained by producing and
selling one additional unit of product. It is also equivalent to the slope of the TR. The
mathematical formula to derive MR is as follows:
∆ TR Change∈Total Revenue
MR= =
∆Q Change∈Output
44
Table 2.2. Revenue Schedule.
Units of Output (Q or TP) TR MR
0 0
6 60 10
10
16 160
10
29 290
10
44 440
10
55 550
10
60 600
10
62 620
10
64 610
10
66 590 10
68 560
Revenue
650
600
550 TR
500
450
400
350
300
250
200
150
100
50
M
0
R Q
0 6 16 29 44 55 60 62 64 66 68
Figure 6.3. Total Revenue Curve and Marginal Revenue Line
Profit, Loss and Break-Even
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 (TR) and both explicit and implicit costs.
Profit maximization involves the comparison of TR and TC. The mathematical formula to
derive profit (π) is by getting the difference between total revenue (TR) and total cost (TC).
π = TR – TC
To maximize profits, the firm must find the equilibrium price and quantity that give the
largest profit on or the largest difference between TR and TC. The rule is simple, a positive
difference indicates profit (π > 0), a negative difference means a loss (π < 0); and when π = 0, it
suggests break-even or TR is equal to TC.
To illustrate the concept, let us assume that the price of the good is P16.00 and variable
cost per unit is P12.00. If the firm produces various amount of good X given in column 2 of the
Table 6.3 below the total revenue (TR) in column 3 is computed by multiplying the various
quantities of goods produce with the given price which is P16.00. Given the firm’s total costs in
column 4, profits (π) can be computed by subtracting column 3 (TR column) with column 4 (TC
column).
45
In the same manner, using the hypothetical data in the Table 6.3 below, the firm incurs
losses during the span of its operation from points A to D, a situation in which negative profit
occurs after subtracting TR in column 3 to TC in column 4. The firm is in equilibrium level or
breaks even at point E when we arrive at a zero profit upon the same process. Thus, in this case,
the firm neither incurs a loss nor a profit. Further, the firm incurs a profit from points F to I.
Table 6.3 below shows the firm’s hypothetical total cost and total revenue while Figure
6.4 presents the typical graphical relationship between Total Revenue and Total Cost showing the
break-even point at a certain output level.
Table 6.3. Hypothetical Data of a Firm’s Total Cost and Total Revenue
Points Quantity (Q) Total Revenue (TR) Total Cost (TC) Profit (π)
(1) (2) (3) (4) (5)
A 0 0 1600 -1600
B 100 1,600 2800 -1200
C 200 3,200 4000 -800
D 300 4,800 5200 -400
E 400 6,400 6400 0
F 500 8,000 7600 400
G 600 9,600 8800 800
H 700 11,200 10000 1200
I 800 12,800 11200 1600
TR,TC
13500
T
12000
O FI R
10500 PR T
T C
9000
7500 E
6000 Break-even
4500
3000
1500 S
LO
0 S Q
0 100 200 300 400 500 600 700 800
Figure 6.4. The Linear Total Cost and Total Revenue with the Break-even point
The Profit Maximization Condition
A competitive firm takes the market price as constant. If the firm wants to maximize
profits, the optimum level of production in the short-run (Q*) is when its marginal cost is equal to
its price (since in a competitive market, price is also equal to marginal revenue).
MC = P = MR
46
MC, MR
30
MC
25
20
15
10 MR
5
0
0 6 16 29 44 55 60 Q*
62 Q
LONG-RUN COST ANALYSIS
Long run is a time period wherein all fixed factors can be variable. 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. The LAC is the curve tangent to each short-run
average cost representing different plant sizes that a firm can build in the long-run.
As you already know, the shapes of short-run cost curves follow directly from the
assumption of fixed factor of production. As output increases beyond a certain point, the fixed
factor, (which we usually think of as fixed scale of plant) causes diminishing returns to other
factors and the increasing marginal costs. In the long run, however, there is no fixed factor of
production. Firms can choose any scale of production. They can double or triple output or go out
of business completely.
The shape of a firm’s long-run average cost curve depends on how costs vary with scale
of operation. For some firms, increased sales, a size, reduces costs; for others, increased sales
leads to inefficiency and waste. When an increase in a firm’s scale of production lead to a lower
average costs, we say there are increasing returns to scale , or economies of scale. When
average costs do not change with the scale of production, we say there are constant returns
to scale. Finally, when an increase in a firm’s scale of production leads to a higher average
costs, we say there are decreasing returns to scale, or diseconomies of scale.
The Sources of Economies and Diseconomies of Scale
Economies of scale often arise because higher production levels allow specialization
among workers, which permits each worker to become better at a specific task. For instance, if
Ford hires a large number of workers and produces a large number of cars, it can reduce costs
with modern assembly-line production. Diseconomies of scale can arise because of coordination
problems that are inherent in any large organization. The more cars Ford produces, the more
stretched the management team becomes, and the less effective the managers become at
keeping costs down.
This analysis shows why long-run average cost curves are often U-shaped (Figure 6.5).
At low levels of production, the firm benefits from increased size because it can take advantage
of greater specialization. Coordination problems meanwhile are not yet acute. By contrast, at
high levels of production, the benefits of specialization have already been materialized, and
coordination problems become more severe as the firm grows larger. Thus, the long-run average
total cost is falling at low levels of production because of increasing specialization and rising at
high levels of production because of increasing coordination problems.
47
Figure 6.5. Economies and Diseconomies of Scale
References
Bello, Amelia L. et al. 2009. Economics. C and E Publishing, Inc.
Case, Karl E. and Fair, Ray C. 2005. 7TH Edition. Principles and Foundations of Economics.
Pearson Education, Inc.
Costales, Achielles C. et al. 2000. Economics: Principles and Applications. JMC Press, Inc.
Gabay, Bon Kristoffer G. et al. 2007. 1 st edition. Economics: Its Concepts and Principles (with
Agrarian Reform and Taxation). Rex Book Store.
Silon, Elsa T. et al. 2009. Manual for Economics with Work Exercises
Mankiw, N. Gregory. 2009. Economics Principles. Philippine Edition. Cengage Learning Asia Pte
Ltd
Mansfield, Edwin. 1975. Microeconomic Problems: Concepts, Cases and Test. 2 nd edition. W.W.
Norton & Company, Inc.
48
Exercise No. 6
THEORY OF COST AND PROFIT
Name: _______________________________ Score: _________
Year/Course/Section: ___________________ Date : _________
TRUE OR FALSE.
Instruction: Write the word TRUE if the given statement is correct and FALSE, if otherwise.
Write your answers on the space provided before the number.
_________ 1. A firm cannot vary the quantity of labor inputs in the short run.
_________ 2. Costs that have already been incurred are important factors in making production
decisions.
_________ 3. The opportunity cost doctrine says that the production of one good may reduce
the cost of another good.
_________ 4. The break-even point lies well above the output level that must be reached if the
firm is to avoid losses.
_________ 5. Average cost must exceed marginal cost at the point where the average cost is
minimum.
_________ 6. Plant and equipment of a firm are fixed in the short-run.
_________ 7. If the marginal cost is falling is below average cost then the average must be
falling.
__________ 8. Business profit is the same as economic profit.
__________ 9. Factor payments for entrepreneurship are called rent.
__________10. Fixed costs changes as the level of production changes.
PROBLEM SOLVING
Instruction: Answer the following problems.
Suppose that the steel firm’s costs are shown below:
Output (Q) TFC TVC TC AFC AVC AC MC TR MR Profit/Loss
0 500 0
1 500 50
2 500 90
3 500 140
4 500 200
49
5 500 270
6 500 350
7 500 450
8 500 600
*Price of steel is P175/unit
a. Complete the table above by solving on what is asked in the first row.
b. Graph the firm’s TFC, TVC, TC and TR in the graphing space below.
c. Graph the firm’s AFC, AVC, AC, MC and MR in the graphing space below.
50
d. At what unit of output that the firm breaks-even? Do you think that the firm attains the
optimum level of output?
51
