Analysis of

Cost, Profit, and

Total
Chapter 7
Title and Content Layout with List
• Cost is the most important consideration in
production. A producer will not just jump into a
particular investment by simply looking at the
potential revenue of the business.
Accounting versus Economic Costs
• The fundamental concept that should be learned is the
difference between economic cost and accounting cost.
• Economic costs are forward looking costs, meaning,
economists are in tune with future costs because these have
major repercussions on the potential profitability of the
firm.
• Economists are also giving emphasis on the so-called
opportunity cost, or costs that are incurred by not putting
the resources to optimum use.
If opportunity costs are measurable, it should be
included in the decision making process, even though it
is expensive to do so.
But there are some costs that should not be used in
decision making such as sunk costs, because there are
costs that are irretrievable due to the fact that these are
already incurred and do not affect a firm’s decision.
Accounting costs tend to be retrospective; they
are recognize costs only when these are made
and properly recorded. They do not adjust these
costs even if opportunity costs change. Therefore,
the difference between economic costs and
accounting costs is opportunity cost.
Implicit versus Explicit Costs
Explicit costs refer to the actual expenses of the firm in purchasing or
hiring the inputs it needs, such as, when a firm purchases a machine
worth one million pesos or rents a building worth one hundred thousand
pesos per month.
Implicit costs refer to the value of inputs being owned by the firm and
used in its own production process. For example, the owner of the
business is an accountant; if he will work for another company he could
earn thirty thousand pesos. However, he chose to be the accountant of his
business. His thirty thousand-peso salary that he could earn for another
company is his implicit cost. These two costs are included in economic
cost.
Short-run Cost Analysis
Short-run for a firm is a time horizon when one input is held constant.
To analyze the short-run costs, it is essential to fix the level of capital and
study the changes in the quantity of labor hired. The following are the types of
short-run costs:
1. Total fixed costs (TFC). These are costs that do not vary with output.
Examples for these costs are depreciation of buildings and machineries,
salaries of top management, rent expenses on leased plant, and interest
payments on borrowed capital.
2. Total variable costs (TVC). These are costs that vary with output.
Examples of these costs are payment for raw materials, wages, tax
payments, and operating expenses (electricity, fuel, and water).
3. Total cost (TC). It is the sum of total fixed costs and total variable costs.
Formula: TC = TFC + TVC Eq. 7

4. Average fixed cost (AFC). This refers to the total fixed costs divided by
the number of outputs produced (Q).
TFC
Formula: AFC = Q Eq. 7.1
5. Average variable cost (AVC). This refers to the total variable costs
divided by the number of output produced (Q).
TVC
Formula: AVC = Q Eq. 7.2
6. Average total cost (ATC). This refers to the total cost divided by the
number of output produced (Q). It is also defined as the cost per unit of
output.
TC
Formula: ATC = Q Eq. 7.3
7. Marginal cost (MC). It refers to changes in total cost divided by the
change in output produced (Q). It is also additional cost incurred from
producing additional unit of output.
TC
Formula: MC = Q Eq. 7.4
Example:
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 the output. The LAC is
the curve tangent to each short-run
average cost (SAC) representing
different plant sizes that a firm can
build in the long-run.
Long-run Marginal Cost
The long-run marginal cost (LMC)
measures the change in long-run
total cost from a given change in
output.
The LMC is U-shaped and reaches
its minimum point before the LAC
curve reaches its minimum just like
in the short-run analysis. At the
increasing portion of the LAC, LMC
is over LAC.
Profit Analysis

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 and both revenue and
both explicit and implicit costs.
For example, a firm give an account on its business profit of P1
Million pesos during a calendar year. The owner could have
earned P300,00.00 if he managed another firm, and earned
P100,000.00 if he loaned his capital to other firms with
corresponding interest.
For an economist, his profit is only P600,000.00, taking his
opportunity cost (implicit cost) of P300,000.00 for his salary
and P100,000.00 for his unearned interest in his capital.
Point of Maximum Profit
•By  definition, profit ( equals total revenue (TR) less total cost (TC).
Whereas, total revenue is equal to price (P) multiplied by quantity (Q). In
symbols:
Eq. 7.5
TR = P x Q Eq. 7.6
To maximize profits, the firm must find the equilibrium price and quantity
that give the largest profit on the largest difference between TR and TC.
The rule is simple: if TR > TC, the firm incurs profit; if TR < TC, the firm
incurs loss; and if TR = TC, the firm experiences break-even condition.
To illustrate the concept, let us
assume that the price of a good
is P16.00. If the firm produces
various amounts of good X
given in column 2 of Table 7.1,
the TR in column 4 is divided
by multiplying P16.00 and each
quantity of goods produced.
Given the firm’s TC shown in
column 3, the firm’s profit
represented in column 5 is
computed by deducting the TC
(column 3) from the TR
(column 4).
Likewise, using the same hypothetical data presented in Table 7.1, the
firm incurs losses during the span of its operation from points A to C, a
situation in which a negative occurs after deducting TC in column number
3 to TR in column 4. The firm is in equilibrium level at points D and I
where, after subtracting TC from TR, we calculate a zero total profit. From
point E to H, the firm incurs profit. This produces a positive result after
deducting TC from TR. In symbols:
TR > TC = profit Eq.. 7.7
TR < TC = loss Eq. 7.8
TR = TC = breakeven Eq. 7.9
Figure 7.4 is a graphical illustration of
Table 7.1 (Q in hundreds) Figure 7.4A of
the said figure shows the relationship
between TR and TC while the curve
shown in Figure 7.4B represents profit.
Area I in Figure 7.4A where TR < TC is
equal to area III in Figure 7.4B which
sows a negative result. Also, area II in
Figure 7.4A where TR > TC is equal to
area IV in Figure 7.4B which shows a
positive result in profit. The firm is in
equilibrium if total revenue equals total
cost.
The Profit of the Firm in the Short-run
A competitive firm takes the market price as constant. If it
wants to maximize profits, the optimum level of production in
the short-run is when its marginal cost is equal to its price
(since in a competitive market, price is also equal to marginal
revenue). Even if the firm produces this quantity, is the firm
incurring profits or losses? If it is incurring losses, should it
shut down in the short-run or not? To answer these questions,
we need the aid of the cost curves to determined the firm’s
profit.
Price is greater than average total cost (P > ATC)
In figure 7.5, the optimum output
of the firm in the short-run is given
by Q, where P = MC. We must use
ATC to find the total cost in order
to compute for the profit. In this
case, the firm is earning profits
because price is greater than the
cost (ATC) given by the shaded
region.
Price is equal to average total cost (P=ATC)
Figure 7.6 shows the case where a
firm is either experiencing profits or
losses. As shown in the graph, price
is equal to marginal cost denoting the
best level of output. But since price
equals ATC, the firm is at a breakeven
(TR = TC).
Profit is zero at price equal to ATC.
Price is less than average total cost (P<AVC)
Even if the price is below ATC, the firm may
continue operating in the short-run as long
as price is greater than AVC (P>AVC). In
Figure 7.7, price intersects marginal cost
indicating the best level of output, but is
above the AVC curve which means that the
firm should not shut down even though
profits are negative. Why? Because total
revenue is greater than total variable costs,
and shutting down the business will
eliminate this extra revenue. The firm can
still pay the wages in operating expenses,
and can still purchase some raw materials,
but not enough to cover the fixed costs.
The Shutdown Point
The firm should shut down if any of the following occurs, P=AVC or P<AVC.
Figure 7.8 shown that price is equal to its marginal cost and average
variable cost. It is no longer practical to continue to do business because
revenue is just enough to cover the variable costs of the firm, and there is
no excess revenue to cover fixed costs.
If P<AVC, the decision is to shut down also, because total revenue is
insufficient to pay variable costs.
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