Chapter 6 – Costs, revenues and profit 9/10

Short Run = Period of time in which at least one factor of production is fixed. All

production takes place in the short run

EG: Adding extra workers to increase production

Long Run = Period of time in which all factors of production are variable, but the state

of technology is fixed. All planning takes place in the long run.

EG: Building an extra factory

(Once the fixed factors are changed the firm is once again in the short run)

Total, Average and Marginal Product

• Total Product (TP) ~> Total output that a firm produces

• Average Product (AP) = Output that is produced on average by one unit of

variable factor. TP / V (V = Number of variable factors employed)

• Marginal Product (MP) = The extra output that is produced by using an extra unit

of variable factor. ΔTP / ΔV (ΔTP = Change in TP and ΔV = Change in V)

V TP AP MP
0 0 0 0
10
1 10 10
15
2 25 12.5
20
3 45 15
25
4 70 17.5
20
5 90 18
15
6 105 17.5
The Law of Diminishing Returns

Definitions

The hypothesis of eventually The hypothesis of eventually diminishing

diminishing marginal returns average returns
As extra units of variable factor are added As extra units of variable factor are added to
to a given quantity or a fixed factor, the a given quantity of a fixed factor, the output
output from each additional unit of variable per unit of the variable factor will eventually
factor will eventually diminish diminish
Explanation ~> Too many cooks spoil the broth

• Production becomes inefficient due to too many variable factors getting in the way

of each other
Cost Theory

Economic Costs

1) Explicit costs = Any costs to a firm that involve the direct payment of money

EG: A firm hires a worker for $1000 a week. The OC is what the firm could have

done with the wages paid to the worker.

2) Implicit costs = Earnings that a firm could have had if it employed its factors in

another use or if it had hired out or sold them to another firm.

EG: A firm owns a building where it produces goods. It can rent this building to other

firms for $15000 per month. The OC of keeping this building for themselves is the

$15000 per month.

Short Run Costs

1) Total costs = Complete costs of producing an output

a) Total Fixed Cost (TFC) = Total cost of fixed assets that a firm uses in a given

time period. This cost is a constant amount because fixed assets don't change.

EG: Rent

b) Total Variable Cost (TVC) = Total cost of the variable assets that a firm uses in

a given time period. TVC increases as more variable factors are employed.

EG: Wages

c) Total Costs (TC) = Total cost of all the fixed and variable factors used to produce

a certain output. TFC + TVC = TC

 2) Average Costs = Costs per unit of output

a) Average Fixed Cost (AFC) = Fixed cost per unit of output. AFC = TFC/q (q =

level of output). Decreases as q increases. The cost is dispersed over more q.

b) Average Variable Cost (AVC) = Average cost per unit of output. AVC = TVC/q

c) Average Total Costs (ATC) = Total cost per unit of output. ATC = TC/q

3) Marginal Costs (MC) = Increase in total cost of producing an extra unit of output.

MC = ΔTC/Δq ( ΔTC = Change in TC and Δq = Change in q)

<AFC, AVC , ATC and MC tends to fall as output increases and then starts to rise

again a s output continues to increase>

<This is due to the law of diminishing returns>

V q TFC TVC TC AFC AVC ATC MC

0 0 400 0 400
20
1 10 400 200 600 40 20 60
13.33
2 25 400 400 800 16 16 32
10
3 45 400 600 1000 8.89 13.33 22.22
8
4 70 400 800 1200 5.71 11.43 17.14
10
5 90 400 1000 1400 4.44 11.11 15.55
13.33
6 105 400 1200 1600 3.81 11.43 15.24
20
7 115 400 1600 2000 3.48 12.17 15.65
40
8 120 400 1800 2200 3.33 13.33 16.67
~> The MC curve cuts the AVC and ATC curve at its lowest point

~> The AVC and ATC curve gets closer together near the end because AFC falls as

output increases
Long Run Costs

• Long Run = Planning Stage

• The entrepreneur is free to adjust the quantity of all of the factors of

production(but restrained by current level of technology)

• We look at what happens to costs when all factors of production are increased

• The Long Run Average cost Curve(LRAC) envelopes an infinite number of

Short Run Average cost Curve(SRAC)

• If a a firm wishes to produce more, it can do so by shifting its the tangential point(C1

, q1) SRAC curve 1 down the LRAC curve 2 to the new SRAC curve 2 at the

tangential point C2, q2.

• The LRAC curve consists of an infinite number of single points of a SRAC curve

~> shows the infinite number of combination of goods and services

• Long Run Average Cost ↓ ~> Firms experience increasing returns to scale

Diagram ~> q2 to q3

• Long Run Average Cost ↑ ~> Firms experience decreasing returns to scale

Diagram ~> q3 to q4

• Economies and Diseconomies of scale causes increasing and decreasing

returns to scale
Economies of Scale ~> When the AC(average costs) of firms ↓ as Q(output) ↑
~> Causes increasing returns to scale
1) Production Economies ~> Big Truck Driver Sells Lollipops = BTDSL
1) Bulk Buying ~> Bulk buying is cheaper
2) Transport Economies ~> Bulk transporting or own transport fleet is cheaper
3) Division of labour ~> Allows Specialization
4) Specialization ~> Expertise allows more efficient production
5) Large machines ~> Firms can afford their own large machines. No payment.
▪ (All of these are internal)

2) Promotional Economies ~> Advertising costs remain low and reduces advertising
costs per unit.
3) Financial Economies ~> Easier to obtain finance
PPF ~> Pigs Pick Flowers
Diseconomies of Scale ~> When the AC of firms ↑ as Q↑
~> Causes decreasing returns to scale
1) Control and communication problems
~> Firm becomes too big to coordinate and control activities
~> Becomes inefficient
2) Alienation and loss of identity
~> Workers lose moral because they feel insignificant when firms are too big
~> Lower productivity and inefficiency

Constant returns to scale occurs when long run average costs are constant as output

increases.
Revenue Theory

Revenue ~> Income that a firm receives through sale of its products

Measurement

1) Total Revenue(TR) = Total amount of money that a firm receives from selling a

certain amount of good or service in a given time period. p x q

2) Average Revenue(AR) = Revenue the firm receives per unit of sale. TR/q = p

3) Marginal Revenue(MR) = Extra revenue that a firm gains from selling an extra unit

of a product. ΔTR/Δq

Revenue curves and output

1) Perfectly elastic Demand Curve

~> TR rises as price increases because there is no price remains constant despite

change in quantity(theoretical)

2) Sloping Demand Curve

~> TR ↑ as price ↓ when the PED of the graph is < 1

~> Starts to ↓ when prices continue to ↑ because the PED on the graph is > 1.

~> MR is always lower than AR.

<Why? In order to sell more products, the firm lowers prices but loses the

revenue from when they sold the good at a higher price.>

<MC = MR ~> PROFIT MAXIMIZED>

<MR = 0 ~> REVENUE MAXIMIZED>

<MC = ATC ~> BREAK EVEN, NO WASTE>

<MC = AVC ~> SHUT DOWN PRICE>

<MC = AR ~> ALLOCATIVE EFFICIENCY>

Profit Theory
Measurement of Profit
Accountant's definition = Revenue – Total Costs
Economist's definition = Revenue – Economic costs(Implicit + Explicit costs)
Normal and Abnormal Profit
• Total revenue > Total cost = Abnormal profit

• Total revenue = Total cost = Normal profit

• Total revenue < Total cost = Loss

The Shut Down Price

• A firm may continue to operate in the short run even though they are making

losses.
• However, they can't do this for a very long time or else they'll have to shut down

permanently.
• They will have to plan in the long run by changing their combination of factors so

they will at least make normal profit.

• Therefore, a firm may shut down temporarily for a short period to open up again to

make profit in the long run.

• EG: An Ice Cream store in Vienna shuts down each October because its revenue is

not enough to cover its variable costs

• It opens again in April until September because demand for ice cream is high

enough to make high profits

The Break Even Price

• The break even price is the price at which the firm is able to cover all costs, variable

and fixed cost, to make normal profit in the long run

• Revenue = Average Total Costs

The profit maximizing level of output

• Profit is maximized where MC = MR at any level of output of q.

• The price we see what the consumers want and in this case it is P.

• To see a measurable amount of profit, a simple rectangle and a AC curve is

added.
YOU MUST MAKE SURE THAT THE MC CURVE CUTS THE AC CURVE AT ITS

LOWEST POINT!!!!!!!!

• The profit maximizing output is q and the price is p when average cost is

represented as AC.

• The profit per unit is AR – AC = a - b

• Since q units are produced, the abnormal profit is ab0q

• Weather abnormal profit is to be made depends on the AC curve

• If the average cost is represented by AC1 = the average revenue and average

cost is equal therefore the firm makes normal profit.

• If the average cost is represented by AC2 = the average revenue is larger than

average cost therefore the firm makes a loss.

• Moving the AC curve up and down shows the profit that a firm can make.
Alternative Goals of Firms ~> Rick Grows Stupid Corn ~> RGCS

1) Revenue Maximization

~> Success = Maximum Revenue

~> Produce at where MR = 0

~> Meaning they produce over the profit maximizing level

2) Growth Maximization

~> Target = Maximum possible growth in the short run

~> Allows firm to grow larger and dominate the market

~> Can be measured in: Senseless Pigs Quiz Eggs ~> SPQE

1/ Sales Revenue

2/ Percentage of market

3/ Quantity of sales

4/ Employment

3) Satisficing

~> An economic agent only produces satisfactorily rather than for maximum profit

~> Produce only enough to cover opportunity cost and TC

~> Produce just enough to satisfy oneself but no more

4) Corporate social responsibility

~> Businesses become ethical

~> Includes 'public interest' in decision making

~> Tries to reduce negative externalities and increase positive externalities

Article on growth maximization leading to increased profits

Internet service provider TPG has lifted its full year profit by 16 per cent, as it continues

to grow its broadband and mobile customer numbers.

TPG on Tuesday said its net profit for the year to July 31 was $90.9 million, up from $78.2 million in the previous 12 months.

The company's broadband customer base grew by 47,000 to 595,000, and mobile customers grew by 54,000 to 255,000.

Allan Franklin, an analyst at stockbroker Patersons, said customer growth was strong for a mid-sized telco.

"TPG's subscriber growth remains at odds with flat to negative growth being delivered by other second-tier competitors," he
said.

TPG's corporate business also posted strong earnings growth as it continued to expand its fibre network, which now connects to
more than 1,400 buildings, it said.

The company's earnings in the year to July were $261 million, up 12 per cent on the previous year.

TPG said it expected earnings to increase in its fiscal 2013 year, to between $263 million and $273 million.

Its shares rose on Tuesday, up seven cents, or 3.4 per cent, at $2.14.

The company declared a final, fully franked dividend of 2.75 cents, up from 2.25 cents previously.

"TPG Profit and Customer Bases Grows." NineMSN. N.p., 18 Sept. 2012. Web. 18 Sept. 2012.

<http://finance.ninemsn.com.au/newsbusiness/aap/8534480/tpg-posts-customer-and-profit-growth>.