Economics Environment

for Business

Master 1 - MBS
WHAT ARE COSTS?

• According to the Law of Supply:

– Firms are willing to produce and
sell a greater quantity of a good
when the price of the good is high.
– This results in a supply curve that
slopes upward.
 WHAT ARE COSTS?
• The Firm’s Objective: The economic goal of
the firm is to maximize profits.
Total Revenue, Total Cost, and
Profit
• Total Revenue
–The amount a firm receives
for the sale of its output.
• Total Cost
–The market value of the inputs
a firm uses in production.
 Total Revenue, Total Cost, and
Profit
• Profit is the firm’s total revenue
minus its total cost.
Profit =Total revenue - Total cost
 Costs as Opportunity Costs
• A firm’s cost of production includes all the
opportunity costs of making its output of
goods and services.
• Explicit and Implicit Costs
– A firm’s cost of production include explicit
costs and implicit costs.
• Explicit costs are input costs that require a
direct outlay of money by the firm.
• Implicit costs are input costs that do not
require an outlay of money by the firm.
 Economic Profit versus
Accounting Profit
• Economists measure a firm’s economic
profit as total revenue minus total cost,
including both explicit and implicit
costs.

• Accountants measure the accounting

profit as the firm’s total revenue minus
only the firm’s explicit costs.
Economic Profit versus Accounting
Profit
• When total revenue exceeds
both explicit and implicit costs,
the firm earns economic profit.
–Economic profit is smaller
than accounting profit.
 Economic versus Accountants

How an Economist How an Accountant

Views a Firm Views a Firm

Economic
profit
Accounting
profit
Implicit
Revenue costs Revenue
Total
opportunity
costs
Explicit Explicit
costs costs

Copyright © 2004 South-Western

 Economic Profit versus Accounting
Profit

• Economic versus Accounting Profits

• Example :
If a firm’s total revenue is $80,000, and
its explicit and implicit costs are $70,000
and $25,000, respectively, what are its
economic and accounting profits?
Microeconomics
Economic Profit versus Accounting
Profit
• Economic versus Accounting Profits
Example answer
Economic Profit = $80,000 - $95,000
= - $15,000

Accounting Profit = $80,000 - $70,000

= $10,000
From a financial point of view, should the
firm continue to operate?
THE VARIOUS MEASURES OF
COST

• Costs of production may be

divided into fixed costs and
variable costs.
Fixed and Variable Costs
• Fixed costs are those costs that
do not vary with the quantity of
output produced.
• Variable costs are those costs
that do vary with the quantity of
output produced.
Fixed and Variable Costs
• Total Costs
–Total Fixed Costs (TFC)
–Total Variable Costs (TVC)
–Total Costs (TC)
–TC = TFC + TVC
Average Costs
• Average Costs
–Average costs can be determined
by dividing the firm’s costs by the
quantity of output it produces.
–The average cost is the cost of each
typical unit of product.
Fixed and Variable Costs
• Average Costs
–Average Fixed Costs (AFC)
–Average Variable Costs (AVC)
–Average Total Costs (ATC)
–ATC = AFC + AVC
Average Costs
Fixed and Variable Costs
• Marginal Cost
– Marginal cost (MC) measures the
increase in total cost that arises from an
extra unit of production.
– Marginal cost helps answer the following
question:
• How much does it cost to produce an
additional unit of output?
 Application
Quantity FC VC
0 50 0
1 50 50
2 50 78
3 50 98
4 50 112
5 50 130
6 50 150
7 50 175
8 50 204
9 50 242
10 50 300
11 50 385
 TC ,AFC,AVC,AC and MC
Quantity FC VC TC MC AFC AVC AC
0 50 0 50 - - - -
1 50 50 100 50 50 50 100
2 50 78 128 28 25 39 64
3 50 98 148 20 16.7 32.7 49.3
4 50 112 162 14 12.5 28 40.5
5 50 130 180 18 10 26 36
6 50 150 200 20 8.3 25 33.3
7 50 175 225 25 7.1 25 32.1
8 50 204 254 29 6.3 25.5 31.8
9 50 242 292 38 5.6 26.9 32.4
10 50 300 350 58 5 30 35
11 50 385 435 85 4.5 35 39.5
 Example : Complete the table

Q FC VC TC AFC AVC ATC MC

1 60 …

2 100 10

3 45

4 13.75

5 27

6 45
 Answer
Q FC VC TC AFC AVC ATC MC
1 60 30 90 60 30 90 …
2 60 40 100 30 20 50 10
3 60 45 105 20 15 35 5
4 60 55 115 15 13,75 28,75 10

5 60 75 135 12 15 27 20

6 60 120 180 10 20 30 45
Complete the table
Q TC TVC TFC ATC AVC AFC MC

0 80 0 80 - - - -

1 160 80 80 160 80 80 80

2 220 140 80 110 70 40 60

3 290 210 80 96,6 70 80/3 70

4 380 300 80 95 75 20 90
 Relation between AC MC and AVC

•
Costs
in Dollars
MC ATC

AVC

Quantity
Produced
Concept of
Elasticity
Master 1
MBS-Dakar
Price Elasticity of Demand
• A measure of the responsiveness of quantity
demanded to changes in price.
• Measured by dividing the percentage change in
the quantity demanded of a good by the
percentage change in its price.
• Economists compute price elasticity of demand
using midpoints as the base values of changes in
prices and quantities demanded.
 Computing Elasticity of
Demand
We divide the change in
quantity demanded by the
average quantity demanded,
all of which is then divided
by the change in price
divided by the average price.
Perfectly Elastic and Perfectly
Inelastic Demand
Percentage change in quantity demanded
Ed = -------------------------------------------
Percentage change in price
• Elastic Demand (Ed > 1): the numerator is
greater than the denominator, the coefficient is
greater than 1 and demand is elastic.
• Inelastic Demand (Ed < 1): the numerator is less
than the denominator , the coefficient is less than
1, and demand is inelastic.
 Perfectly Elastic and
Perfectly Inelastic Demand
• Unit Elastic Demand (Ed = 1): If the numerator and
denominator are the same, the coefficient is equal to
one. The quantity demanded changes proportionally
to a change in price.
Elastic and Inelastic Demand
• Perfectly Elastic Demand (Ed = ∞) If
the quantity demanded is extremely
responsive to a change in price.
• Perfectly Inelastic Demand (Ed = 0) If
quantity demanded is completely
unresponsive to changes in price,
demand is perfectly inelastic. A
change in price causes no change in
quantity demanded.
Price Elasticity of Demand
 Price Elasticity of Demand
and Total Revenue
• Total Revenue (TR) of a seller equals the price of a
good times the quantity of the good sold.
• Total revenue may increase, decrease or remain
constant.
• If demand is elastic, a price rise decreases total
revenue.
• If demand is elastic, a price fall increases total
revenue.
• If demand is inelastic, a price fall decreases total
revenue.
• If demand is unit elastic, a price fall will sell more
goods while total revenue remains constant.
Elasticities,
Price
Changes and
Total
Revenue
 Q&A
• On Tuesday, price and quantity demanded are $7 and 120
units, respectively. Ten days later, price and quantity are $6
and 150 units, respectively. What is the price elasticity of
demand between the price of $6 and $7?
• What does a price elasticity of demand of 0.39 mean?
• Identify what happens to total revenue as a result of each of
the following: price rises and demand is elastic; price falls
and demand is inelastic; price rises and demand is unit
elastic; price rises and demand is inelastic; price falls and
demand is elastic.
• Alexi says, “When a seller raises his price, his total revenue
rises.” What is Alexi implicitly saying?
Price Elasticity of Demand
Along a Straight Line
Demand Curve
 Determinants of Price
Elasticity on Demand
• Number of Substitutes: The more substitutes
for a good, the higher the price elasticity of
demand; the fewer substitutes for a good, the
lower the price elasticity of demand. The more
broadly defined the good, the fewer the
substitutes; the more narrowly defined the good,
the greater the substitutes.
• Necessities Versus Luxuries: The more that a
good is considered a luxury rather than a
necessity, the higher the price elasticity of
demand.
 Determinants of Price
Elasticity on Demand
• Percentage of One’s Budget Spent on the
Good: The greater the percentage of one’s
budget that goes to purchase a good, the higher
the price elasticity of demand; the smaller the
percentage of one’s budget that goes to
purchase a good, the lower the elasticity of
demand.
• Time: The more time that passes, the higher
the price elasticity of demand for the good; the
less time that passes, the lower the price
elasticity of demand for the good.
Cross Elasticity of Demand
• Measures the responsiveness in the quantity
demanded of one good to changes in the price of
another good.
• Defined as the percentage change in the quantity
demanded of one good divided by the
percentage change in the price of another good.
• This concept is often used to determine whether
two goods are substitutes or complements and
the degree to which one good is a complement to
or substitute for another.
 Income Elasticity of
Demand
• Measures the responsiveness of quantity
demanded to changes in income.
• Define as the percentage change in quantity
demanded of a good divided by the percentage
change in income.
• Income elasticity of demand is positive (Ey > 0)
for a normal good.
• The demand for an inferior good decreases as
income increases.
Income Elasticity of
Demand
• If Ey >1, demand is
considered to be
income elastic.
• If Ey <1, demand is
considered to be
income inelastic.
• If Ey =1, demand is
considered to be
unit elastic.
Price Elasticity of Supply
• Measures the responsiveness of quantity
supplied to changes in price.
• Defined as the percentage change in
quantity supplied of a good divided by the
percentage change in the price of the
good.
• Supply can be classified as elastic,
inelastic, unit elastic, perfectly elastic, or
perfectly inelastic.
Price Elasticity of Supply
 Price Elasticity of Supply
and Time
• The longer the period of
adjustment to a change
in price, the higher the
price elasticity of
supply.
• Additional production
takes time.
• Reducing production
takes time.
• A tax placed on the Who Pays the
sellers of VCR tapes
shifts the supply curve
Tax?
from S1 to S2 and raises
the equilibrium price
from $8 to $8.50. Part of
the tax is paid by buyers
through a higher price
paid, and part of the tax
is paid by sellers through
a lower price kept.
• Tax revenues are
maximized by placing
the tax on the seller who
faces the more inelastic
demand curve.
Different Elasticities and Who Pays
the Tax
 Questions
• What does an income elasticity of demand of
1.33 mean?
• If supply is perfectly inelastic, what does this
signify?
• Why will government raise more tax revenue if
it applies a tax to a good with inelastic demand
than if it applies the tax to a good with elastic
demand?
• Under what condition would a per-unit tax
placed on the sellers of computers be fully paid
by the buyers of computers?
Profit Maximizing and
Shutting Down
Mater 1
MBS Dakr
 Profit-Maximizing Level of
Output
• The goal of the firm is to maximize
profits.
• Profit is the difference between total
revenue and total cost.
 Profit-Maximizing Level of
Output
• What happens to profit in response to a
change in output is determined by
marginal revenue (MR) and marginal cost
(MC).

• A firm maximizes profit when MC = MR.

 Profit-Maximizing Level of
Output
• Marginal revenue (MR) – the change
in total revenue associated with a
change in quantity.

• Marginal cost (MC) – the change in

total cost associated with a change in
quantity.
 Marginal Revenue

• A perfect competitor accepts

the market price as given.
• As a result, marginal revenue
equals price (MR = P).
 Marginal Cost
• Initially, marginal cost falls
and then begins to rise.
• Marginal concepts are best
defined between the
numbers.
Profit Maximization: MC = MR
• To maximize profits, a firm should
produce where marginal cost equals
marginal revenue.
 How to Maximize Profit
• If marginal revenue does not equal
marginal cost, a firm can increase
profit by changing output.
• The supplier will continue to produce
as long as marginal cost is less than
marginal revenue.
How to Maximize Profit
• The supplier will cut back on
production if marginal cost is greater
than marginal revenue.

• Thus, the profit-maximizing condition of a

competitive firm is MC = MR = P.
 Again! MR=MC
• Profit is maximized when MR=MC.
– If the cost of producing one more unit is
less than the revenue it generates, then a
profit is available for the firm that
increases production by one unit.
– If the cost of producing one more unit is
more than the revenue it generates, then
increasing production reduces profit.
 Marginal Cost, Marginal Revenue,
and Price
Costs MC
Price = MR Quantity Marginal
Produced Cost
$35.00 0 60
35.00 1 $28.00
20.00 50
35.00 2 16.00
35.00 3 40 A C
14.00 P = D = MR
35.00 4 12.00 30 B
35.00 5 A
17.00
35.00 6 22.00 20
35.00 7 30.00
35.00 8 10
40.00
35.00 9 54.00 0
35.00 10 68.00 1 2 3 4 5 6 7 8 9 10 Quantity
Profit Maximization:
Graphical Analysis
 Profit Maximization: The
Numbers MR=MC
Q P TR TC TR-TC MR MC ATC
0 $1 $0 $1.00 -$1.00 $1
1 $1 $1 $2.00 -$1.00 $1 $1.00 $2.00
2 $1 $2 $2.80 -$0.80 $1 $0.80 $1.40
3 $1 $3 $3.50 -$0.50 $1 $0.70 $1.17
4 $1 $4 $4.00 $0.00 $1 $0.50 $1.00
5 $1 $5 $4.50 $0.50 $1 $0.50 $0.90
6 $1 $6 $5.20 $0.80 $1 $0.70 $0.87
7 $1 $7 $6.00 $1.00 $1 $0.80 $0.86
8 $1 $8 $6.86 $1.14 $1 $0.86 $0.86
9 $1 $9 $7.86 $1.14 $1 $1.00 $0.87
10 $1 $10 $9.36 $0.64 $1 $1.50 $0.94
11 $1 $11 $12.00 -$1.00 $1 $2.64 $1.09
The Marginal Cost Curve Is
the Supply Curve
• The marginal cost curve is the firm's
supply curve above the point where
price exceeds average variable cost.
The Marginal Cost Curve Is
the Supply Curve
• The MC curve tells the competitive
firm how much it should produce at a
given price.

• The firm can do no better than produce the

quantity at which marginal cost equals
marginal revenue which in turn equals
price.
 The Marginal Cost Curve Is the
Firm’s Supply Curve
Marginal cost
$70 C
60
50
Cost, Price

A
40
30 B
20
10
0 1 2 3 4 5 6 7 8 9 10 Quantity
Firms Maximize Total Profit
• Firms seek to maximize total profit,
not profit per unit.
– Firms do not care about profit per unit.
– As long as increasing output increases
total profits, a profit-maximizing firm
should produce more.
 Profit Maximization Using Total
Revenue and Total Cost

• Profit is maximized where the vertical

distance between total revenue and
total cost is greatest.
• At that output, MR (the slope of the
total revenue curve) and MC (the
slope of the total cost curve) are equal.
Profit Determination Using Total Cost
and Revenue Curves
TC TR
$385 Loss
Total cost, revenue

350
315 Maximum profit =$81 Profit
280
245
210 $130
175
140
105 Profit =$45
70
35 Loss
0
1 2 3 4 5 6 7 8 9 Quantity
 Total Profit at the Profit-
Maximizing Level of Output
• The P = MR = MC condition tells us
how much output a competitive firm
should produce to maximize profit.
• It does not tell us how much profit the
firm makes.
Determining Profit and Loss From
a Table of Costs
• Profit can be calculated from a table of
costs and revenues.
• Profit is determined by total revenue
minus total cost.
Costs Relevant to a Firm
Costs Relevant to a Firm
Determining Profit and Loss
From a Graph
• Find output where MC = MR.
– The intersection of MC = MR (P)
determines the quantity the firm will
produce if it wishes to maximize profits.
Determining Profit and Loss
From a Graph
• Find profit per unit where MC = MR.

– Drop a line down from where MC equals MR,

and then to the ATC curve.
– This is the profit per unit.
– Extend a line back to the vertical axis to
identify total profit.
Determining Profit and Loss
From a Graph
• The firm makes a profit when the ATC
curve is below the MR curve.

• The firm incurs a loss when the ATC curve

is above the MR curve.
Determining Profit and Loss From
a Graph
• Zero profit or loss where MC=MR.

– Firms can earn zero profit or even a loss

where MC = MR.
– Even though economic profit is zero, all
resources, including entrepreneurs, are being
paid their opportunity costs.
 Determining Profits Graphically
Price MC Price MC Price MC
65 65 65
60 60 60
55 55 55 ATC
50 50 50
45 45 ATC 45
40 D A P = MR 40 40 Loss P = MR
35 Profit 35 P = MR 30 35
30 B ATC 30 AVC
25 C AVC 25 AVC 25
20 E 20 20
15 15 15
10 10 10
5 5 5
0 1 23 4 5 67 891012 0 1 23 4 5 67 8910 12 0 1 23 467
5 89 1 12
Quantity Quantity Quantity
a) Profit case (b) Zero profit case (c) Loss case 0
 Loss Minimization
Average cost of a unit of
output

Market
price
falls

Revenue
generated
by a unit of
output
 The Shutdown Point
• The firm will shut down if it cannot
cover average variable costs.
– A firm should continue to produce as
long as price is greater than average
variable cost.
– If price falls below that point it makes
sense to shut down temporarily and save
the variable costs.
 The Shutdown Point
• The shutdown point is the point at
which the firm will be better off it it
shuts down than it will if it stays in
business.
The Shutdown Point
• If total revenue is more than total
variable cost, the firm’s best strategy is
to temporarily produce at a loss.
• It is taking less of a loss than it would by
shutting down.
The Shutdown Decision
MC
Price
60
50 ATC
40 Loss
30 P = MR
AVC
20
$17.80 A
10
0 2 4 6 8 Quantity
 Minimizing Loss

• Shutdown price: the minimum point of

the average-variable-cost (AVC) curve.

• Break-even price: A price that is equal to

the minimum point of the average-total-
cost (ATC) curve.
– At this price, economic profit is zero.
 Profit Maximizing Level of Output
• The goal of the firm is to maximize profits, the difference
between total revenue and total cost

• A firm maximizes profit when marginal revenue equals

marginal cost
• Marginal revenue (MR) is the change in
total revenue associated with a change in
quantity
• Marginal cost (MC) is the change in total cost associated
with a change in quantity

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Profit Maximizing Level of
Output
• The profit-maximizing condition of a competitive firm is:
MR = MC

• For a competitive firm, MR = P

• A firm maximizes total profit, not profit per unit

If MR > MC,
• a firm can increase profit by increasing output
If MR < MC,
• a firm can increase profit by decreasing its output

14-83
 Marginal Cost, Marginal Revenue, and
Price Graph
P Margin
al Cost
MC > P,
MC = P decrease output to
increase total profit

$35 P=D=
MC < P, MR
increase output to
increase total profit

Q
MC = P at 8
units,
total profit is
14-84
maximized
 The Marginal Cost Curve is
the Supply Curve
Margin = Firm’s
P al Cost Supply
Curve
$6 Because the marginal cost
1 curve tells us how much of
a good a firm will supply at
$3 a given price, the
marginal cost curve is the
5
$19. firm’s supply curve
50
Q
6 8 10

14-85
Profit Maximization using Total
Revenue and Total Cost
• An alternative method to determine the profit-maximizing
level of output is to look at the total and total cost curves

• Total cost is the cumulative sum

• Total profit is the difference between total
of theand
revenue marginal
total cost costs,
curves plus the
fixed costs

14-86
 Total Revenue and Total Cost
Table
Total Cost, The total revenue
TC
Total Max profit = TR curve
The is a straight
total cost
Revenue $81 at 8 units curve line
is bowed
$280
of output upward at most
quantities
$175
reflecting
Profits are
increasing
$130 maximized when
marginal cost
the vertical
Losses Profits Losses distance between
5 8
Q TR and TC is
3
greatest
14-87
 Determining Profits Graphically: A
Firm with Profit
P Find output where
MC MC = MR, this is the
profit maximizing Q
MC = ATC
MR Find profit per unit
P Profits P=D= where the profit max Q
AVC
ATC MR intersects ATC
ATC at Qprofit
max Since P>ATC at the
profit maximizing quantity,
this firm is earning profits
Q
Qprofit max

14-88
 Determining Profits Graphically:
A Firm with Zero Profit or Losses
P
Find output where MC
MC = MR, this is the
profit maximizing Q
ATC
Find profit per unit MC =
where the profit max Q AVC
P
MR
intersects ATC P=D=
=ATC
ATC at QMR
profit
Since P=ATC at the max
profit maximizing quantity,
this firm is earning Q
zero profit or loss Qprofit max

14-89
 Determining Profits Graphically: A
Firm with Losses
P Find output where
MC MC = MR, this is the
profit maximizing Q
ATC at Qprofit ATC
max Find profit per unit
where the profit max Q
AVC
ATC intersects ATC
Losses P=D=
P
MR Since P<ATC at the
MC = profit maximizing quantity,
MR this firm is earning losses
Q
Qprofit max

14-90
 Determining Profits Graphically:
The Shutdown Decision
• The shutdown point is the P
point below which the firm MC
will be better off if it shuts
down than it will if it stays
in business ATC
• If P>min of AVC, then the
firm will still produce, but
earn a loss AVC
• If P<min of AVC, the firm PShut
will shut down down
P=D=
• If a firm shuts down, it still MR
has to pay its fixed costs Q
Qprofit max

14-91
Short-Run Market Supply and
Demand
• While the firm’s demand curve is perfectly elastic,
the industry’s demand curve is downward sloping

• The market supply curve takes into account any

changes in input prices that might occur

• The market (industry) supply curve

is the horizontal sum of all the firms’
marginal cost curves
14-92
 Short-Run Market Supply and
Demand Graph
P Market P Firm

Market MC
Supply

ATC

P P Profits
P = D = MR
ATC

Market
Demand

Q Q
Qprofit max

14-93