revenue,
cost and profit.
•
•
•
•
Revenue $100
Fixed costs $ 20
Variable costs $ 70
Profit $ 10
• revenue minus cost equals
• profit.
• Handout Visual 3.2
• Understand the relationships among total,
marginal and average costs.
• Be sure to understand how the law of
diminishing marginal returns affects output
and, correspondingly, cost. This is critical to
your future success in this unit.
• implicit costs: The money income a firm
sacrifices when it employs a resource it owns
rather than selling it to someone else
• explicit costs: The money payment a firm
must make to an outsider to obtain and use a
resource
• Handout visual 3.3
• define and show the relationships among FC,
VC and TC.
• Insert visual 3.4 to define and show the
relationships among AFC, AVC, ATC and MC.
• Also use Visual 3.4 to explain why MC crosses
ATC at its minimum point.
• In Part A, the return on investment is a loss
when opportunity cost is included. This
gives a negative rate of return if “psychic
income” from being in business for yourself
is ignored.
• In Part B, marginal cost is plotted at the
midpoints of the quantity intervals, and the
quantity intervals are 100 units, not one unit.
• We will plot marginal cost and marginal
revenue at the midpoints.
• First calculate marginal cost from the chart.
Marginal cost is ΔTC / ΔQ or ΔTC / 100. To find
MC as output increases from 500 units to 600
units, find the change in total cost over this
interval: $4,320 – $3,600 = $720. Divide by the
change in quantity (100), and MC = $7.20 at
an output of 550 units
Activity 26
• The accountant’s concept of “profit” differs
from the economist’s because the economist’s
concept includes implicit opportunity costs.
When M.I. Fortunate goes into business for
herself, she incurs two implicit opportunity
costs:
• (i) Her former salary of $50,000
• (ii) The 8 percent return on $100,000, which is
$8,000
Activity 26
• The second is incurred because the$100,000
must be used to invest in the new business.
While it earns some return, it does not earn
the previous $8,000 realized when it was
invested in securities. The “net income” of
$55,000 is gross return net of explicit cost
only, and it gives an accounting profit only. To
find economic profit, the opportunity cost of
$58,000must also be subtracted.
Activity 26
• The possibility of “psychic income” from being
in business for herself is not considered in
establishing her total income of $55,000 after
all expenses. If “psychic income” is
considered, she may not lose $3,000.
Activity 26
Part B. Students must use these formulas:
Total Cost = Fixed Cost + Variable Cost
• Average Fixed Cost (AFC) = Fixed Cost = FC
Quantity
Q
• AVC = VC
ATC = TC
Q
Q
• MC = Change in Total Cost = ΔTC
Change in Quantity = ΔQ
Activity 26
• Question 6 answer: If marginal cost is below
average cost, average cost is falling because
the marginal, or additional, cost is pulling AC
down. If marginal cost is above average cost,
average cost is rising because the marginal,
or additional, cost is pulling AC up. Because
AC declines and then rises, MC crosses AC at
the lowest point on the average cost curve.
Activity 26
• Part B
• 4. How is marginal cost (ΔTC / ΔQ)
represented in Figure 26.2? It is the slope of
the TC curve.
• 5. On Figure 26.3, total cost per unit (TC / Q or
average total cost) is at a minimum at an
output level of between 500 and 600 units.
Activity 26
• 6. On Figure 26.3, variable cost per unit (VC /
Q or average variable cost) is at a minimum at
an output level of between 300 and 400 units.
• 7. On Figure 26.3, what is the relation
between marginal cost (ΔTC / ΔQ) and average
total cost (TC / Q) when average total cost is at
its minimum? They are equal.
Activity 26
• 8. On Figure 26.3, what is the relation
between marginal cost (ΔTC / ΔQ) and average
variable cost (VC / Q) when average variable
cost is at its minimum? They are equal.
Activity 27
• 9. Explain why marginal cost on a unit-cost graph always intersects
average total cost and average variable cost at their minimum
points. A minimum is the lowest point. If ATC ( TC/Q ) and AVC (
VC/Q ) fall when MC ( ΔTC ΔQ / ) is below them (as they must
since the cost of one additional unit is less than the average, it
pulls average cost down), and if ATC and AVC increase when MC is
above them (as they must since the cost of one additional unit is
more than the average, it pulls average cost up), and if MC is
rising, ATC and AVC must be at a minimum when they are equal to
MC since you have to pass through a minimum when you stop
falling and start rising. Let’s say that a basketball player is
averaging 10 points a game. In the next game, she scores eight
points. Because the marginal (additional) points are less than her
average, her average must fall. On the other hand, what if she
scored 12 points? Then her average would rise because the
marginal points would be greater than her average.
Activity 27
• 10. On Figure 26.3, what does the vertical
distance between the TC / Q curve and VC / Q
curve represent?
FC
Q
or average fixed cost
Activity 27
• 11. Explain why fixed cost has no influence on
marginal cost. Fixed cost, by definition, does
not change as output changes. Marginal
cost, by definition, is the change in total cost
as output changes. Therefore, fixed cost,
which does not change, can have no
influence on the changes in cost measured by
marginal cost.
For Activity 27
quick review of costs and basic concepts:
Average fixed cost (AFC): Fixed cost / output
Average total cost (ATC): Total cost / output
• Average variable cost (AVC):Variable cost / output
• Economic cost: Any cost that must be incurred to
obtain and use a resource
• Economic profit: The amount of a firm’s total
revenue that exceeds all its economic costs
including both explicit and implicit costs.
For Activity 27
• Explicit cost: The money payment a firm
must make to an outsider to obtain and use
a resource.
• Fixed cost (FC): A cost that does not change
with output.
• Implicit cost: The money income a firm
sacrifices when it employs a resource it owns
rather than selling it to someone else.
Activity 27
• Law of diminishing marginal returns: As equal
amounts of variable resources are added to a
fixed resource, eventually the marginal
product (extra output) will decline.
• Long run: A period of time long enough to
change all inputs. All inputs are variable in
the long run.
• Marginal cost (MC): The extra cost of
producing one more unit of output, ΔTC/ΔQ
Activity 27
• Normal profit: A measure of the opportunity
cost of capital; a profit that is equal to a
firm’s implicit costs; the minimum profit
needed to stay open in the long run.
• Short run: A period of time when at least one
input is fixed, when existing firms can
increase the quantity of their output with
their existing plants.
Activity 27
• Total cost (TC): All of the costs of the firm
both fixed and variable costs.
• Variable cost (VC): The cost of variable
resources (resources that change with
output).
Visual 3.5 questions
• Use Visual 3.5 to show the perfectly
competitive firm and industry in short-run
equilibrium.
1. How is the price established at which the
firm sells? Visual 3.5 answer 1
2. How much control does the firm have over
this price? Visual 3.5 answer 2
Visual 3.5 questions
3. Why do we say a perfect competitor is a price
taker?Visual 3.5 answer 3
4. Why does a perfect competitor maximize
profits where Price = MC?Visual 3.5 answer 4
5. Is this perfect competitor making a profit?
Why or why not?Visual 3.5 answer 5
Visual 3.6 questions
Now, use Visual 3.6 to illustrate profit, loss and
shutdown for a perfectly competitive firm.
1. At what output will the firm operate at price
P4? Will it make a profit?Visual 3.6 answer 1
2. At price P3, will the firm make a profit, break
even or have an economic loss? What does it
mean to break even?Visual 3.6 answer 2
Visual 3.6 questions
3. At P2, will the firm make a profit, break even
or have an economic loss? Will it continue to
produce? Why or why not?Visual 3.6 answer 3
4. At P1 , will the firm make a profit, break even
or have an economic loss? Will it continue to
produce? Why or why not?Visual 3.6 answer 4
Visual 3.7 questions
Use Visual 3.7 to illustrate long-run equilibrium
for a perfect competitor. Emphasize these
points:
• The market price is determined by supply and
demand in the industry.
• Once the price is established, every firm must
sell at that price or not sell at all. There is no
reason for a firm to lower its price since it can
already sell as much as it wants.
Visual 3.7 questions
• If firms are making economic profits, more firms
will enter the industry-an event that reduces
price and makes profits disappear.
• If firms have economic losses, firms will exit the
market-an event that will cause the price to rise.
• A perfectly competitive firm in long-run
equilibrium is good for society because there is
productive and allocative efficiency when the
firm is at the lowest point on its average total
cost curve.
Activity 27 answers
• 1. What is the relationship between MC and output as
shown on your graph? As output increases, marginal
cost decreases, reaches a minimum and then
increases.
• 2. Explain why MC falls and then rises as output
increases. According to the law of diminishing
marginal returns, as variable inputs are added to
fixed inputs, output increases at a fast rate (marginal
product increases), so the marginal costs of that
output decrease. But when MP falls, the marginal
cost of producing that output will increase.
Activity 27 answers
3. Graph FC, VC and TC on Figure 27.4. Label each curve. Then
answer the questions.
• (A) What is the difference between fixed and total costs?
Variable cost
• (B) Why does VC rise as output increases? In order to
increase output, the firm must hire more variable inputs
(labor). So the cost of this input (variable cost) must
increase.
• (C) Why is FC a horizontal line? Because fixed costs are
constant, regardless of the level of output
• (D)Why does the TC curve have the same slope as the VC
curve? The difference between the TC curve and the VC
curve is FC, which is constant.
Activity 27 answers
4. Graph AFC, AVC, ATC and MC on Figure 27.5
(be sure to plot MC on the midpoints of
output). Label each cost curve. Then answer
the questions.
(A) What happens to AFC as output rises? Why?
AFC decreases because total fixed cost is
constant. To get AFC, one divides FC by Q, so
AFC must decrease.
Activity 27 answers
(B) What happens to AVC as output rises? Why?
AVC decreases and then increases. When MC is
less than AVC, AVC decreases. When MC is
greater than AVC, AVC increases.
(C) What happens to ATC as output rises? Why? ATC
decreases and then increases. When MC is less
than AVC, ATC decreases. When MC is greater
than ATC, ATC increases.
(D)What happens to MC as output rises? Why? MC
decreases and then increases. This is because of
increasing returns and then diminishing returns.
Activity 27 answers
(E) At what unique point does marginal cost cross
AVC and ATC? Why? At the minimum of AVC and
ATC. If marginal cost is less than average cost,
average cost falls. If marginal cost is greater
than average cost, average cost will rise, so they
are equal when average cost is at its minimum.
(F) Why is MC the same whether computed from TC
or VC? Fixed costs don’t change, and marginal
cost is the change in costs divided by the change
in output. Change in variable cost always equals
the change in total cost.
Visual 3.5 answer 1
1. By the intersection of the industry supply
and demand curves.
Back
Visual 3.5 answer 2
2. None
Back
Visual 3.5 answer 3
3. Because the firm has no control over the
price and has to “take” the price established
in the industry.
Back
Visual 3.5 answer 4
4. All firms maximize profit by producing at the
quantity where MR = MC, and for a perfectly
competitive firm P = MR since a firm can sell
all it wants at the price determined by the
industry.
Back
Visual 3.5 answer 5
5. Yes. P > ATC and TR > TC.
Back
Visual 3.6 answer 1
1. At what output will the firm operate at price
P4? Q4 .Will it make a profit? Yes
Back
Visual 3.6 answer 2
2. At price P3, will the firm make a profit, break
even or have an economic loss? Break even.
What does it mean to break even? TR just
covers TC.
Back
Visual 3.6 answer 3
3. At P2, will the firm make a profit, break even
or have an economic loss? Economic loss. Will
it continue to produce? It will continue to
produce. Why or why not? Price is greater
than AVC or TR > TVC.
Back
Visual 3.6 answer 4
4. At P1 , will the firm make a profit, break even
or have an economic loss? Economic loss. Will
it continue to produce? Indifferent. Why or
why not? If firm produces, revenue covers
variable costs, but firm must pay fixed costs
out-of-pocket. Price = AVC or TR = TVC
Back