Lesson 6

THEORY OF COST AND

PROFIT
Cueto, Ivan
Macayan, Jhon Alexis
Bangcuyo, Andrei Nicole
Betsaida, Angelika
(Group 6)
 EXPLICIT AND IMPLICIT COSTS

EXPLICIT IMPLICIT OPPORTUNITY

COSTS COSTS COST
 EXPLICIT AND IMPLICIT COSTS

Comprise all explicit

payment to the
factors of production
EXPLICIT the firm uses
COSTS
 EXPLICIT AND IMPLICIT COSTS
Consist of the opportunity
costs of using the firms own
resources without receiving
any explicit compensation for
those resources

IMPLICIT  NOT REGARDED as costs in

an accounting sense, BUT
COSTS they are a part of the firm’s
costs of doing business
 EXPLICIT AND IMPLICIT COSTS
The value of the next best
alternative that is forgone when
another alternative is chosen

The opportunity cost of a

OPPORTUNITY particular alternative is the payoff
COST associated with the best of the
alternatives that are not
chosen.
 EXAMPLE:

What is the cost to an airline of using

one of its planes in scheduled
passenger service?
 EXAMPLE:
 An airline’s expenditures on fuel
and salaries are explicit costs;

 Whereas the income it forgoes

by not leasing its jets is an
implicit cost;
 EXAMPLE:
 Therefore, the sum total of the
explicit costs and the implicit costs
represents what the airline
sacrifices when it makes the
decision to fly one of its planes on
a particular route which is the
opportunity cost.
FIXED AND VARIABLE COSTS
 FIXED AND VARIABLE COSTS
 In the short – run, some of the input factors
the firm uses in production are fixed
 The cost of these fixed factors are the firm’s
fixed costs
 The firm’s fixed costs DO NOT vary with
increases in the firm’s output
 FIXED COSTS
Cost incurred by the firm which DOES
NOT vary with the volume of production.

Whether you produce or not, you still

incur that cost

Firm also employs a number of variable

factors of production

The cost of these variable factors of

production are the firm's variable costs
 FIXED COSTS

In order to increase output, the firm must

increase the number of variable factors of
production that it employs.
As firm output increases, the firm's
variable costs must also increase.
 VARIABLE COSTS

Cost incurred by the firm which varies

with the volume of production.

If you have your production, you will

incur it, if you have zero production,
your variable cost is equal to zero too.
 VARIABLE COSTS

An example of this is the cost of your

raw materials:

 As you produce more, more raw

materials are needed; so, your
variable costs will increase.
 VARIABLE COSTS

The sum of your FIXED COST and VARIABLE

COST is the TOTAL COST

Total Cost = Fixed Cost + Variable Cost

 
ACCOUNTING PROFITS,
ECONOMIC PROFITS,
AND NORMAL PROFITS
 ACCOUNTING PROFITS, ECONOMIC
PROFITS, AND NORMAL PROFITS

The difference between EXPLICIT and

IMPLICIT COSTS is crucial to understanding the
difference between ACCOUNTING PROFITS and
ECONOMIC PROFITS. 
 ACCOUNTING
PROFITS

Accounting Profits are the

firms total revenue from sales of
it’s output, minus the firms
explicit cost.
 ECONOMIC
PROFITS

Economic Profits are the

total revenues minus
explicit and implicit cost.
 NORMAL PROFITS

A firm is said to make

normal profits when it’s
economic profit is zero.
PROFIT, TOTAL REVENUE
and TOTAL COST
 Total Revenue
The amount of goods being sold or services
being rendered multiplied by its price.

Total Revenue = Price and Quantity

 
  EXAMPLE:
A leather craftsman who sells
boots for 100 pesos per pair.
If he regularly sells 50 pairs
per month, his total revenue
is
5,000 (100 x 50 = 5,000).
 Total Profit

The firm’s main goal or objectives is to maximize profit.

Total Profit = Total Revenue – Total Cost

 Francis wants to find out how much money they’ve made in their dog
walking business. They need to know their total revenue and total
expenses to calculate their profit.

Total Revenue : 10,000

Total Expenses : 1,500

Francis’ total expenses are calculated by adding their direct and indirect costs,
as follows:

Direct costs, such as dog treats: 1,000

Indirect costs, like posters and flyers: 500
Total expenses: 1,000 of direct costs + 500 indirect costs = 1,500

By subtracting 1,500 of total expenses from their total revenue of 10,000, Francis
can calculate that their profit is equal to 8,500.
CONCEPT OF REVENUE
 CONCEPT OF REVENUE
Total Revenue is Price x Quantity

TR = P x Q
Average Revenue is Total Revenue/Output

AR = TR/Q
Marginal Revenue is Change in Total Revenue/Change in Output

MR = Change in TR/Change in Q
Total Cost
 The market value of the inputs a firm uses in production
Firm’s cost of production
 Includes all the opportunity costs in making its output of
goods and services as well as explicit costs and implicit costs
Explicit costs
 Input costs that REQUIRE direct outlay of money by the firm
Implicit costs
 Input costs that DO NOT REQUIRE outlay of money by the
firm
AVERAGE COSTS,
MARGINAL COSTS
 Average total cost
MOST OF THE TIME, economist deals with the average total cost.
The total cost divide by total output

ATC = TC/Q
(also the same as ATC = AFC + AVC)

 It is important to determine because it depicts the cost incurred of 1 unit of

product.

 It can be used as the basis for pricing.

 REMEMBER that your price must be greater than ATC.

 Average fixed cost

Total fixed cost divide by output

This depicts the fixed cost incurred of every unit of product

Average Fixed Cost = Total Fixed Cost/Output

AFC = TFC/Q
 Average variable cost

Total variable cost divide by output

Denotes the variable cost incurred of 1 unit of product

Average Variable Cost = Total Variable Cost/Output

AVC = TVC/Q
 Marginal Cost (MC)

Measures the increase in total cost that arises from an extra

unit of production

The change in total cost divided by the change in output

MC =
Applying the formula, please see the following table.
Q TC TFC TVC ATC AFC AVC MC

     
0 - - - -
Php3.00 Php3.00

1 3.30 3.00 Php0.30 3.30 Php3.00 Php 0.30 Php 0.30

2 3.80 3.00 0.80 1.9 1.50 0.40 0.50

3 4.50 3.00 1.50 1.5 1.00 0.50 0.70

4 5.40 3.00 2.40 1.35 0.75 0.60 0.90

5 6.50 3.00 3.50 1.30 0.60 0.70 1.10

6 7.80 3.00 4.80 1.30 0.50 0.80 1.30

7 9.30 3.00 6.30 1.33 0.43 0.90 1.50

 
8 3.00 8.00 1.38 0.38 1 1.70
11.00

9 12.90 3.00 9.90 1.43 0.33 1.1 1.90

10 15.00 3.00 12.00 1.5 0.30 1.2 2.10

Table 6.1
Cost Table Incurred by Firm
 Table 6.1
Cost Table Incurred by Firm

• Cost also varies depending on the timeframe.

• Timeframe
– Short-run and long-run
• There is no specific time in which we can say
it is short run or long run.
 Table 6.1
Cost Table Incurred by Firm

Short-run
- The timeframe which requires an immediate
concern
Long-run
- Requires planning before you can make a
decision
*Between today and tomorrow, short run is today while
tomorrow is the long-run.*
 Table 6.1
Cost Table Incurred by Firm

NOTE:

These costs are incurred by the firm for short-run.

In long-run, all cost become variable cost.