THEORY OF COST

AND PROFITS
Leader: Ellexis Magpantay

Member: Joanalyn Mae Bucalos

Micko Marasigan
Renalyn Gratico
Lea Mendoza
 Objectives
At the end of this chapter, the student is expected to:
1. Describe the concept of the theory of cost and profit in
economics;
2. Distinguish fixed and variable costs;
3. Compute total cost based on total fixed cost and total
variable cost;
4. Differentiate opportunity and imputed cost; and
5. Discuss how to compute profit.
 Terms to Remember
assets - a resource that has economic value owned by individual or a company cost - value of money
that has been used up
to produce something
entrepreneur - one who introduces new things and uses this innovations for the betterment of the
economy
imputed cost - cost that is implied but not included in financial report or accounting record
inventories - a detailed list or report in one's
possession
opportunity cost - deals on how much more (less) one gains in giving up alternatives to benefit from a
choice
revenues - also known as income; total amount received by the company for the goods or services
sold
 Introduction
The producer in this chapter is presented as one whose objective is profit maximiza-
tion. To attain this objective, the producer is equipped with explicit concepts in order
to arrive at a more refined and rational decision. Moreover, these concepts help in
understanding market behavior as discussed in the succeeding chapters.
The framework of discussion is the concept of business, which defines cost and profit.
This definition serves to identify the components of cost-output as well as revenue-
output relationships, which in turn lead to the concept of maximum profit.
 GENERAL CONCEPT
From the point of view of an entrepre-neur, a business or firm exists to reward
entrepreneurial efforts. To render this reward, the firm undergoes a production process
the outcome of which serves the consumers or buyers. Production embraces the
whole process of making the product available to consumer, which therefore includes
the final process of distribution." In so doing, the firm pays a price by using its stock of
assets and the value foregone is called cost. At the end of the said process, the firm
earns revenues through the sale of goods or services. The positive net effect or the
difference between revenue and cost is called profit and accrues as said reward to the
entrepreneur
 Hence, profit is a creation of entrepre-neurship. With the revenue earned,
the firm can recover what it foregoes in the process of production and the
excess is simply the profit created. To retain this profit is to increase the
firm's stock of assets. Conversely, the negative difference between revenue
and cost results in a loss which erodes this stock of assets.
 Cost Concepts
A firm maintains a stock of assets that it can use for production.
Two Classifications of Assets
1. Real assets - machineries, buildings, materials, and supplies
"thus a buy and sell business is also involved in production which is the service of
bringing supplies from the source to the users
Monetary assets - forms of money and near money, part of which the firm tranforms
into real assets through purchases or acquisitions
the firm incurs cost by using these assets for production. It should be noted that
expenditure does not constitute a transformation of an asset from one form to
another but rather the giving up of values for the production process
 Hence, a firm incurs cost not in the paying for the acquisition of real assets but
rather in their use. Likewise, the use of rasources in the production of unsold good,
is not considered cost as the meaning or production covers a broader perspective.
The resources used are simply transformed into these unsold goods which become
part of the Gim's stock of assets called inventories. On the other hand, the depletion
of monetary assets only constitutes cost when used as payments for the utilization of
other resources, such as labor, as well as for the other obligations of the firms, such
as some forms of taxes.
 Table 16
XYZ Company Income Statement for the Year Ended December 2005
(a hyphothetical example)
 Table 16 presents a simple statement of cost and profit. The reasons for the
inclusion of the types of cost are discussed in the succeeding sections.

Opportunity Cost

As a concept, opportunity cost is the foregone opportunity of choosing an

alterna-tive. The difference between the opportunity gained from the alternative
and its opportunity cost is the net gain (loss) from said choice. Simply put, it is
how much more (less) one gains in giving up alternatives to benefit from a
choice. Ideally, the concept should help us change decisions for the best. In the
real world however, it should at least, help us make better decisions.
 In business, the use of stock of assets for production is opportunity cost
since such assets could have been used for something else. Also included
as opportunity cost are the owner's foregone earnings, which are what they
could earn alterna-tively. One example is the interest income that owner's
money could have earned from money market placement. Another example
is the employment income the entrepreneur lost by not working somewhere
else.
 "
Table 16 matches business gross income (sales) with opportunity cost in the
forms of business cost (goods or operation) and foregone earnings of owner's
money and entrepreneurial activity. The business earns the net amount of
P1,175,532 by using the current asset stock and entrepreneurial skill. How-
ever, it gave up P792,491 as foregone earnings of investment funds and
entrepreneurial activity to earn P382,861 more, which is a
better choice.In a broader perspective, cost is the foregone opportunity of the
stakeholders in the business, such as the owners/stockholders, creditors,
employees, and suppliers. The net gain of production (net of opportunity cost)
is also theirs as they forego opportunities to earn more. The opposite is true
when the business incurs losses.
 In to a broader perspective, cost is the foregone opportunity of the
stakeholders in the business, such as the owners/stockholders, creditors,
employees, and suppliers. The net gain of production (net of opportunity
cost) is also theirs as they forego opportunities to earn more. The opposite
is true when the business incurs losses.
 Imputed Cost
The business is a separate entity as it rewards its stakeholders. Therefore, it should
pay any use of resources and other assets to determine gains (losses) even before
making the best investment choice. But accounting records exclude uses which involve
no cash outlay which is cost, nonetheless. These uses should have assigned values
called imputed cost. One example is the imputed salary of the entrepreneur who
doubles as the general manager of the business. Other examples are imputed rent for
the use of personal properties for production and the interest income for the
opportunity of using owner's money. Incidentally, accounting records impute
depreciation charges to the use of fixed assets.
 Since the said uses have alternative uses, their imputed costs should
approximate their opportunity costs. Therefore, all imputed costs are
opportunity costs although it is not necessary true the other way around.

Cost-Output Relationship in the Short Run

Given a certain level of optimum input and maximum output, cost-output

relationship assumes different forms. These are the short-run cost
functions since plant size and capacity are fixed. Table 17 presents the
different forms of this cost-output relationship and serves as a reference in
the succeeding discussions.
 Fixed and Variable Costs
Total cost (TC) has two basie compo-nents, namely: fixed cost and variable
cost.
Total fixed cost (TFC) does not vary with output; whereas, total variable cost
(TVC) varies in direct proportion. The following equation illustrates:
TC = TFC + TVC
where:
TC = Total Cost
TFC = Total Fixed Cost
TVC = Total Variable Cost
 The items presented in the income statement in Table 16 are classified into
fixed and variable costs. Depreciation, salaries, and wages fall under fixed cost
although the utilization of the corresponding resources varies with output.
Depreciation of fixed assets is something difficult to measure and is expressed
in monetary terms although imputed with a fixed amount. On the other hand, a
business is not flexible to vary its labor inputs in the short run and hence
maintains a maximum work force size, the remuneration of which is likewise in
the form of fixed cost. Furthermore, other cost items like supplies and utility
expenses are partly
classified as variable as they also consist or direct inputs of production and
marketing. whereas, the rest are classified as fixed being supportive or
indirect inputs.
Figure 48 illustrates the functional relationship between output and each of
the aforementioned cost concepts lie., TC, TFC, and TVC) from Table 17.
TFC assumes a horizontal line since it does not vary with output. Moreover,
the TC and TVC curves are parallel as the difference between them at any
level of output is the constant value of total fixed cost (TFC) since:
TFC = TC - TVC
Figure 48: Total Cost Function
 on Table 17. The symbol for change carries a positive sign if the variable increases and a
negative sign if the variable decreases.
However, MC or MVC always carries a positive sign, which means that total cost (TC)
increases with output. Moreover, MC or MVC is also the cost of the additional or last unit of
output. For example, the table shows that MC or MVC is P2, which is the increase in TC or
TVC when output level increases from three to four units. This marginal level is simply the
cost of the 4th or last unit when producing four units of output.
To further illustrate the derivation of the
MC curve from the TC curve, point J along the MC curve in Figure 49 registers a value
equals to 30 when output is equal to 10 units.
On the other hand, the corresponding change in the TC or TVC curve in producing the 10th
unit along the same point is likewise equal to 30. In addition, the behavior of the MC curve
determines the shape of the TC curve.
From its point of origin, the MC curve initially declines causing the increase in TC for every
additional unit of output to diminish.
Eventually, the MC curve increases causing AC to accelerate instead. The lowest point of the MC curve
corresponds to the turning point of the TC curve. The same behavior is also true of the TVC curve since
MC is equal to MVC.
On the other hand, the MC values corresponding to all the units of a certain output level sum up to TVC.
Referring again to Figure 49, the output level equals to 10 units corresponds to a TVC value equals to
155.
This value is also represented by the shaded portion under the MC curve representing the
MC values from the 1st to the 10th unit of output. Hence, the alternative expressions of the TC and TVC
functions are as follows:
TC = ¿(MC) + TFC
TVC = ≥(MC)
where: & is the symbol for summation.
 Finally, the MC curve exhibits a decreasing and then increasing pattern as
output increases due to the same pattern of marginal input in the production
function. Recalling Chapter 5, marginal input is simply the inverse of marginal
product with the opposite pattern of change.
Initially, total cost (TC) increases at a slower pace since less and less is added
to It with a decrease in marginal cost (MC).
This implies that production becomes more and more efficient before the
threshold of diminishing returns as the cost of producing an additional unit of
output decreases. Even-tually, production becomes less and less efficient,
thus increasing the cost of producing an additional unit of output with the
increase h MC and faster increase in TC. It should
de noted at this point that the production function infuences the behavior of the
MC
Figure 50 illustrates the three forms of average cost based on Table 17. The
ATC curve is above its AFC and AVC components.
The ATC curve decreases with its components to point I where output is
equal to 10 But beyond this point, it increases as AVC increases faster than
AFC decreases. The ATC curve is bell-shaped upside down due to
production efficiency factors as explained in the next section.
 Figure 50: The Average Cost Function

Finally TC, TVC, and TFC can be derived from ATC, AVC, and AFC, respectively by simply
multiplying the latter by (output).
TC = (ATC)(Q)
TVC = (AVC)(Q)
TFC = (AFC)(Q)
Assuming the quantity level to be Q. in Figure 51, TC, TFC, and TVC are represented
respectively by the shaded rectangular areas bounded by average cost and output.
C, and Q.
C, and Q C, and Q
The lowest point of an average cost curve (i.e., ATC or AVC) corresponds to the output
level between the phases where it registers decreasing and then increasing trends from
the point of origin of the graph.
It should be noted, however, that the points at which MC intersects the ATC and
AVC curves differ.
Unit Cost and Production Efficiency
Abstracting from Figure 50, the average total cost (ATC) curve exhibits a
decreasing and then increasing pattern as output increases. The general
decrease in ATC means production becomes more and more efficient in the use
of resources because of two factors. First, the increase in the marginal product
(MP) and productivity in the production function (Chapter 5) decreases the
marginal cost (MC) and average variable cost (AVC) in Figure 54. Second, more
use of a fixed plant size spreads out fixed cost (FC) to more output, thus
decreasing idle capacity and average fixed cost (AFC). In Figure 50, ATC
decreases due to the same change in its AVC and AFC components.
This pattern continues up to point I despite an increase in AVC. The decrease in
AFC
Figure 51: The Average and Total Cost
Functions
 Figure 52: The Average Cost Functions

outweighs the increase in AVC, causing the

ATC to continuously decrease, thus making a unit of output cheaper to produce.
Eventually, production becomes less and less efficient with the offsetting effect of the increase
in MC and AVC due to the Law of Diminishing Returns. Figure 52 shows that bevond point I, the
increase in AVC outweighs the decrease in AFC, making a unit of output costlier to produce.
The most efficient plant use is at point I, which is the lowest point of the ATC curve.
Producing before this point means underusing fixed resources, and increasing use toward point
I means increasing efficiency of their use due to decreasing idle capacity. On the other hand,
producing beyond this point means overutilization and less efficient use of resources
(diminishing returns).
This contrast explains why, for example, electricity rate in the provinces is higher than that in
Metro Manila. The basic assumption is that an electricity-producing plant and its installations are
not highly divisible.
As such, a small provincial plant might be
 relatively large to serve a limited market in a sparsely populated area as
compared to a big plant to serve the big demand of , densely populated
metropolis. In effect, a provincial plant may be underutilized as in point B in
Figure 52 with a higher per unit cost of output thus a higher rate. However, the
plant in Metro Manila is either optimally utilized as in point I or slightly
overutilized as in point J having a lower cost per unit of output, and thus a lower
rate. Therefore, the behavior of MC and AC, i.e., within a fixed plant size,
reflects resource utilization and efficiency in the context of diminishing
returns.
 Cost-Output Relationship in the Long Run
The overall level of the ATC curve varies as plant size expands in the long
run due to changing returns to scale and plant efficieney.
As a reference, assume plant expansion with constant returns to scale and
no change in plant efficiency. In Figure 51, the average cost remains the
same at the same rate of plant use as at points A, and A, despite plant
expansion from AVC. to AVC,. Plant
 Figure 54: The Average Cost Function and Changing Capacity

efficiency (output/input) and input efficiency (input/output) which influence average cost are
constant due to constant returns to scale.
Maintaining AVC despite plant expansion is likened to enlarging one's photo without distorting body
proportions. But the average cost curve is lower (AVC,) as returns to scale increase with higher
plant efficiency and lower (input/output) ratio. The opposite is true as returns to scale decrease at
AVCs.
The long curve in Figure 55 is the trend of the short-run ATC curve as plant size expands in the long
run. Increasing returns to scale account for its initial decline, while decreasing returns cause it to
increase eventually. The most efficient plant is ATC and operating it most efficiently at point E
makes production most efficient in the long run (shown in Figure 56).
As already mentioned in Chapter 5, size conditions efficiency but becomes a liability with more
expansion in the absence of innovation. While big firms can be more cost efficient and price
competitive than small
 firms, decreasing returns can catch up with complacency. Reconstructing the long-run
average cost curve in Figure 55, continuing innovation can prolong the stage of increasing
returns and postpone the decline of production and cost efficiencies due to decreasing
returns.
Average and Marginal Cost Curves
Referring again to Figure 53, the MC curve intersects the ATC and AVC curves at their
lowest levels. An increase in MC increases cost faster than output to slow down the decline
in ATC and AVC until it meets them at their lowest points. There-from, continued increase in
MC leads the two curves upward as it now costs more to produce a unit of output due to
diminishing returns.
PROFIT CONCEPT
Total and Marginal Revenues
The following are the concepts of revenue-output relationship with the equations that define
them:
 where:
TR = Total Revenue
AR = Average Revenue or Revenue
per Unit of Output
MR = Marginal Revenue or Revenue
or per Additional Unit of Output
P= Price
Q= Quantity
A= Infinitesimal change
Figure 57 illustrates the aforementioned concepts assuming constant price at any level of output.
Change carries a positive sign if the variable increases and a negative sign if the variable
declines. However, MR always carries a positive sign since revenue increases with output.
Moreover, MR is also the revenue from the additional or last unit of output. For example, the
figure shows that MR is a" which is the increase in TR when its level increases from Qi to Q..
This level of MR is also the revenue from Qi or last unit of output.
The TR curve increases at a constant rate with every additional unit of output, imply. ing that the
resulting additional revenue (MR) is equal to price (AR) since the latter is constant at any level of
output. To restate, the following is equal and constant, assuming constant price at any level of
output.
MR = P= AR
Maximum Profit and the Marginal
Approach
This section presents the concept of maximizing profit in the short run (fixed plant size), and for
simplicity, assumes a constant price at any level of output.
Profit is defined as Total Revenue (TR)
less Total Cost (TC) with Total Variable Cost
(TVC) and Total Fixed Cost (TFC) as the latter's components. The profit function is alternatively
expressed as follows:
Profit = TR - (TFC + TVC)
= (TR - TVC) - TFC
Since TR and TVC are the sums of their marginal values (MR and MC) and TFC is
fixed, the profit function is further expressed as follows:
Profit = ›(MR - MC) + TFC
= ¿(MR - MC)- TFC
So long as MR is greater than MC, producing more increases profit through
(TR - TVC) in equation 1 or ≥(MR - MC) in equation 2. In Figure 58, profit is maxi-
 Figure 56: Long-run Average Cost (LAC)

mized or loss is minimized, depending on the value of TFC, at the point where the MC equals
MR. Beyond this point, producing more decreases profit through the same component of the
profit function since MC has now increased beyond MR. Diminishing returns and decreasing
efficiency of plant use catch up with profit as it is more costly to produce an additional unit of
output beyond product price.

Average profit is profit per unit of out-put, which is equal to total profit divided by Q (output).
Therefore, total profit is equal to average profit multiplied by Q (output).
Figure 59 illustrates maximum profit as the area bounded by (P-C-E) representing average
profit and Q representing output. At no point is profit maximized except at point E where MR is
already equal to MC.
 In addition, change in price can change the level of output and maximum profit. As an example in
Figure 60, price increases from P, to Ps resulting in more production and profit. There is now more
latitude for price to outrun diminishing returns and increasing unit cost to increase output and
maximize profit. The opposite is true when price decreases. Thus, the MC curve is the supply curve
of production.
Finally, the anatomy of profit is an eye opener to the reasons behind low profit levels and their
downside. A decrease in profit may be due to prices of variable inputs that increase faster than
product price. In which case, (TR - TVC) may not be much to cover TFC and create a big profit
margin. Behind low profit level may be price, which may not also be much to create the margin that
pays for fixed cost. Still another possible reason
Figure 57: The Total and Marginal Revenue
Functions
 is fixed cost itself as it may tend to erode the (TR - TVC) margin and profit. In other words, the
profit function is the starting point of profit analysis.
Shifts in the Supply Curve
As already mentioned, the marginal cost curve is the supply curve of the firm.
Shifts and movements along the MC eurve are therefore associated with supply factors, which
have something to do with cost and profit.
Price and Number of Sellers
The volume that a seller is willing to sell at a certain price level is his maximum profit output or
supply. Raising the price level from P, to P, in Figure 60 shifts the MR curve upward and
stretches the maximum profit point to Q, (point B). This is inasmuch as a higher price level yields
more additional profit [›(MR - MC)] with more output but only up to the point before the
increasing MC curve begins to erode total profit. In Figure 60, the summation of additional profit
[›(MR - MC)J is now represented by areas A and B. Therefore, total profit (TP) likewise increases
assuming the same fixed cost (FC).
To restate the profit equation:
Profit = >(MR - MC) - TFC
 The opposite can be said when the price level drops.
On the other hand, an increase in the number of sellers means the multiplication of aggregate
output at more or less the same price level. To emphasize this concept, assume that sellers are
homogeneous in size and cost behavior. In Figure 61, the industry would produce Q, at price P, if
there was only one seller with marginal cost curve MC.. However, the entry of another seller
doubles industry output to Q, for the same price, marginal cost, and average cost levels, which are
P, and Y, and Yo, respectively.
This is also true for the other levels with the same underlying conditions of cost and profit.
Thus, the new cost curves are MC, and ACz.
The opposite can be said with a decrease in the number of sellers.
Productivity and Technology
As discussed in Chapter 5, an increase/ decrease in the overall productivity level due to
technological change expands/limits production capacity. This is due to an increase/decrease in
the capacity to produce per unit of input as reflected in the marginal and average products. In
effect, the cost of producing an additional unit of output decreases/increases due to the changing
efficiency of production.
 In reconstructing Figure 69, an improvement in the overall productivity level shifts the marginal
cost (MC) and average total cost (ATC) curves downward. This shift indicates less variable cost
per unit of output as well as a bigger production capacity with a longer ATC curve.
However, the AFC curve also shifts downward to further decrease ATC when productivity
improves due to resource-saving technology. Going back to Chapter 5. such technological
change (e.g., computers) requires less resource to maintain output, thus decreasing TFC and
AFC. In the case of capital spending to improve the productivity of other resources (e.g., irrigation
to improve crop yield), the decrease in AC depends on how much productivity is gained in relation
to additional cost of capital, which increases TFC. If TFC outpaced output to increase AFC, AC
would only decrease with the offsetting effect of a decrease in AVC as a component. On the other
hand, if output increases faster than TFC, AFC decreases with AVC and AC.
 Cost of Production
An increase in the prices of variable inputs increases the MC, TVC, AVC,, and ATC. This
increase in cost is not associated with plant expansion and therefore cost changes but not
maximum output. Going back to Figure 53, the AVC curve will shift upward only because of the
same shift in the MC and AVC curves. There is no rightward shift whatsoever since maximum
output is constant in the absence of plant expansion.
Also, going back to Figure 59, the increase in MC will decrease profit by shrinking (TR - TVC)
which pays for TPC
Japan as a Giant in Car Manufacturing: A
Reading
Today, Japan as a world economic superpower is totally different from where she was right
after the Second World War more than 68 years ago. She has rebuilt her economy from the
ashes of that war to be a key player in the world economy. Armed with a national drive to grow
beyond the limits of her natural
resources and the sophisticated technology that she has developed through the year, she has
extended her economic activities ang infuence to the rest of the world. She has become a
dominant producer of final products, in the world using the latter's resources and raw products,
thus getting a lion's share from the fruits of production. She is in almost all sophisticated lines
of business from the manufacture of cars, computers, and ships. to banking and trading. What
she earns she reinvests to produce more and add value to world production. This explains her
huge foreign exchange surplus from the surplus of goods and services (both factor and non-
factor) that she exports to almost all parts of the world.
 One of the key industries that has led her to be where she is today is the car industry
Japanese car producers have invaded even the once indomitable U.S. market getting thirty
percent (30%) of the pie and pushing aside even the Big Three among the American car
manufacturers. Yet, the latter can hardly penetrate the Japanese market accounting for only
one percent (19) of the demand. During the 1992 visit of President George Bush to Japan,
to push for a freer trade with the tiger of Asia, members of his delegation suggested to their
Japanese counterparts that Japan's trade surplus is a result of her protectionist attitude
toward foreign products. She exports more but imports less. However, the Japanese
differently view the surplus as a logical consequence of producing quality, designed for
consumer's taste and sold at the most competitive prices.
 There is truth in the protectionist issue.
According to Kim Woo-Choong. Daewoo Head, South Korea's second largest industrial group.
"Every country has trouble selling to Japan. It is much harder selling to the Japanese than to the
Americans." There is also truth in the Japanese productivity credo. According to Lee laccoca, head
of Chrysler, a giant among the American car manufacturers, "Only 15% of the problem is access to
their market. The other 85% is their exports. They have the capacity to build 14 million cars a year
in a market for 7 million.
The Europeans won't let them. What are they going to do? Send them to the U.S.
that's what."
 Both sides are correct but the hidden fact is that protectionism enhances efficiency to multiply
production. Japanese car manufacturers prefer to use their surplus earnings, mostly from
exports, to buy more steel and reinvest in their overseas plants. Thus, they create the multiplier
effect of increasing scale and efficiency. Generally, Japanese prefer to do this rather than spend
their huge foreign exchange surplus to satisfy local consumption. Thus, it is not surprising that
dividend payout in Japanese corporations is only thirty percent (30%) in contrast to fifty-four
percent (54%) in the U.S. and sixty-six percent (66%) in Britain.

In the final analysis, the secret of their economic success is an even more basic for-mula.
Japanese spend less and save more and therefore invest and produce more. In contrast, many
countries that she has beaten in the economic race spend more, save less and therefore
produce less. As aptly described in the feature article of the February 10, 1992 issue of the
Fortune Magazine, "As
 Japan's major trading partners look to the east, they see a mercantilist samurai whose successive
swings of the sword hack many jobs and the wealth of other nations."
The Shutdown Price
The output level where MR is equal to
MC yields the maximum profit or minimum loss if price is greater than the average variable cost
(AVC), or total revenue (TR) is greater than total variable cost (TVC).
Consider again the profit equations:
P = (TR - TVC) - TFC
= &(MR- MC)- TFC
If price is less than AVC, then TR is also less than TVC. Therefore, total loss is equal to TFC and the
amount of TVC that TR cannot recover. The negative difference between TR and TVC is at a
minimum at the output level where MR is equal to MC as shown in Figure 62. As the output level
increases up to the optimum point (point of intersection), the first shaded area where MC is greater
than MR is bigger than the succeeding area where MR is greater than MC. The latter represents the
positive amount that minimizes the loss created when MC is greater than MR.
 However, minimizing the negative difference between TR and TVC does not necessarily lead
to a minimum of total loss.
Production at any output level results in a loss equals to the said difference and TFC; whereas,
a shutdown or no-production decision incurs no more than the minimum level of total loss
equals to TFC alone. Hence, the firm is better off when not producing if the total revenue (TR)
is still inadequate to cover total variable cost (TVC) or simply the average variable cost (AVC)
is still greater than price.
Finally, the no-production or shutdown decision may apply during periods of low prices and
demand as it minimizes losses while waiting for the boom period in the market.