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Revenue, Costs, and Profit
Marginal Analysis of Revenue and Costs
Economic Profit
Profit = Total Revenue - Total Costs
= TR - TC
Total Revenue = Price x Quantity Sold
TR = P x Q
Total Costs = Opportunity costs of all factors of production: land, capital, labor and
other inputs supplied by the firms owner(s)

Economic Profit versus Business Profit

Economic Costs =Explicit costs + Implicit Costs
Economic Profit = T. Revenue -T. Economic Costs
=TR- Explicit Costs-Implicit Costs
Business Profit = T. Revenue -Explicit Costs
=>We expect: Bus. Profit > Economic Profit

Total Revenue and Demand Curve

Consider the following two cases:

Note that in the diagram on the left with a horizontal demand curve the revenue
increases at a constant rate (price) as the output increases. In the case of a downwardsloping demand curve, however, as the quantity increases, total revenue increases first
reaches a maximum and then starts falling.

Profit
Recall that we defined a firms short-run total costs as:
Total Cost = TFC + TVC
Now we can define economic profit:
Profit = Total Revenue - Total Cost
Profit =
TR - TC

Total Revenue and Total Costs

The Case of a Horizontal Demand Curve

Demand Curve

The Case of a Downward-Sloping

The vertical (linear) spread between the TC curve and the TR curve measures the
profit.

Profit Determination: A Marginal Approach

As a firm increases its output, both its revenue and costs increase. That will result in
changes in its profit.
Change in Profit = Change in Revenue + Change in Costs
If the firm changes its output one unit at a time,
Change in Profit = Marginal Revenue - Marginal Cost
Marginal Revenue(MR): Change in total revenue resulting from producing one
additional unit of output.
Marginal Cost(MC): Change in total cost resulting from producing one additional unit

of output
Profit: A Marginal Approach
If change in total revenue > change in total cost,
MR
>
MC
==> Change in profit will be positive
==> Profit will increase
==> The firm will stop increasing output when
MR =
MC
Marginal Revenue and Marginal cost

Note that on the left side of the crossing between marginal revenue and marginal cost
MR>MC.
That means increases in the output will increase the profit. On the right side of the
crossing between MR and MC, MR<MC; increases in the output will result in
reductions in the profit.

Revenue, Costs, and Profit

Profit = TR - TC
Profit= Q(P-ATC)
In the table below, assuming a horizontal demand curve (fixed price), a firm's profits
have been calculated for different levels of output.

Revenue, Costs, and Profit: The Case of a Downward-Sloping Demand Curve

The case of downward-sloping demand curve:

Marginal Revenue, ATC, AVC, MC

The case of downward-sloping demand curve:

Marginal Revenue, ATC, AVC, MC

The Firm Under Perfect Competition

Perfect Competition
Many firms and many buyers
A homogenous product
Free entry and exit
Perfect information
=>The demand curve facing the firm under perfect
competition is horizontal: perfectly elastic.
=>A perfectly competitive firm is a price taker.
Profit Maximization Under Perfect Competition
Profit Maximization in the Short Run
MC = P = MR (=AR)

TR P . Q
Recall: AR = ------- = --------- = P
Q
Q
Under perfect competition a firm is a price taker:
To maximize its profit in the short run a perfectly competitive firm (facing a given
market price) sets its short-run marginal cost equal to the price.
Revenue, Costs, and Profit
Short-Run Equilibrium

The Shutdown Price

Marginal Cost and the Supply Curve

A firm's short-run supply curve: The segment of the marginal cost above AVC.
The Industrys Supply Curve

Profit under Competitive Conditions

The Long-Run Behavior of a Firm Under Competition

Long-Run Equilibrium under Competition

http://catalog.flatworldknowledge.com/bookhub/reader/5572?e=stengel_1.0ch02_s03#stengel_1.0-ch02_s01

2.1 Revenue, Cost, and Profit

Most businesses sell somethingeither a physical commodity like an ice cream bar or a service like a car repair.
In a modern economy, that sale is made in return for money or at least is evaluated in monetary terms. The
total monetary value of the goods or services sold is calledrevenue.

Few businesses are able to sell something without incurring expenses to make the sale possible. The collective
expenses incurred to generate revenue over a period of time, expressed in terms of monetary value, are
the cost. Some cost elements are related to the volume of sales; that is, as sales go up, the expenses go up.
These costs are called variable costs. The cost of raw materials used to make an item of clothing would be an
example of a variable cost. Other costs are largely invariant to the volume of sales, at least within a certain
range of sales volumes. These costs are called fixed costs. The cost of a machine for cutting cloth to make an
item of clothing would be a fixed cost.

Businesses are viable on a sustained basis only when the revenue generated by the business generally exceeds
the cost incurred in operating the business. The difference between the revenue and cost (found by subtracting
the cost from the revenue) is called the profit. When costs exceed revenue, there is a negative profit, or loss.

The students in our simple venture realize they need to determine whether they can make a profit from a
summer ice cream bar business. They met the person who operated an ice cream bar business in this building
the previous summer. He told them last summer he charged $1.50 per ice cream bar and sold 36,000 ice cream
bars. He said the cost of the ice cream barswholesale purchase, delivery, storage, and so oncomes to about
$0.30 per bar. He indicated his other main costsleasing the building, license, local business association fee,
and insurancecame to about $16,000.

Based on this limited information, the students could determine a rough estimate of the revenue, costs, and
profit they would have if they were to repeat the outcomes for the prior operator. The revenue would be $1.50
per ice cream bar times 36,000 ice cream bars, or $54,000. The variable cost would be $0.30 per ice cream bar

times 36,000 ice cream bars, or $10,800. The fixed cost would be $16,000, making the total cost $26,800. The
profit would be $54,000 minus $26,800, or $27,200.

Based on this analysis, the students are confident the summer business venture can make money. They
approach the owner of the building and learn that if they want to reserve the right of first option to lease the
building over the summer, they will need to make a nonrefundable $6000 deposit that will be applied to the
lease. They proceeded to make that deposit.

A few weeks later, all three students were unexpectedly offered summer business internships at a large
corporation. Each student would earn $10,000. However, the work site for the internships is far from the beach
and they would be in an office all day. They now must decide whether to accept the internships and terminate
their plan to run a business at the beach or turn down the internships.

2.2 Economic Versus Accounting Measures of Cost and

Profit
The discipline of accounting provides guidelines for the measurement of revenue, cost, and profit. Having
analyses based on generally accepted principles is important for making exchanges in our economy. For
example, corporations must produce financial statements to help investors and creditors assess the health of
the corporation. Individuals and businesses must produce tax returns to determine a fair measurement of
income for taxation purposes.

Costs as measured according to accounting principles are not necessarily the relevant measurements for
decisions related to operating or acquiring a business. For example, accounting standards dictate that
businesses depreciate long-lived assets, like buildings, by spreading the cost over the life of the
asset.

[1]

However, from the perspective of the business, the entire expense was incurred when the asset was

acquired, even if borrowing was necessary to make the purchase and there will be the opportunity to take
increased tax deductions in future years.

Likewise, there are other business costs relevant to decision making that may not be considered as costs from
the perspective of accounting standards. For example, the owner/operator of a proprietorship invests time and

effort in operating a business. These would typically not be treated as expenses on the proprietorships tax
return but are certainly relevant to the owner in deciding how to manage his self-run business.

Based on these differences in perspective, it is useful to distinguish accounting costs from economic costs.
In turn, since profit is the residue of revenue minus costs, we also
distinguish accounting profit from economic profit.

Consider our three students who are now in a quandary about whether to sell ice cream bars on the beach or
accept the summer internships, and let us see how distinguishing the economic cost/profit from the accounting
cost/profit helps to clarify their decision.

There is the matter of the students time and energy, which is not reflected in the projection of the $27,200
profit based on last years operation. One way to measure that cost is based on how much they will forfeit by not
using their time in the next best alternative, which in this case is the summer internship. We can consider this
forfeited income as being equivalent to a charge against the operation of the ice cream business, a measurement
commonly referred to as an opportunity cost. The students time has an opportunity cost of $30,000. This
should be added to the earlier fixed cost of $16,000, making an economic fixed cost of $46,000, a total
economic cost of $56,800, and an economic loss of $2800. So maybe the ice cream business would not be a
good idea after all.

However, recall that the students have already made a $6000 nonrefundable deposit. This money is spent
whether the students proceed to run the summer business or not. It is an example of what is called
a sunk cost. Assuming the fixed cost of the business was the same as for the prior operator, the students would
have a $16,000 accounting fixed cost to report on a tax return. Yet, from the perspective of economic costs, only
$10,000 is really still avoidable by not operating the business. The remaining $6000 is gone regardless of what
the students decide. So, from an economic cost/profit perspective, viewed after the nonrefundable deposit but
before the students declined the summer internships, if the students other costs and revenue were identical to
the previous year, they would have economic costs of just $50,800 and an economic profit of $3200.

If a business properly measures costs from an economic perspective, ignoring sunk costs and including
opportunity costs, you can conclude that a venture is worth pursuing if it results in an economic profit

of zero or better. However, this is generally not a valid principle if you measure performance in terms of
accounting profit. Most stockholders in a corporation would not be satisfied if the corporation only managed a
zero accounting profit because this means there is no residual from the business to reward them with either
dividends or increased stock value. From an economic cost perspective, stockholder capital is an asset that can
be redeployed, and thus it has an opportunity costnamely, what the investor could earn elsewhere with their
share of the corporation in a different investment of equivalent risk.

[2]

This opportunity cost could be estimated

and included in the economic cost. If the resulting profit is zero or positive after netting out the opportunity
cost of capital, the investors participation is worthwhile.

2.3 Revenue, Cost, and Profit Functions

In the preceding projections for the proposed ice cream bar venture, the assumption was that 36,000
ice cream bars would be sold based on the volume in the prior summer. However, the actual volume
for a future venture might be higher or lower. And with an economic profit so close to zero, our
students should consider the impact of any such differences.
There is a relationship between the volume or quantity created and sold and the resulting impact on
revenue, cost, and profit. These relationships are called the revenue function, cost function, and
profit function. These relationships can be expressed in terms of tables, graphs, or algebraic
equations.
In a case where a business sells one kind of product or service, revenue is the product of the price per
unit times the number of units sold. If we assume ice cream bars will be sold for $1.50 apiece, the
equation for the revenue function will be
R = $1.5 Q,
where R is the revenue and Q is the number of units sold.
The cost function for the ice cream bar venture has two components: the fixed cost component of
$40,000 that remains the same regardless of the volume of units and the variable cost component of
$0.30 times the number of items. The equation for the cost function is

C = $40,000 + $0.3 Q,
where C is the total cost. Note we are measuring economic cost, not accounting cost.
Since profit is the difference between revenue and cost, the profit functions will be
= R C = $1.2 Q $40,000.
Here is used as the symbol for profit. (The letter P is reserved for use later as a symbol for price.)
Table 2.1 "Revenue, Cost, and Profit for Selected Sales Volumes for Ice Cream Bar
Venture" provides actual values for revenue, cost, and profit for selected values of the volume
quantity Q. Figure 2.1 "Graphs of Revenue, Cost, and Profit Functions for Ice Cream Bar
Business at Price of $1.50", provides graphs of the revenue, cost, and profit functions.
The average cost is another interesting measure to track. This is calculated by dividing the total
cost by the quantity. The relationship between average cost and quantity is the average cost
function. For the ice cream bar venture, the equation for this function would be
AC = C/Q = ($40,000 + $0.3 Q)/Q = $0.3 + $40,000/Q.
Figure 2.2 "Graph of Average Cost Function for Ice Cream Bar Venture" shows a graph of
the average cost function. Note that the average cost function starts out very high but drops quickly
and levels off.
Table 2.1 Revenue, Cost, and Profit for Selected Sales Volumes for Ice Cream Bar Venture

Units

Revenue

Cost

Profit

$0

$40,000

$40,000

10,000

$15,000

$43,000

$28,000

20,000

$30,000

$46,000

$16,000

30,000

$45,000

$49,000

$4,000

Units

Revenue

Cost

Profit

40,000

$60,000

$52,000

$8,000

50,000

$75,000

$55,000

$20,000

60,000

$90,000

$58,000

$32,000

Figure 2.1 Graphs of Revenue, Cost, and Profit Functions for Ice Cream Bar Business
at Price of $1.50

Essentially the average cost function is the variable cost per unit of $0.30 plus a portion of the fixed
cost allocated across all units. For low volumes, there are few units to spread the fixed cost, so the
average cost is very high. However, as the volume gets large, the fixed cost impact on average cost
becomes small and is dominated by the variable cost component.

Figure 2.2 Graph of Average Cost Function for Ice Cream Bar Venture

2.4 Breakeven Analysis

A scan of Figure 2.1 "Graphs of Revenue, Cost, and Profit Functions for Ice Cream Bar
Business at Price of $1.50" shows that the ice cream bar venture could result in an economic
profit or loss depending on the volume of business. As the sales volume increases, revenue and cost
increase and profit becomes progressively less negative, turns positive, and then becomes
increasingly positive. There is a zone of lower volume levels where economic costs exceed revenues
and a zone on the higher volume levels where revenues exceed economic costs.
One important consideration for our three students is whether they are confident that the sales
volume will be high enough to fall in the range of positive economic profits. The volume level that
separates the range with economic loss from the range with economic profit is called
thebreakeven point. From the graph we can see the breakeven point is slightly less than 35,000
units. If the students can sell above that level, which the prior operator did, it will be worthwhile to

proceed with the venture. If they are doubtful of reaching that level, they should abandon the venture
now, even if that means losing their nonrefundable deposit.
There are a number of ways to determine a precise value for the breakeven level algebraically. One is
to solve for the value of Q that makes the economic profit function equal to zero:
0 = $1.2 Q $40,000 or Q = $40,000/$1.2 = 33,334 units.
An equivalent approach is to find the value of Q where the revenue function and cost function have
identical values.
Another way to assess the breakeven point is to find how large the volume must be before the
average cost drops to the price level. In this case, we need to find the value of Q where AC is equal to
$1.50. This occurs at the breakeven level calculated earlier.
A fourth approach to solving for the breakeven level is to consider how profit changes as the volume
level increases. Each additional item sold incurs a variable cost per unit of $0.30 and is sold for a
price of $1.50. The difference, called the unit contribution margin, would be $1.20. For each
additional unit of volume, the profit increases by $1.20. In order to make an overall economic profit,
the business would need to accrue a sufficient number of unit contribution margins to cover the
economic fixed cost of $40,000. So the breakeven level would be
Q = fixed cost/(price per unit variable cost per unit) = $40,000/($1.50 $0.30) =
33,333.3 or 33,334 units.
Once the operating volume crosses the breakeven threshold, each additional unit contribution
margin results in additional profit.
We get an interesting insight into the nature of a business by comparing the unit contribution margin
with the price. In the case of the ice cream business, the unit contribution margin is 80% of the price.
When the price and unit contribution margins are close, most of the revenue generated from
additional sales turns into profit once you get above the breakeven level. However, if you fall below
the breakeven level, the loss will grow equally dramatically as the volume level drops. Businesses like

software providers, which tend have mostly fixed costs, see a close correlation between revenue and
profit. Businesses of this type tend to be high risk and high reward.
On the other hand, businesses that have predominantly variable costs, such as a retail grocery outlet,
tend to have relatively modest changes in profit relative to changes in revenue. If business level falls
off, they can scale down their variable costs and profit will not decline so much. At the same time,
large increases in volume levels beyond the breakeven level can achieve only modest profit gains
because most of the additional revenue is offset by additional variable costs.

2.5 The Impact of Price Changes

In the preceding analyses of the ice cream venture, we assumed ice cream bars would be priced at
$1.50 per unit based on the price that was charged in the previous summer. The students can change
the price and should evaluate whether there is a better price for them to charge. However, if the price
is lowered, the breakeven level will increase and if the price is raised, the breakeven level will drop,
but then so may the customer demand.
To examine the impact of price and determine a best price, we need to estimate the relationship
between the price charged and the maximum unit quantity that could be sold. This relationship is
called a demand curve. Demand curves generally follow a pattern called thelaw of demand,
whereby increases in price result in decreases in the maximum quantity that can be sold.
We will consider a simple demand curve for the ice cream venture. We will assume that since the
operator of the business last year sold 36,000 units at a price of $1.50 that we could sell up to 36,000
units at the same price this coming summer. Next, suppose the students had asked the prior operator
how many ice cream bars he believes he would have sold at a price of $2.00 and the prior operator
responds that he probably would have sold 10,000 fewer ice cream bars. In other words, he estimates
his sales would have been 26,000 at a price of $2.00 per ice cream bar.
To develop a demand curve from the prior operators estimates, the students assume that the
relationship between price and quantity is linear, meaning that the change in quantity will be

proportional to the change in price. Graphically, you can infer this relationship by plotting the two
price-quantity pairs on a graph and connecting them with a straight line. Using intermediate algebra,
you can derive an equation for the linear demand curve
P = 3.3 0.00005 Q,
where P is price in dollars and Q is the maximum number of ice cream bars that will sell at this
price. Figure 2.3 "Linear Demand Curve for Ice Cream Bar Venture" presents a graph of the
demand curve.

Figure 2.3 Linear Demand Curve for Ice Cream Bar Venture

It may seem awkward to express the demand curve in a manner that you use the quantity Q to solve
for the price P. After all, in a fixed price market, the seller decides a price and the buyers respond
with the volume of demand. Mathematically, the relationship for ice cream bars could be written
Q = 66,000 20,000 P.

However, in economics, the common practice is to describe the demand curve as the highest price
that could be charged and still sell a quantity Q.
The linear demand curve in Figure 2.3 "Linear Demand Curve for Ice Cream Bar
Venture" probably stretches credibility as you move to points where either the price is zero or
demand is zero. In actuality, demand curves are usually curved such that demand will get very high
as the price approaches zero and small amounts would still sell at very high prices, similar to the
pattern in Figure 2.4 "Common Pattern for Demand Curves". However, linear demand curves
can be reasonably good estimates of behavior if they are used within limited zone of possible prices.

Figure 2.4 Common Pattern for Demand Curves

We can use the stated relationship in the demand curve to examine the impact of price changes on
the revenue and profit functions. (The cost function is unaffected by the demand curve.) Again, with
a single type of product or service, revenue is equal to price times quantity. By using the expression
for price in terms of quantity rather than a fixed price, we can find the resulting revenue function
R = P Q = (3.3 0.00005 Q) Q = 3.3 Q 0.00005 Q 2.

By subtracting the expression for the cost function from the revenue function, we get the revised
profit function
= (3.3 Q 0.00005 Q2) (40,000 + $0.3 Q) = 0.00005 Q2 + 3 Q 40,000.
Graphs for the revised revenue, cost, and profit functions appear in Figure 2.5 "Graphs of
Revenue, Cost, and Profit Functions for Ice Cream Bar Venture for Linear Demand
Curve". Note that the revenue and profit functions are curved since they are quadratic functions.
From the graph of the profit function, it can be seen that it is possible to earn an economic profit
with a quantity as low as 20,000 units; however, the price would need to be increased according to
the demand curve for this profit to materialize. Additionally, it appears a higher profit is possible
than at the previously planned operation of 36,000 units at a price of $1.50. The highest profitability
appears to be at a volume of about 30,000 units. The presumed price at this volume based on the
demand curve would be around $1.80.

Figure 2.5 Graphs of Revenue, Cost, and Profit Functions for Ice Cream Bar Venture
for Linear Demand Curve

2.6 Marginal Analysis

Economists analyze relationships like revenue functions from the perspective of how the function
changes in response to a small change in the quantity. These marginal measurements not only
provide a numerical value to the responsiveness of the function to changes in the quantity but also
can indicate whether the business would benefit from increasing or decreasing the planned
production volume and in some cases can even help determine the optimal level of planned
production.
The marginal revenue measures the change in revenue in response to a unit increase in production
level or quantity. The marginal costmeasures the change in cost corresponding to a unit increase in
the production level. The marginal profit measures the change in profit resulting from a unit
increase in the quantity. Marginal measures for economic functions are related to the operating
volume and may change if assessed at a different operating volume level.
There are multiple computational techniques for actually calculating these marginal measures. If the
relationships have been expressed in the form of algebraic equations, one approach is to evaluate the
function at the quantity level of interest, evaluate the function if the quantity level is increased by
one, and determine the change from the first value to the second.
Suppose we want to evaluate the marginal revenue for the revenue function derived in the previous
section at last summers operating level of 36,000 ice cream bars. For a value of Q = 36,000, the
revenue function returns a value of $54,000. For a value of Q = 36,001, the revenue function returns
a value of $53,999.70. So, with this approach, the marginal revenue would be $53,999.70 $54,000,
or $0.30. What does this tell us? First, it tells us that for a modest increase in production volume, if
we adjust the price downward to compensate for the increase in quantity, the net change in revenue
is a decrease of $0.30 for each additional unit of planned production.
Marginal measures often can be used to assess the change if quantity is decreased by changing sign
on the marginal measure. Thus, if the marginal revenue is $0.30 at Q = 36,000, we can estimate

that for modest decreases in planned quantity level (and adjustment of the price upward based on
the demand function), revenue will rise $0.30 per unit of decrease in Q.
At first glance, the fact that a higher production volume can result in lower revenue seems
counterintuitive, if not flawed. After all, if you sell more and are still getting a positive price, how can
more volume result in less revenue? What is happening in this illustrated instance is that the price
drop, as a percentage of the price, exceeds the increase in quantity as a percentage of quantity. A
glance back at Figure 2.5 "Graphs of Revenue, Cost, and Profit Functions for Ice Cream Bar
Venture for Linear Demand Curve" confirms that Q = 36,000 is in the portion of the revenue
function where the revenue function declines as quantity gets larger.
If you follow the same computational approach to calculate the marginal cost and marginal profit
when Q = 36,000, you would find that the marginal cost is $0.30 and the marginal profit is $0.60.
Note that marginal profit is equal to marginal revenue minus marginal cost, which will always be the
case.
The marginal cost of $0.30 is the same as the variable cost of acquiring and stocking an ice cream
bar. This is not just a coincidence. If you have a cost function that takes the form of a linear equation,
marginal cost will always equal the variable cost per unit.
The fact that marginal profit is negative at Q = 36,000 indicates we can expect to find a more
profitable value by decreasing the quantity and increasing the price, but not by increasing the
quantity and decreasing the price. The marginal profit value does not provide enough information to
tell us how much to lower the planned quantity, but like a compass, it points us in the right direction.
Since marginal measures are the rate of change in the function value corresponding to a modest
change in Q, differential calculus provides another computational technique for deriving marginal
measures. Differential calculus finds instantaneous rates of change, so the values computed are
based on infinitesimal changes in Q rather than whole units of Q and thus can yield slightly different
values. However, a great strength of using differential calculus is that whenever you have an

economic function in the form of an algebraic equation, you can use differential calculus to derive an
entire function that can be used to calculate the marginal value at any value of Q.
How to apply differential calculus is beyond the scope of this text; however, here are the functions
that can be derived from the revenue, cost, and profit functions of the previous section (i.e., those
that assume a variable price related to quantity):
marginal revenue at a volume Q = $3.3 $0.0001 Q,marginal cost at a volume Q = $
0.3,marginal profit at a volume Q = $3 $0.0001 Q.
Substituting Q = 36,000 into these equations will produce the same values we found earlier.
However, these marginal functions are capable of more.
Since the marginal change in the function is the rate of change in the function at a particular point,
you can visualize this by looking at the graphs of the functions and drawing a tangent line on the
graph at the quantity level of interest. A tangent line is a straight line that goes through the point on
the graph, but does not cross the graph as it goes through the point. The slope of the tangent line is
the marginal value of the function at that point. When the slope is upward (the tangent line rises as it
goes to the right), the marginal measure will be positive. When the slope is downward, the marginal
measure will be negative. If the line has a steep slope, the magnitude of the marginal measure will be
large. When the line is fairly flat, the magnitude will be small.
Suppose we want to find where the profit function is at its highest value. If you look at that point (in
the vicinity of Q = 30,000) on Figure 2.5 "Graphs of Revenue, Cost, and Profit Functions for
Ice Cream Bar Venture for Linear Demand Curve", you see it is like being on the top of a hill. If
you draw the tangent line, it will not be sloped upward or downward; it will be a flat line with a zero
slope. This means the marginal profit at the quantity with the highest profit has a value of zero. So if
you set the marginal profit function equal to zero and solve for Q you find
0 = $3.00 $0.0001 Q implies Q = $3.00/$0.0001 = 30,000.
This confirms our visual location of the optimum level and provides a precise value.

This example illustrates a general economic principle: Unless there is a constraint preventing a
change to a more profitable production level, the most profitable production level will be at a
level where marginal profit equals zero. Equivalently, in the absence of production level constraints,
the most profitable production level is where marginal revenue is equal to marginal cost. If marginal
revenue is greater than marginal cost at some production level and the level can be increased, profit
will increase by doing so. If marginal cost is greater than marginal revenue and the production level
can be decreased, again the profit can be increased.

2.7 The Conclusion for Our Students

Our students will look at this analysis and decide not only to go forward with the ice cream business
on the beach but to charge $1.80, since that is the price on the demand curve corresponding to a
sales volume of 30,000 ice cream bars. Their expected revenue will be $54,000, which coincidently
is the same as in the original plan, but the economic costs will be only $49,000, which is lower than
in the original analysis, and their economic profit will be slightly higher, at $5000.
At first glance, a $5000 profit does not seem like much. However, bear in mind that we already
assigned an opportunity cost to the students time based on the income foregone by not accepting the
corporate internships. So the students can expect to complete the summer with $10,000 each to
compensate for the lost internship income and still have an additional $5000 to split between them.

2.8 The Shutdown Rule

You may recall earlier in this chapter that, before deciding to disregard the $6000 nonrefundable
down payment (to hold the option to operate the ice cream business) as a relevant economic cost, the
total cost of operating the business under a plan to sell 36,000 ice cream bars at a price of $1.50 per
item would have exceeded the expected revenue. Even after further analysis indicated that the
students could improve profit by planning to sell 30,000 ice cream bars at a price of $1.80 each, if
the $6000 deposit had not been a sunk cost, there would have been no planned production level and
associated price on the demand curve that would have resulted in positive economic profit. So the
students would have determined the ice cream venture to be not quite viable if they had known prior

to making the deposit that they could instead each have a summer corporate internship. However,
having committed the $6000 deposit already, they will gain going forward by proceeding to run the
ice cream bar business.
A similar situation can occur in ongoing business concerns. A struggling business may appear to
generate insufficient revenue to cover costs yet continue to operate, at least for a while. Such a
practice may be rational when a sizeable portion of the fixed costs in the near term are effectively
sunk, and the revenue generated is enough to offset the remaining fixed costs and variable costs that
are still not firmly committed.
Earlier in the chapter, we cited one condition for reaching a breakeven production level where
revenue would equal or exceed costs as the point where average cost per unit is equal to the price.
However, if some of the costs are already sunk, these should be disregarded in determining the
relevant average cost. In a circumstance where a business regards all fixed costs as effectively sunk
for the next production period, this condition becomes a statement of a principle known as
the shutdown rule: If the selling price per unit is at least as large as the average variable cost per
unit, the firm should continue to operate for at least a while; otherwise, the firm would be better to
shut down operations immediately.
Two observations about the shutdown rule are in order: In a circumstance where a firms revenue is
sufficient to meet variable costs but not total costs (including the sunk costs), although the firm may
operate for a period of time because the additional revenue generated will cover the additional costs,
eventually the fixed costs will need to be refreshed and those will be relevant economic costs prior to
commitment to continue operating beyond the near term. If a business does not see circumstances
changing whereby revenue will be getting better or costs will be going down, although it may be a net
gain to operate for some additional time, such a firm should eventually decide to close down its
business.
Sometimes, it is appropriate to shut down a business for a period of time, but not to close the
business permanently. This may happen if temporary unfavorable circumstances mean even

uncommitted costs cannot be covered by revenue in the near term, but the business expects
favorable conditions to resume later. An example of this would be the owner of an oil drilling
operation. If crude oil prices drop very low, the operator may be unable to cover variable costs and it
would be best to shut down until petroleum prices climb back and operations will be profitable again.
In other cases, the opportunity cost of resources may be temporarily high, so the economic profit is
negative even if the accounting profit would be positive. An example would be a farmer selling his
water rights for the upcoming season because he is offered more for the water rights than he could
net using the water and farming.

2.9 A Final Word on Business Objectives

In the example used in this chapter, we assumed the students goal in how to operate the ice cream
business was to maximize their profitmore specifically, to maximize their economic profit. Is this
an appropriate overall objective for most businesses?
Generally speaking, the answer is yes. If a business is not able to generate enough revenue to at least
cover their economic costs, the business is losing in the net. In addition to the business owners
having to cover the loss out of their wealth (or out of societys largesse for a bankruptcy), there is an
inefficiency from a societal perspective in that the resources used by the business could be more
productive elsewhere.
The ice cream business analyzed here was simple in many respects, including that it was intended to
operate for only a short period of time. Most businesses are intended to operate for long periods of
time. Some businesses, especially newly formed businesses, will intentionally operate businesses at a
loss or operate at volumes higher than would generate the maximum profit in the next production
period. This decision is rational if the business expects to realize larger profits in future periods in
exchange for enduring a loss in the near future. There are quantitative techniques, such as
discounting,

[1]

that allow a business decision maker to make these trade-offs between profit now and

profit later. These techniques will not be covered in this text.

Economists refer to a measure called the value of the firm, which is the collective value of all
economic profits into the future and approximately the amount the owners should expect to receive
if they sold the business to a different set of owners. For a corporation, in theory this would roughly
equate to the value of the equity on a companys balance sheet, although due to several factors like
sunk costs, is probably not really that value. Economists would say that a business should make
decisions that maximize the value of the firm, meaning the best decisions will result in larger
economic profits either now or later.
One response to the principle that the overall goal of a firm is to maximize its value is that, although
that goal may be best for those who own the business, it is not the optimal objective for the overall
society in which the business operates. One specific objection is that those who work for the business
may not be the same as those who own the business and maximizing the value for the owners can
mean exploiting the nonowner employees. The common response to this objection is that it will be in
the owners best interest in the long run (several periods of operation) to treat their employees fairly.
Businesses that exploit their employees will lose their good employees and fail to motivate those
employees who remain. The collective result will be lower profits and a lower value of the firm.
A second objection to the appropriateness of operating a business to maximize the value for the
owners is that this invites businesses to exploit their customers, suppliers, and the society in which
they operate to make more money. Firms may be able to take advantage of outside parties for a
while, but eventually the customers and suppliers will wise up and stop interacting with the business.
With a high level of distrust, there will be a decline in profits in future periods that will more than
offset any immediate gain. If a business tries to exploit the overall society by ruining the environment
or causing an increase in costs to the public, the business can expect governmental authorities to take
actions to punish the firm or limit its operations, again resulting in a net loss over time. So
maximizing the value of the firm for the owners does not imply more profit for the owners at the
expense of everyone else. Rather, a rational pursuit of maximal value will respect the other
stakeholders of a business.

In the case of nonprofit organizations, maximizing the value of the organization will be different than
with for-profit businesses like our ice cream example. A nonprofit organization may be given a
budget that sets an upper limit on its costs and is expected to provide the most value to the people it
serves. Since most nonprofit organizations do not charge their customers in the same way as forprofit businesses, the determination of value will be different than estimating sales revenue.
Techniques such as cost-benefit analysis

[2]

have been developed for this purpose.

https://www.boundless.com/economics/textbooks/boundless-economics-textbook/production9/production-cost-64/short-run-and-long-run-costs-242-12340/
In economics, "short run" and "long run" are not broadly defined as a rest of time. Rather, they are unique
to each firm.
Long Run Costs
Long run costs are accumulated when firms change production levels over time in response to
expected economic profits or losses. In the long run there are no fixed factors of production. The
land, labor, capital goods, and entrepreneurship all vary to reach the the long run cost of producing a
good or service. The long run is a planning and implementation stage for producers. They analyze the
current and projected state of the market in order to make production decisions. Efficient long run costs
are sustained when the combination of outputs that a firm produces results in the desired quantity of the
goods at the lowest possible cost. Examples of long run decisions that impact a firm's costs include
changing the quantity of production, decreasing or expanding a company, and entering or leaving a
market.
Short Run Costs
Short run costs are accumulated in real time throughout the production process. Fixed costs have no
impact of short run costs, only variable costs and revenues affect the short run production. Variable
costs change with the output. Examples of variable costs include employee wages and costs of raw
materials. The short run costs increase or decrease based on variable cost as well as the rate of
production. If a firm manages its short run costs well over time, it will be more likely to succeed in
reaching the desired long run costs and goals.
Differences
The main difference between long run and short run costs is that there are no fixed factors in the long run;
there are both fixed and variable factors in the short run . In the long run the general price level,
contractual wages, and expectations adjust fully to the state of the economy. In the short run these
variables do not always adjust due to the condensed time period. In order to be successful a firm must set
realistic long run cost expectations. How the short run costs are handled determines whether the firm will
meet its future production and financial goals.

Cost curve
This graph shows the relationship between long run and short run costs.

Source: Boundless. Short Run and Long Run Costs. Boundless Economics. Boundless, 21 Jul. 2015.
Retrieved 11 Dec. 2015 from https://www.boundless.com/economics/textbooks/boundless-economicstextbook/production-9/production-cost-64/short-run-and-long-run-costs-242-12340/

http://www.allbusiness.com/barrons_dictionary/
dictionary-imputed-cost-4943940-1.html
imputed cost
Dictionary of Accounting Terms for: imputed cost

cost that is implied but not reflected in the financial reports of the firm; also
called implicit cost. Imputed costs consist of the opportunity cost of time and capital that
the manager has invested in producing the given quantity of production and the

opportunity costs of making a particular choice among the alternatives being

considered.
Dictionary of Business Terms for: imputed cost

expense not incurred directly, but actually borne. For example, a person who owns a
home debt-free has an imputed rent expense equal to the amount of interest that could
be earned on the proceeds from the sale of the home if the home were sold.
http://pakaccountants.com/what-is-imputed-cost/
Imputed cost mostly termed as opportunity cost or implicit cost is a more technical aspect
of economic theory (economic problem).
According to economic theory due to scarce resources investor cannot fulfill all what he
wants and thus has to pick and chose among alternatives and investor will choose the
alternative that gives the maximum return. And right here in the selection lies the concept
of imputed cost.
When one alternative is preferred over the other i.e. if one option is selected then it
automatically means that all the other options are dropped. In other words to enjoy the
benefits of one alternative the benefits of other alternatives are foregone.
The benefits that are sacrificed act as a hidden cost of selecting one alternative. For
example, a business own a building that is used as a warehouse. Alternative use of the
building could have been that it is rented out and thus rental incomes. Thus imputed cost of
using building as a warehouse is rentals sacrificed.
Another example can be that entity is already producing an item called Sporty on which it
earns a profit of $5/unit.
Another order is received to produce Athlety that require same labour force that is
currently working on Sporty.
Currently there is no spare labour available and if new order is accepted then Sportys
production will stop that means the profit of $5/unit have to be sacrificed. Therefore, the
imputed cost of accepting a new order is $5/unit.

Another good example of imputed cost is inflation or time value of money where money
loses its value over a long period of time.
As these costs are not actual cash outflows therefore, such costs are not accounted for in
entitys accounting system and often no effort is made to trace such costs if management
decides to evaluate alternatives without considering imputed costs or lacks resources to
collect necessary information. However, cost and management accountants give due
importance to this concept under the name relevant cost. However, not all imputed costs
are relevant costs in a given situation.
Important application of imputed cost in economics, accounting and business studies is
calculation of economic profit to get better information for decision making purposes instead
of relying on nominal profit. Economic profit calculation considers both explicit and implicit
costs whereas nominal profit is calculated using explicit cost alone.

http://economics.fundamentalfinance.com/micro_atc_mc.php
Marginal Cost (MC) & Average Total Cost (ATC)

Total cost is variable cost and fixed cost combined.

TC=VC+FC
Now divide total cost by quantity of output to get average total cost.
ATC=TC/Q
Average total cost can be very handy for firms to compare efficiency at different output or when
adjusting different factors of production.

Marginal cost is a concept that's a bit harder for people grasp. The "margin" is the end
or the last. The marginal unit is the last unit. Think of marginal cost as the cost of the
last unit, or what it costs to produce one more unit. It's hard to find exactly what the cost
of the last unit is, but it's not hard to find the average cost of a group of a few more
units. To find this, simply take the change in costs from a previous level divided by the
change in quantity from the previous level.
MC = Change in TC / Change in Q
Take a look at the table below to see how marginal cost was computed. For example, the
marginal cost when the quantity is 56 is $2.82. This was computed by taking TC at 55.90Q
($350) minus TC at 38.16Q ($300) divided by 55.9Q minus 38.16Q (17.74Q).

Take a look at the graph. You'll notice that the ATC curve is a U-shape. This is always
the case if there are increasing marginal costs. You'll also notice that the MC curve
intersects the ATC curve at the ATC curve's minimum point. This will always be the case
if there are increasing marginal costs. A helpful way to think of this is to imagine that the
MC curve is graphing your semester GPA (grade point average) and that the ATC curve
is graphing your cumulative GPA. Perhaps you transfered to a harder school. You
previously had a high cumulative GPA but your semester GPA starts to pull it down. As
you improve your grades each semester your cumulative and semester GPA will meet.
After that, if you continue to improve, your semester GPA will pull up your cumulative
GPA again.
In other words, the marginal cost is factored into the average total cost at every unit.
Because of fixed cost, marginal cost almost always begins below average total cost. As
quantity increases, ATC will decrease and MC will increase. Eventually they intersect,
then MC continues to increase and pulls ATC up after it.
A firm's marginal cost curve also acts as its supply curve. Read The Supply Curve article to get
a more detailed explaination of why this is so.

http://www.amosweb.com/cgi-bin/awb_nav.pl?s=wpd&c=dsp&k=average%20cost

AVERAGE COST:
The opportunity cost incurred per unit of good produced. This is calculated by dividing the
cost of production by the quantity of output produced. While average cost is a general term
relating cost and the quantity of output, three specific average cost terms are average total
cost, average variable cost, and average fixed cost. A related cost term is marginal cost.
Average cost is a general notion of the per unit cost incurred in theproduction of a good or
service. It is specified as the total cost divided by the quantity of output. Average cost plays
a key role in the short-run production decision by a firm when evaluated against the price,
which is per unit revenue. A comparison between per unit revenue (price) and per unit cost
(average cost) indicates whether a firm is making a profit, incurring a loss, or should shut
down production operations.

A Couple of Equations
A generic formula for calculating average cost is specified as:
total cost
average cost

=
quantity of output

This equation can be turned on its head to calculate total cost from average cost:
total cost = average cost x quantity of output

Three Averages
Short-run production analysis makes use of three average cost measures--average total
cost, average fixed cost, and average variable cost. Each is derived from a corresponding
total--total cost, total fixed cost, andtotal variable cost.

Average Total Cost: This is per unit total cost, or total cost divided by the quantity of
output produced. Average total cost is also the sum of average fixed cost and
average variable cost.

Average Fixed Cost: This is per unit total fixed cost, or total fixed cost divided by the
quantity of output produced. Because fixed cost does not vary with output, average
fixed cost declines with larger quantities of production.

Average Variable Cost: This is per unit total variable cost, or total variable cost
divided by the quantity of output produced. Average variable cost is influenced by

short-run marginal returns, decreasing for small quantities, then increasing for larger
quantities.

Short-run Production Analysis

Average cost is perhaps most important for short-run production analysis, especially when
serious talk turns to the topic of profit. In terms of totals, profit is the difference
between total revenue and total cost. However, profitability can also be identified per unit of
output. In this case, a comparison between price (the revenue received for each unit sold)
and average cost is highly informative. If price exceeds average total cost, then profit is
received for each unit sold. If price is less than average total cost, then each unit is sold at a
loss.
This price-average cost comparison is just the sort of thing that can keep a firm
from bankruptcy. In fact, those firms that have some degree of control over price,
frequently set prices based on average cost. The most common techniques used are markup pricing or cost-plus pricing, which ensure that firms cover cost and receive a profit on
each unit sold.
Suppose, for example, that the average cost incurred by Waldo's TexMex Taco World in the
production of Super Deluxe TexMex Gargantuan Tacos is $3. If each Super Deluxe TexMex
Gargantuan Taco sells for $3.50, then Waldo's TexMex Taco World receives $0.50 per taco.
In all likelihood, Waldo's TexMex Taco World sets the price at $3.50 for their Super Deluxe
TexMex Gargantuan Tacos by adding a "reasonable" fifty-cent per taco profit to the three
dollar per taco cost.

Profit, Loss, or Shutdown

Per unit profitability is not the only information that can be garnered with a comparison of
price and average cost. In fact, firms face three short-run alternatives revealed by price and
average cost.

Produce at a Profit: The first alternative, the one sought after by profit-maximizing
firms, is to generate a positive profit on output produced. This is achieved if price is
equal to or greater than average total cost.

Produce at a Loss: A second alternative is to produce output in the short run, even
though profit is negative, that is, the firm incurs a loss. This is achieved if the price is
greater than average variable cost, but less than average total cost. The loss from
production is less than the fixed cost loss that would be incurred by shutting down
production.

Shutdown Production: The last alternative is to stop producing in the short run and
incur the loss of fixed cost. This is achieved if price is less than average variable cost.
The loss from production is greater than the fixed cost loss incurred by shutting
down production.

MARGINAL COST: The change in total cost (or total variable cost) resulting from a change
in the quantity of output produced by a firm in the short run. Marginal cost indicates how
much total cost changes for a give change in the quantity of output. Because changes in
total cost are matched by changes in total variable cost in the short run (remember total
fixed cost is fixed), marginal cost is the change in either total cost or total variable cost.
Marginal cost, usually abbreviated MC, is found by dividing the change in total cost (or total
variable cost) by the change in output.