Module
Econ: 52
Defining Profit
KRUGMAN'S
MICROECONOMICS for AP*
Margaret Ray and David Anderson
What you will learn
in this Module:
• The difference between explicit and
implicit costs and their importance in
decision making.
• The different types of profit, including
economic profit, accounting profit, and
normal profit.
• How to calculate profit.
Understanding Profit
• Implicit versus explicit
costs
• Accounting profit
versus economic profit
• Normal profit
I. Defining Profit
A. Profit is equal to total revenue minus total cost
B. Economists use the symbol π to represent profit
1. π = total revenue – total cost
2. π = TR – TC
C. Total revenue equals the price paid times the number sold.
1. TR = P x Q
•An explicit cost is a cost that involves actually laying out money.
II. Implicit versus Explicit
Costs
A. An explicit cost is a cost that involves actually laying out
money.
1. Examples include Rent, Wages, Interest on debt,
depreciation and utility bills
2. These are referred to as “accounting costs”
B. An implicit cost does not require an outlay of money; it is
measured by the value, in dollar terms, of the benefits that
are forgone.
C. Businesses can face implicit costs for two reasons.
1. A business’s capital could have been put to use in some
other way.
2. The owner devotes time and energy to the business that
could have been used elsewhere.
3. These are referred to as “economic costs”
III. Accounting versus
Economic Profit
A. Accounting costs include only EXPLICIT costs
B. Accounting profit equals total revenue minus total EXPLICIT
costs
• Accounting π = TR – TC (explicit)
C. Economic costs include BOTH explicit and implicit costs
D. Economic profit is total revenue minus total costs (including
both explicit and implicit costs)
• π = TR – TC (explicit + implicit)
IV. Normal Profit
A. An economic profit equal to zero is known as a “Normal
profit”
B. A normal profit means that all costs (explicit and implicit) are
covered by revenues.
C. When a firm is earning a normal profit, it can do no better
using resources in the next best alternative use.
Example:
If Betsy has zero economic profit, Betsy has sold enough clothing to:
1. Pay all of her employees, insurance company, utilities, the bank, and her
clothing suppliers. And!
2. Compensate her for all of the rental income she gave up and the Macy’s
salary that she gave up.
Module
Econ: 53
Profit Maximization
•KRUGMAN'S
•MICROECONOMICS for AP*
Margaret Ray and David Anderson
What you will learn
in this Module:
• The principle of marginal analysis.
• How to determine the profit-maximizing
level of output using the optimal output
rule.
Profit Maximization
• Both TR and TC are
functions of output. As
more output is sold (at a
constant price), TR and
TC both rise.
The goal of the firm is to
find the level of output
where the economic
profit is greatest
(maximized).
I. Marginal Analysis
A. Marginal revenue is the additional revenue from selling one
more unit of output.
• MR = ΔTR/∆Q
B. Marginal cost is the additional cost incurred from producing
one more unit of output.
• MC = ΔTC/∆Q
C. Firms will continue to produce as long as MR > MC and will
stop producing when MC = MR
II. The Optimal Output Rule
MC = MR!
III. Graphical Representation of
Profit Maximization
IV. When is Production
Profitable?
A. So long as economic profit is greater than or
equal to zero, the firm should continue to
operate.
B. If economic profits dip below zero (i.e. below a
normal profit), the firm would consider
permanently closing and moving resources to
their next best alternative.
Module
Econ: 54
The Production Function
•KRUGMAN'S
•MICROECONOMICS for AP*
Margaret Ray and David Anderson
What you will learn
in this Module:
• The importance of the firm’s production
function, the relationship between the
quantity of inputs and the quantity of
output.
• Why production is often subject to
diminishing returns to inputs.
Production Functions
A production
function shows
the relationship
between a
firm’s inputs
and output
I. Inputs and Output
A. Variable Inputs: can be increased to increase
production.
B. Fixed Inputs: cannot be increased in the near term to
increase production.
C. The short run versus the long run
1.
Short run: at least one input is fixed. The time period that is
too brief for a firm to alter its plant size (capital is fixed).
2.
Long run: all inputs may vary. A period of time long enough
for a firm to vary all inputs, including capital (plant size).
II. Total Product
A. Total Product (TP or Q) is the total output produced by
the firm. A graph of the firm’s TP when it uses different
levels of a variable input (with a given level of fixed
inputs)is the firm’s production function.
B. Total Product curves typically increase as the first
workers are hired—workers specialize etc. Eventually
additional workers get in the way and total output falls.
III. Marginal Product
A. Marginal Product (MP) of an input is the additional output
produced as a result of hiring one more unit of the input.
B. Proper Labeling:
MPL = (Δ Total Output)/(Δ Labor)
MPC = (Δ Total Output)/(Δ Capital)
IV. Diminishing Returns
A. The shape of the TP curve illustrates the
principle of Diminishing Returns to an Input.
B. Diminishing Returns to an Input: as more and
more of a variable input is added to a fixed
input, the additional output produced will
decline.
Diminishing Returns
Diminishing Returns
Module
Econ: 55
Firm Costs
•KRUGMAN'S
•MICROECONOMICS for AP*
Margaret Ray and David Anderson
What you will learn
in this Module:
• The various types of cost a firm faces,
including fixed cost, variable cost, and
total cost
• How a firm’s costs generate marginal
cost curves and average cost curves
From the Production Function
to Cost Curves
The previous module
covered the production
function and diminishing
returns. In the short run,
there are variable inputs
and at least one fixed
input. To hire inputs for
production, the firm will
incur production costs
which we represent with
cost curves.
I. Total Costs
A. Fixed costs (FC) are costs whose total does not vary
with changes in output. These are the payments to
the fixed inputs in the production function.
B. Variable costs (VC) are costs that change with the
level of output. These are the payments to the
variable inputs in the production function.
C. Total cost (TC) is the sum of total fixed and total
variable costs at each level of output.
• TC = FC + VC
II. Marginal cost
A. MC is the additional cost of producing one
more unit of output.
• MC = ΔTC/ΔQ = Δ(VC + FC)/ΔQ = ΔVC/ΔQ
III. Average Cost
A. Average (AC) is the total cost
divided by the level of output (it
is also called average cost, unit
cost, or per unit cost).
1. ATC = TC/Q
2. AVC = TVC/Q
3. AFC = TFC/Q
• Since TC = TFC + TVC,
• ATC= AFC + AVC
IV. The relationship between
MC and AC
A.
The MC curve intersects the Ushaped ATC and AVC at their
respective minimum points.
• If the next (or marginal) value is above
the average, it pulls the average up
• If the next (or marginal) value is below
the average, it pulls the average down.
Therefore;
• The AC will fall as long as the MC<AC.
• As soon as the MC rises so that
MC>AC, the AC will begin to rise.
• If the MC of the next unit is equal to the
current AC, AC will not change.