COST AND PROFIT
ECO 2023
Principles of Microeconomics
Dr. McCaleb
Cost and Profit
1
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
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Short Run and Long Run
Cost and Profit
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SHORT RUN AND LONG RUN
 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.
Cost and Profit
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SHORT RUN AND LONG RUN
 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
Cost and Profit
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SHORT RUN AND LONG RUN
 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.
Cost and Profit
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SHORT RUN AND LONG RUN
 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
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SHORT RUN AND LONG RUN
 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
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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.
Cost and Profit
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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.
Cost and Profit
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Types of Costs
Cost and Profit
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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=TVCQ
Cost and Profit
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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=TFCQ
Cost and Profit
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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=TCQ=AVC+AFC
Cost and Profit
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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=TCQ
Cost and Profit
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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.
Cost and Profit
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Quantity
0
1
2
3
4
Total Fixed Cost
$10
$10
$10
$10
$10
Total Variable Cost
$0
$8
$10
$11
$12
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.
Cost and Profit
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Quantity
0
1
2
3
4
Total Fixed Cost
$10
$10
$10
$10
$10
Total Variable Cost
$0
$8
$10
$11
$12
What is the total cost of 3 units of output?
Cost and Profit
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Quantity
0
1
2
3
4
Total Fixed Cost
$10
$10
$10
$10
$10
Total Variable Cost
$0
$8
$10
$11
$12
What is the average fixed cost of 2 units of output?
Cost and Profit
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Quantity
0
1
2
3
4
Total Fixed Cost
$10
$10
$10
$10
$10
Total Variable Cost
$0
$8
$10
$11
$12
What is the average variable cost of 4 units of output?
Cost and Profit
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Quantity
0
1
2
3
4
Total Fixed Cost
$10
$10
$10
$10
$10
Total Variable Cost
$0
$8
$10
$11
$12
What is the marginal cost when quantity increases from 1 unit
to 2 units?
Cost and Profit
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TYPES OF COSTS
Total Variable Cost, Total
Fixed Cost, and Total Cost
As Q increases, total variable cost
first increases at a slower and
slower rate, but then increases at a
faster and faster rate.
Because total fixed cost does not
vary with Q, it is constant at all
levels of output.
Total cost follows the same pattern
as TVC. The vertical distance
between TC and TVC equals TFC.
Cost and Profit
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TYPES OF COSTS
Average Variable, Average
Fixed, and Average Total
Cost
Average variable cost is U-shaped.
As Q increases, AVC decreases,
reaches a minimum, and then
increases.
As Q increases, average fixed cost
steadily decreases.
Average total cost follows the same
pattern as AVC. The vertical
distance between ATC and AVC
equals AFC.
Cost and Profit
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TYPES OF COSTS
Average and Marginal Cost
Marginal cost is U-shaped and
intersects both AVC and ATC at
their minimum points.
When MC is below AVC, AVC
decreases. When MC is above AVC,
AVC increases.
Also, when MC is below ATC, ATC
decreases. When MC is above ATC,
ATC increases.
Cost and Profit
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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.
2.
3.
4.
5.
6.
i only
ii only
iii only
i and ii only
i and iii only
i, ii, and iii
Cost and Profit
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Accounting and Economic Profit
Cost and 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?
Cost and 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?
Cost and Profit
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Period
Profit as a Percent of Sales
1974-1997
4.58%
Wal-Mart earned 3.6% on revenues—that’s 3.6 cents for
each dollar of sales.
Cost and Profit
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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
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Exxon
Coca-Cola
Total Revenues
$270,772,000,000
$21,962,000,000
Return on Revenues
Equity*
15.8%
$101,756,000,000
22.1%
$15,935,000,000
Return on Equity**
24.9%
30.4%
*Current value of stockholders’ total investment.
**Percent return to stockholders’ total investment.
Cost and Profit
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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.
Cost and Profit
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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.
Cost and Profit
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ACCOUNTING AND ECONOMIC PROFIT
 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.
Cost and Profit
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ACCOUNTING AND ECONOMIC PROFIT
 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.
Cost and Profit
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ACCOUNTING AND ECONOMIC PROFIT
 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
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ACCOUNTING AND ECONOMIC PROFIT
 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
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ACCOUNTING AND ECONOMIC PROFIT
 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
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ACCOUNTING AND ECONOMIC PROFIT
 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.
Cost and Profit
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ACCOUNTING AND ECONOMIC PROFIT
 Normal Profit
Normal accounting profit equals zero economic profit
When accounting profit=normal profiteconomic 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 profiteconomic profit<0: Owners
and investors are not compensated for all their costs. In the long run,
resources exit the market.
Accounting profit>normal profiteconomic 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
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Total revenue=$15,000
Total expenses (wages, salaries, interest, rent, etc.)=$10,000
Expected income from best alternative investment=$2,500
How much is
a.
accounting profit or loss?
b.
normal profit?
c.
economic profit or loss?
In the long run, there is an incentive for resources to
a.
enter the market
b.
exit the market
c.
neither enter nor exit
Cost and Profit
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Total revenue=$15,000
Total expenses (wages, salaries, interest, rent, etc.)=$10,000
Expected income from best alternative investment=$2,500
Accounting profit or loss=$5,000
Normal profit=$2,500
Economic profit or loss=$2,500
In the long run, there is an incentive for resources to enter the market.
Cost and Profit
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Total revenue=$15,000
Total expenses (wages, salaries, interest, rent, etc.)=$10,000
Expected income from best alternative investment=$5,000
How much is
a.
accounting profit or loss?
b.
normal profit?
c.
economic profit or loss?
In the long run, there is an incentive for resources to
a.
enter the market
b.
exit the market
c.
neither enter nor exit
Cost and Profit
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Total revenue=$15,000
Total expenses (wages, salaries, interest, rent, etc.)=$10,000
Expected income from best alternative investment=$5,000
Accounting profit or loss=$5,000
Normal profit=$5,000
Economic profit or loss=$0
In the long run, there is an incentive for resources to neither enter nor exit
the market.
Cost and Profit
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Total revenue=$15,000
Total expenses (wages, salaries, interest, rent, etc.)=$10,000
Expected income from best alternative investment=$7,500
How much is
a.
accounting profit or loss?
b.
normal profit?
c.
economic profit or loss?
In the long run, there is an incentive for resources to
a.
enter the market
b.
exit the market
c.
neither enter nor exit
Cost and Profit
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Total revenue=$15,000
Total expenses (wages, salaries, interest, rent, etc.)=$10,000
Expected income from best alternative investment=$7,500
Accounting profit or loss=$5,000
Normal profit=$7,500
Economic profit or loss= -$2,500
In the long run, there is an incentive for resources to exit the market.
Cost and Profit
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Incentive Effects of Profits
Cost and Profit
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INCENTIVE EFFECTS OF PROFITS
 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.
Cost and Profit
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INCENTIVE EFFECTS OF PROFITS
 Economic Functions of Profits (and Losses)
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
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INCENTIVE EFFECTS OF PROFITS
 Economic Functions of Profits (and Losses)
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.
Cost and Profit
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INCENTIVE EFFECTS OF PROFITS
 Economic Functions of Profits (and Losses)
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
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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.
Cost and Profit
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INCENTIVE EFFECTS OF PROFITS
 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.
Cost and Profit
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INCENTIVE EFFECTS OF PROFITS
 Example: Pharmaceutical Research
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.
Cost and Profit
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INCENTIVE EFFECTS OF PROFITS
 Example: Pharmaceutical Research
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.
Cost and Profit
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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.
Cost and Profit
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INCENTIVE EFFECTS OF PROFITS
 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.
Cost and Profit
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INCENTIVE EFFECTS OF PROFITS
 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 Profit
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