Theory of Cost and Profit

6
Theory of Cost and Profit
The relationships and the interactions of consumers and producers can be easily understood
using the economic model in Chapter 1 showing the Circular flow of Income. Chapter 5 on the
Theory of Consumer Behavior discusses the demand side of the market flow. We had initially
presented the Theory of Production in Chapter 5 focusing on the physical production-inputs and
outputs. In this chapter, we will continue to study the behavior of the firm (producers and
sellers), the supply side of the product market in terms of the relationships between costs and
output.

Objectives:

After studying this chapter, the students should be able to:

• Account for the factors that comprise a firm’s cost

• Explain the relationship among the different economic costs
• Differentiate between economic profit and accounting profit
• Explain how firms decide what and how to produce.

I. The Production and Costs

Production cost is a determinant of supply and exhibits an inverse relationship.
Thus, the objective of producers is to generate products and services at the lowest cost
possible without sacrificing quality. High production cost means higher prices for their
products which could limit the consumer demand while less cost would mean increase
demand for the product resulting to higher sales and chance for higher profit.

To produce a good or a service, a firm needs economic resources or factors of

production referred to as inputs and process them into outputs. The firm has to pay for
these inputs and in the process, generate costs. As discussed in Chapter 1, the inputs or
factors of production are the following with their corresponding factor payments:

Factor of Production Factor Payments

or Input
Land Rent
Labor Salary or Wage
Capital Interest
Entrepreneur Profit

Cost of production is the sum of the costs of all inputs used in production.

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 Theory of Cost and Profit

Types of Economic Cost

1. Explicit Cost

Payments to the owners of the factors of production like wage, interests, and raw
materials. It is also called the expenditure cost and requires money outlay from
the firm.

2. Implicit Cost

This is the firm’s opportunity cost of using its own factors of production without a
corresponding cash payment like rent for land. In economics, implicit costs are
taken into account in determining the performance of the firm (profit or loss).

3. Opportunity Cost

This refers to the cost of foregone opportunity or alternative benefit. It is the value
of the next-highest-valued alternative use of that resource

4. Fixed Cost (FC)

Fixed cost is the type of cost which remains constant regardless of the volume of
production. It does not change with an increase or decrease in the amount of
goods or services produced. Even at zero production the firm still incurs this cost.
Rent for stalls and offices has to be paid whether you utilize them or not.

5. Average Fixed Cost (AFC)

Average Fixed Cost (AFC) is total fixed cost divided by the quantity of the
output:

AFC = TFC
Q

6. Variable Cost (VC)

Costs that vary or change depending on the volume of production are called
variable costs. They rise as production increases and fall as production decreases
like raw materials, wages and salaries.

7. Average Variable Cost (AVC)

Total variable cost divided by the quantity of the output or AVC = TFC
Q

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Theory of Cost and Profit

8. Total Cost (TC)

Total cost is the market value of all the inputs used by the firm in production. It is
the sum of all the fixed and variable costs incurred by the firm in producing its
products.
TC = FC + VC

9. Average Cost (AC)

Average cost is also called the unit cost and is equivalent to the total cost divided
evenly by the quantity of the output.
AC = TC
Q

Average cost can also be expressed as the sum of Average Fixed Cost (AFC) and
Average Variable Cost (AVC), since total cost is just the sum of fixed and
variable cost.
AC = AFC + AVC

10. Marginal Cost (AC)

This cost refers to the increase in total cost from producing one extra unit of
output. It is also known as the slope of the total cost curve. Marginal cost is
obtained by dividing change in total cost by change in quantity of the output.

MC = ∆TC
∆Q

Short Run Cost Curves

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 Theory of Cost and Profit
A. Total Cost Curves
Graphs are useful to better understand the relationships between production and costs.
The Total Product Curves below are based on Table 6.1: Total Cost and Output Schedule
of LAM Company, on the short run. It can be noted that at least one input is fixed.

Table 6.1: Total Costs and Output Schedule

OUTPUT TFC TVC TC
0 40 0 40
2 40 70 110
3 40 130 170
4 40 180 220
5 40 240 280
6 40 310 350
7 40 380 420
8 40 460 500
9 40 550 590
10 40 650 690

Total Cost Curves

COST
800

700

600

500
TFC
400
TVC
300 TC
200

100
OUTPUT
0
0 2 3 4 5 6 7 8 9 10

The cost curves show the relationship between the quantity of production and the costs
involved in production. The total cost curve gets steeper as the production increases
because of the diminishing marginal product. The graph above clearly shows the
behavior of the fixed and variable costs, the components of the total cost. Fixed cost is
constant at all level of production, while the variable cost increases with more
production.

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Theory of Cost and Profit

B. Average and Marginal Costs Curves

Table 6.2 on the average cost schedule was based on Table 6.1: Total Cost and Output
Schedule.

Table 6.2: AVERAGE COSTS SCHEDULE

OUTPUT AFC AVC ATC MC
0 0 0 0
2 20 35 55 35
3 13 44 57 60
4 10 45 55 50
5 8 48 56 60
6 7 51 58 70
7 6 54 60 70
8 5 57 62 80
9 5 61 66 90
10 4 65 69 100

Looking more closely, both at the schedule and the graph, reveal that the marginal cost
generally rises as the output increases. When the MC is lower than the average total cost
(ATC), the average total cost is falling. On the other hand, when the MC is higher than
the ATC, the ATC is rising. It crosses the average cost curve at its minimum.

Average Cost Curves

COST
120

100

80
AFC
60 AVC
AC
40
MC
20

0 OUTPUT
0 2 3 4 5 6 7 8 9 10

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 Theory of Cost and Profit
III. REVENUE AND PROFIT
A. Total Revenue and Marginal Revenue
Total revenue (TR) refers to the total receipts from sales of a given quantity of goods or
services. It is the total income of a firm and is calculated by multiplying the quantity of
goods (Q) sold by the price (P) of the goods.

TR = P x Q

Other concepts related to total revenue are the average revenue (AR) and marginal
revenue (MR).

Average revenue refers to the revenue per unit of output sold and is computed by
dividing the total revenue by the number of units sold.

Marginal revenue (MR) is the additional income generated from the sale of an
additional unit of output. It is the change in total revenue from the sale of one more unit
of a good. MR = ∆TR
∆Q

Table 6.3: Profit and Loss Schedule

OUTPUT TC MC TR MR Profit/(Loss)
0 40 0 20
2 110 35 120 60 10
3 170 60 180 60 10
4 220 50 240 60 20
5 280 60 300 60 20
6 350 70 360 60 10
7 420 70 420 60 0
8 500 80 480 60 -20
9 590 90 540 60 -40
10 690 100 600 60 -80

LAM Company sells its product at P60.00/unit and Table 6.3 shows the company’s
performance at various levels of production. The level that would give the company the
highest profit based on output and pricing is the profit maximization point.

Profit maximization can be determined through the Marginal Cost – Marginal Revenue
Method and the Total Cost-Total Revenue Method. The Marginal Cost – Marginal
Revenue Method is based on the fact that total profit reaches its maximum point where
marginal revenue equals marginal cost. On the other hand, the total revenue–total cost
focuses on maximizing the difference between revenue and costs which is equal to the
company’s profit.

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Theory of Cost and Profit

TOTAL REVENUE AND TOTAL COST CURVES

C IV. ..
O
V. ..
S
VI.
T

B. Break-even Point
The break-even point (BEP) is the point at which total cost and total revenue are equal:
there is no net loss or gain. A profit or a loss has not been made, but all costs that need to
be paid were fully settled. The level of output at which total revenue equals total cost and
can be determined using 3 approaches:

1. Based on the total cost and total revenue schedule. Analyze the entries. The break-even
point is when total revenue = total cost. In Table 6.3, LAM Company’s break-even
point is at Output 7, where the total cost and total revenue were both at P 420.00.

2. Graphing - the point of intersection between the total cost and total revenue curves

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 Theory of Cost and Profit
3. Mathematical computation using the following basic equation:

where:

 TFC is Total Fixed Costs,

 P is Unit Sale Price, and
 V is Unit Variable Cost.

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Theory of Cost and Profit

References:

Mankiw, G.N., (2012). Essentials of Economics 6th Edition. Harvard University: South-Western,
Cengage Learning

Mastrianna, F.V., (2013). Basic Economics 16th Edition. South-Western Cengage Learning

McConnel, C., et.al (2012). Economics: Principles, Problems, and Policies (Global Edition).
McGraw Hill Co., Inc.

Paraiso, O.C., et.al (2011). Introduction to Microeconomics, Mutya Publishing House, Inc.

Stock, W.A., (2013) Introduction to Economics: Social Issues and Economic Thinking

http://ph.images.search.yahoo.com
http://www.intelligenteconomist.com
http://www.investopedia.com

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