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Theory of Cost and Profit

Cost is one of the most essential matters to be considered 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.

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
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.
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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 4, 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 1. Costs and Output Schedules

X TP MP AP TVC TFC TC AVC AFC AC MC

0 0 - - 0 150 150 - - - -
1 6 6 6.0 50 150 200 8.33 25.00 33.33 8.33
2 16 10 8.0 100 150 250 6.25 9.38 15.63 5.00
3 29 13 9.7 150 150 300 5.17 5.17 10.34 3.85
4 44 15 11.0 200 150 350 4.55 3.41 7.95 3.33
5 55 11 11.0 250 150 400 4.55 2.73 7.27 4.55
6 60 5 10.0 300 150 450 5.00 2.50 7.50 10.00
7 62 2 8.9 350 150 500 5.65 2.42 8.06 25.00

Figure 1. Typical Total Cost Curves.

Average and Marginal Cost Curves

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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).

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).

AFC = TFC
Q

Average Variable Cost (AVC) is the variable cost per unit of output. This can be
obtained in two ways:

AC = TC or AC = AFC + AVC
Q
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.

MC = ∆TC = change in total cost

∆Q change in quantity

Figure 2. Typical Average and Marginal Cost Curves

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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:

MR = ∆TR = change in total revenue

∆Q change in quantity

Table 2. Revenue Schedule.

Units of Output TR MR
(Q or TP) (P x Q) (∆TR
∆Q)

0 0 -
6 60 10
16 160 10
29 290 10
44 440 10
55 550 10
60 600 10
62 620 10
61 610 10
59 590 10
56 560 10

Figure 4. Total and Marginal revenue.

700 Total Revenue

600
500
400
300
200
100 Marginal Revenue

0
0 6 16 29 44 55 60 62 61 59 56
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Profit, Loss and Break-Even

Accounting/Business Profit versus Economic Profit

Accounting/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. If
the firm produces various amount of good X given in column 2 of the table 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).

In the same manner, using the hypothetical data in the table below, the firm
incurs losses during the span of its operation from points A to C, 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 points D and I 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 E to H.

Table 3 below shows the firm’s hypothetical total cost and total revenue while
figure 5 presents the typical graphical relationship between Total Revenue and Total
Cost showing the break-even points at certain output levels.
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Table 3. Hypothetical Data of a Firm’s Total Cost and Total Revenue

Points Quantity (Q) Total Total Cost Profit

Revenue (TC) (π)
(TR)

(1) (2) (3) (4) (5)

A 0 0 1,600 -1,600
B 100 1,600 4,000 -2,400
C 200 3,200 4,600 -1,400
D 300 4,800 4,800 0
E 400 6,400 5,048 1,352
F 500 8,000 5,550 2,450
G 600 9,600 6,400 3,200
H 700 11,200 8,000 3,200
I 800 12,800 12,800 0

Figure 5. Total Cost, Total Revenue and the Break-Even point.

TR, TC

TR

profits
TC

Break-even point
losses

Output (Q)

The Relationship Between Short-Run

and Long-Run Average Total Cost

For many firms, the division of total costs between fixed and variable costs
depends on the time horizon. Consider, for instance, a car manufacturer such as Ford
Motor Company. Over a period of only a few months, Ford cannot adjust the number
or sizes of its car factories. The only way it can produce additional cars is to hire more
workers at the factories, build new factories, or close old ones. Thus, the cost of its
factories is a variable cost in the long run.
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Because many decisions are fixed in the short run but variable in the long run,
a firm’s long-run cost curve differ from its short-run-average-total-cost-curves- for a
small, medium, and large factory. It also presents the long-run average total cost
curve. As the firm moves along the long-run curve, it is adjusting the size of the factory
to the quantity of production.

This graph shows how short-run and long-run costs are related. The long-run-
average-total-cost curve is a much flatter U-shape than the short-run average-total-
cost curve. In addition, all the short-run curves lie on or above the long-run curve.
These properties arise because firms have greater flexibility in the long run. In
essence, in the long run, the firm gets to choose which short-run curve it wants to use.
But in the short-run, it has to use whatever short-run curve it has chosen in the past.

The figure shows an example of how a change in production alters costs over
different time horizons. When Ford wants to increase production from 1000 to 1200
cars per day, it has no choice in the short run but to hire more workers at its existing
medium-size factory. Because of diminishing marginal product, average total cost
rises from Php 10,000 to Php 12, 000 per car. In the long run, however, Ford can
expand both the size of the factory and its workforce, and the average total cost returns
to Php10,000.

How long does it take a firm to get to the long run? The answer depends on the
firm. It can take a year or longer for a major manufacturing firm, such as a car
company, to build a larger factory. By contrast, a person running a coffee shop can
buy another coffee maker within a few hours. There is, therefore, no single answer to
how long it takes a firm to adjust its production facilities.

Figure 6. Average Total Cost in the Short and Long Run

Average
Total Cost

Diseconomies of Scale

Economies
of scale

Constant Returns to Scale

Quantity of Cars
per day
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Economies and Diseconomies of Scale

The shape of the long-run average-total-cost curve conveys important

information about the production processes that a firm has available for manufacturing
a good. In particular, it tells us how costs vary with the scale – that is, the size – of a
firm’s operations. When long-run average total cost declines as output increases, there
are said to be economies of scale. When long-run average total cost rises as output
increases, there are said to be economies of scale. When long run average total cost
rises as output increases, there are said to be diseconomies of scale. When long-run
average total cost does not vary with the level of output, there are said to be constant
returns to scale. In this example, Ford has economies of scale at low levels of output,
constant returns to scale at intermediate levels of output, and diseconomies of scale
at high levels of output.

What might cause economies or 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-total cost curves are often U-
shaped. At low levels of production, the firm benefits from increased size because it
can take advantage of specialization. Coordinating problems, meanwhile, are yet
acute. By contrast, at high levels of production, the benefits of specialization have
already been realized, and the coordination problems become more severe as the firm
grows larger. Thus, 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.