Cost and Profit1 COST AND PROFIT ECO 2023 Principles of Microeconomics Dr. McCaleb.

Cost and Profit 1

COST AND PROFIT

ECO 2023Principles of Microeconomics

Dr. McCaleb

Cost and Profit 2

TOPIC OUTLINE

I. Short Run and Long Run

II. Types of Costs

III. Accounting and Economic Profit

IV. Incentive Effects of Profits and Losses

Cost and Profit 3

Short Run and Long Run

Cost and Profit 4

Short-Run

Definition

Period of time during which some resources or inputs are fixed.

A seller in the short run has some fixed inputs that cannot be increased and the costs of are unavoidable even if the seller shuts down. Fixed costs do not change when quantity changes.

Resources that are not fixed in the short run are variable inputs. The amount of the input used and the cost changes when the quantity of the output changes. The costs of variable inputs are avoidable—if the seller shuts down, it doesn’t bear any cost for the variable inputs.

SHORT RUN AND LONG RUN

Cost and Profit 5

Short-Run

Examples of fixed resources and unavoidable costs

• A lease

• The capacity of a plant or facility

• The opportunity cost of equipment that cannot be quickly liquidated or converted to alternative uses

• Specialized skills, training, or education needed to serve a market


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Long-Run

Definition

A point in time when a seller is no longer committed

At certain points in time, a seller is no longer committed to a market and has the opportunity to either expand in the market or exit the market and enter a new market.

There are no fixed inputs and no unavoidable costs in the long run. All inputs are variable in the long run and all long-run costs are variable.


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How Long Is the Short Run?

Short run is not a fixed period of calendar or clock time

Life is a succession of short runs, each punctuated by a long-run decision point.

As long as some resources are fixed and some costs are unavoidable, a seller is operating in the short run and making short run decisions.

At the point in time when the seller no longer has unavoidable costs, the seller can make a long-run decision. Once the long-run decision is made, the seller is again operating in the short run.


Cost and Profit 8

Decisions about Resource Use

Short-run and long-run decisions

Both short-run and long-run decisions are decisions about the use of productive resources.

Short run decision: What quantity to produce. Seller chooses the quantity that maximizes profits or minimizes losses, given the fixed resources and associated fixed costs.

Long run decision: Market entry or exit. Seller chooses to stay in the market or exit the market and enter a new market depending on whether existing sellers are earning profits or losses.


Cost and Profit 9

Which of the following statements is FALSE? In the short run, Honda can increase the supply of Accord 6-cylinder sedans in the U.S. market by

1. speeding up its assembly lines and reducing quality control testing.

2. adding a second shift at its Ohio assembly plant.

3. building a new assembly plant.

4. exporting fewer Accords to Japan and selling more in the U.S.

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Which of the following statements is FALSE?

1. There are no fixed costs in the long run.

2. The short run is one year; anything longer than one year is the long run.

3. The calendar length of the short run is different for different businesses.

4. In the short run, there are fixed inputs with fixed or unavoidable costs.

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Types of Costs

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TYPES OF COSTS

Variable Cost

Variable costs are costs of variable inputs

Variable costs increase when Q increases and decrease when Q decreases. When Q=0, variable costs are zero.

Total variable cost: Total cost of all variable inputs

TVC=(Variable input price) x (Variable input quantity)

Average variable cost:

AVC=TVCQ

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TYPES OF COSTS

Fixed Cost

Fixed costs are unavoidable costs of fixed inputs

Fixed costs do not depend on Q. Fixed costs are constant no matter how much output is produced. Fixed costs are incurred even if Q=0.

Total fixed cost: Total unavoidable cost of all fixed inputs

TFC=(Fixed input price) x (Fixed input quantity)

Average fixed cost:

AFC=TFCQ

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TYPES OF COSTS

Total Cost

Total cost is cost of all inputs

Total cost includes cost of both fixed and variable inputs, both avoidable and unavoidable costs.

Total cost: Total avoidable and unavoidable cost of all inputs

TC=TVC+TFC

Average total cost:

ATC=TCQ=AVC+AFC

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TYPES OF COSTS

Marginal Cost

Marginal cost varies with Q

Marginal cost is the increase (decrease) in total cost when Q increases (decreases).

Marginal cost:

MC=TCQ

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TYPES OF COSTS

Long Run Cost

All long-run costs are variable

By definition, there are no fixed inputs or unavoidable costs in the long run. All inputs are variable in the long run, so all long-run costs are variable.

Long-run costs depend on Q. In the long run, if Q=0, TC=0 and if Q>0, TC>0.

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1. Calculate total cost at each quantity.

2. Calculate average total cost, average fixed cost, and average variable cost at each quantity.

3. Calculate marginal cost between 1 and 2, between 2 and 3, and between 3 and 4.

Quantity Total Fixed Cost Total Variable Cost

0 $10 $0

1 $10 $8

2 $10 $10

3 $10 $11

4 $10 $12

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What is the total cost of 3 units of output?


0 $10 $0

1 $10 $8

2 $10 $10

3 $10 $11

4 $10 $12

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What is the average fixed cost of 2 units of output?


0 $10 $0

1 $10 $8

2 $10 $10

3 $10 $11

4 $10 $12

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What is the average variable cost of 4 units of output?


0 $10 $0

1 $10 $8

2 $10 $10

3 $10 $11

4 $10 $12

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What is the marginal cost when quantity increases from 1 unit to 2 units?


0 $10 $0

1 $10 $8

2 $10 $10

3 $10 $11

4 $10 $12

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As Q increases, total variable cost first increases at a slower and slower rate, but then increases at a faster and faster rate.

Total Variable Cost, Total Fixed Cost, and Total Cost

Total cost follows the same pattern as TVC. The vertical distance between TC and TVC equals TFC.

Because total fixed cost does not vary with Q, it is constant at all levels of output.

TYPES OF COSTS

Cost and Profit 23

Average variable cost is U-shaped. As Q increases, AVC decreases, reaches a minimum, and then increases.

Average Variable, Average Fixed, and Average Total Cost

Average total cost follows the same pattern as AVC. The vertical distance between ATC and AVC equals AFC.

As Q increases, average fixed cost steadily decreases.

TYPES OF COSTS

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Marginal cost is U-shaped and intersects both AVC and ATC at their minimum points.

Average and Marginal Cost

Also, when MC is below ATC, ATC decreases. When MC is above ATC, ATC increases.

When MC is below AVC, AVC decreases. When MC is above AVC, AVC increases.

TYPES OF COSTS

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Which of the following statements is true? When average total cost is decreasing,i. marginal cost is decreasing.ii. marginal cost is less than average total cost.iii. marginal cost is less than average fixed cost .

1. i only2. ii only3. iii only4. i and ii only5. i and iii only6. i, ii, and iii

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Accounting and Economic Profit

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How profitable are U.S. businesses? One measure of profitability is “return on revenues”. That means profit as a percent of sales. So, on average, how much is profit as a percent of sales? In other words, how much of each dollar you spend ends up as profit?

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How profitable is Wal-Mart, the world’s largest private company? Of each dollar that is spent at Wal-Mart, how much ends up as profit?

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Wal-Mart earned 3.6% on revenues—that’s 3.6 cents for each dollar of sales.

Period Profit as a Percent of Sales

1974-1997 4.58%

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Politicians and media pundits were appalled in a recent year when Exxon reported record profits of $25,330,000,000. That is more than the entire gross domestic product of most countries. But very little attention was paid to Coca-Cola’s profits, which were only $4,847,000,000.

So which firm was more profitable? If you had $1,000 to invest and you wanted the maximum return on your investment, in which firm would you invest?

1. Exxon

2. Coca-Cola

3. Not enough information

Cost and Profit 31

*Current value of stockholders’ total investment.**Percent return to stockholders’ total investment.

Exxon Coca-Cola

Total Revenues $270,772,000,000 $21,962,000,000

Return on Revenues 15.8% 22.1%

Equity* $101,756,000,000 $15,935,000,000

Return on Equity** 24.9% 30.4%

Cost and Profit 32

ACCOUNTING AND ECONOMIC PROFIT

Accounting and Economic Cost

Explicit and implicit costs

Explicit cost: A cost paid in money—an opportunity cost for use of a resource for which there is a monetary payment.

Implicit cost: A cost incurred but without a monetary payment—an opportunity cost for use of a resource for which there is no monetary payment.

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ACCOUNTING AND ECONOMIC PROFIT Accounting and Economic Profit

Definitions

Accounting profit=Total revenue-total explicit cost

The accounting concept of profit includes only the explicit opportunity cost of production, those for which there is a monetary payment.

Economic profit=Total revenue-(total explicit cost+total implicit cost)

The economic concept of profit includes all opportunity costs, explicit and implicit, whether the costs are reflected in a monetary payment or not.

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Accounting and Economic Profit

Three observations

Because economic profit includes both explicit and implicit costs, economic profit is less than accounting profit and economic losses are greater than accounting losses.

When accounting profit is exactly equal to all the implicit costs, economic profit is zero.

Accounting profit provides very little useful information but it can be objectively measured. Economic profit provides important information but, because we can’t easily and objectively measure implicit opportunity costs, economic profit can only be estimated.


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Why the Difference?

Economic profit explains resource allocation

Economics is about how resources are allocated. It explains and predicts the decisions people make about the use of scarce resources.

Those decisions are based on all the opportunity costs, not just the costs for which there is a monetary payment. Economic profit is a better predictor and provides better explanations of people’s behavior.

Economic profit is the residual left over after paying all the costs, both the explicit monetary costs and the implicit non-monetary costs.


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Why the Difference?

Example 1: Owners’ time

Owners of a business contribute time and effort to running the business. If they were not running a business, they could earn a salary somewhere else. The foregone salary is a cost to the owners of running the business.

To provide an incentive for owners to stay in business, they must earn at least enough to compensate for the foregone salary. This is not something left over after the costs have been paid; it is part of the cost. Accountants misclassify the required return to the owners as profit. Economists correctly classify it is an implicit cost, not as profit.


Cost and Profit 37

Why the Difference?

Example 2: Financial capital

Investors contribute financial capital to a business. If the financial capital were not invested in the business, it could be invested elsewhere and provide interest or dividend income to the investors. The foregone investment income is a cost of running the business.

To provide an incentive for continued investment in the business, the investors must earn at least enough to compensate for the foregone investment income. This too is not something left over after the costs have been paid; it is part of the cost. Accountants misclassify the required return to invested capital as profit. Economists correctly classify it is an implicit cost, not as profit.


Cost and Profit 38

Why the Difference?

Example 3: Owned buildings and equipment

Businesses own buildings. If these were not used in the business, they could be rented to other people and would generate rental income to the owners and investors. The foregone rental income is a cost of using the building in the business.

To provide an incentive for continued use of the building by the business, the investors must earn at least enough to compensate for the foregone rental income. This too is not something left over after the costs have been paid; it is part of the cost. Accountants misclassify the required return as profit. Economists correctly classify it is an implicit cost, not as profit.


Cost and Profit 39

Normal Profit

Definition

The minimum amount of accounting profit necessary to compensate owners and investors for the implicit opportunity cost of their time, financial capital, buildings, equipment, and other resources used in the business.

The amount of accounting profit that is more correctly classified as a cost, not as something left over after payment of the costs.


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Normal Profit

Normal accounting profit equals zero economic profit

When accounting profit=normal profiteconomic profit=0: Owners and investors are fully compensated for all their costs. There is no incentive for resources to either enter or exit the market.

When accounting profit<normal profiteconomic profit<0: Owners and investors are not compensated for all their costs. In the long run, resources exit the market.

Accounting profit>normal profiteconomic profit>0: Owners and investors are more than fully compensated for all their costs. In the long run, new resources enter the market.


Cost and Profit 41

Total revenue=$15,000Total expenses (wages, salaries, interest, rent, etc.)=$10,000Expected income from best alternative investment=$2,500

How much isa. accounting profit or loss?b. normal profit?c. economic profit or loss?

In the long run, there is an incentive for resources toa. enter the marketb. exit the marketc. neither enter nor exit

Cost and Profit 42


Accounting profit or loss=$5,000Normal profit=$2,500Economic profit or loss=$2,500

In the long run, there is an incentive for resources to enter the market.

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Accounting profit or loss=$5,000Normal profit=$5,000Economic profit or loss=$0

In the long run, there is an incentive for resources to neither enter nor exit the market.

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Accounting profit or loss=$5,000Normal profit=$7,500Economic profit or loss= -$2,500

In the long run, there is an incentive for resources to exit the market.

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Incentive Effects of Profits

Cost and Profit 48

Economic Functions of Profits (and Losses)

Profits provide incentives for efficient resource use

The possibility of earning economic profits and the threat of economic losses provide incentives for suppliers to provide those goods most highly valued by consumers at the lowest possible cost.

Profits and losses create incentives for resource owners to use resources in ways that maximize the net social value or benefit of those resources.

INCENTIVE EFFECTS OF PROFITS

Cost and Profit 49


Profits direct resources to their highest-valued uses

Economic profits arise when the value of a good to consumers is greater than the cost of providing it.

Suppliers respond to economic profits by providing more of those goods where the profit is greatest.

Economic profits direct resources to those goods, services, and activities that consumers value most highly.


Cost and Profit 50


Losses direct resources away from lower-valued uses

Economic losses arise when the value of a good to consumers is less than the cost of providing it.

Suppliers respond to economic losses by providing less of those goods where there are losses.

Economic losses direct resources away from those goods, services, and activities that consumers value less, freeing up those resources to increase other goods that consumers value more.


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Profits create incentives to minimize costs

The possibility of earning profits by being more efficient and reducing cost creates incentives for sellers to adopt technological innovations and less costly production techniques.

The incentive is reinforced by the threat of incurring losses and being forced out of the market if a seller fails to adopt the most efficient, least-cost operating methods.


Cost and Profit 52

Based on the video clip, which statement is correct?

1. Most new drugs in the U.S. come from the federal government, not the drug manufacturers.

2. Most new drugs are developed outside the U.S. in countries that have price controls on drugs.

3. Even high-priced drugs are often less costly than alternative treatments such as surgery.

4. Imposing price controls on drugs in Canada in the 1960’s had no effect on Canadian drug research.

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Example: Pharmaceutical Research

Pharmaceutical research and the pursuit of profit

For a given expenditure on research, profit is greatest in markets that are likely to generate the most revenue:

TR=PxQ

The most profitable markets are those where either the price is expected to be high or large sales are expected.


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Which markets are most profitable?

The expected price of a drug is determined by its marginal benefit to consumers, their willingness to pay. The price consumers are willing to pay reflects the seriousness of the disease, the pain and discomfort, and the effectiveness of the drug.

The expected quantity is determined by the size of the market—the number of people who are affected by the disease and who can benefit from the drug.


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Pursuit of profit maximizes social benefit

The greatest social benefit comes from curing or alleviating the most serious, painful, and unpleasant diseases, or from curing or alleviating those diseases that affect the largest number of people, or both.

Those are the very diseases that promise the highest prices, the largest markets, and the highest profits to pharmaceutical companies.


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Which of the following statements is FALSE?

1. Profits and losses direct resources to their highest-valued use and away from lower-valued uses.

2. The possibility of earning profits and the threat of losses provides incentives for minimizing cost.

3. The pursuit of profits often maximizes social benefit.

4. Profits perform no useful economic function; they only transfer wealth from consumers to suppliers.

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Absence of the Profit (and Loss) Motive

Profit versus non-profit

“The potential for profits and the threat of losses is what forces a business owner in a capitalist economy to produce at the lowest cost and to sell what the customers are most willing to pay for.”

Thomas Sowell, Basic Economics

A non-profit enterprise or a government agency cannot earn profits by better satisfying consumer demand or by being more efficient or by being innovative. A non-profit enterprise or a government agency also faces no threat from losses if it fails to satisfy consumer demand or is high-cost or is inefficient.


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Absence of the Profit (and Loss) Motive

A puzzle

What is the incentive for managers of non-profit enterprises and government agencies to satisfy consumers and clients, to use resources efficiently, and to be innovative?

Which is more responsive to consumer demands, for-profit or non-profit enterprises? Which is more innovative, for-profit or non-profit enterprises? Which operates more efficiently, for-profit or non-profit enterprises?

If profits (and losses) provide the incentives to satisfy consumer wants at the lowest possible cost, what does the slogan “for people, not profits” mean? Aren’t consumers people?


Cost and Profit1 COST AND PROFIT ECO 2023 Principles of Microeconomics Dr. McCaleb.

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