Understanding Costs, Profits, and Production Analysis

Explicit Cost

Actual money spent on business expenses.

Implicit Cost

Opportunity costs; value of benefits foregone.

Accounting Profit

Total revenue - explicit costs - depreciation.

Economic Profit

Total revenue - explicit costs - implicit costs - depreciation.

Implicit Cost of Capital

Opportunity cost of using capital in the business instead of elsewhere.

Normal Profit

Economic profit = 0; enough to keep a firm engaged in current activity.

Principle of Marginal Analysis

Continue activity until marginal benefit = marginal cost.

Marginal Revenue (MR)

Change in total revenue from one additional unit.

MR Formula

MR = (Change in Total Revenue) / (Change in Quantity)

Production Function

Relationship between input quantity and output quantity.

Fixed Input

Cannot be varied in the short run.

Variable Input

Can be changed at any time.

Short Run

At least one input is fixed.

Long Run

All inputs can be varied.

Total Product Curve

Shows relationship between output quantity and variable input.

Marginal Product of Labor (MPL)

Additional output from one more unit of labor.

MPL Formula

MPL = (Change in Quantity) / (Change in Labor)

Fixed Cost (FC)

Does not depend on output quantity (e.g., rent, buildings).

Variable Cost (VC)

Depends on output quantity (e.g., wages, materials).

Total Cost (TC)

Sum of fixed and variable costs.

TC Formula

TC = FC + VC

Marginal Cost (MC)

Change in total cost from producing one more unit.

MC Formula

MC = (Change in Total Cost) / (Change in Quantity)

Average Total Cost (ATC)

Cost per unit of output.

ATC Formula

ATC = TC / Quantity

Average Fixed Cost (AFC)

Fixed cost per unit.

AFC Formula

AFC = FC / Quantity

Average Variable Cost (AVC)

Variable cost per unit.

AVC Formula

AVC = VC / Quantity

Minimum Cost Output Level

Lowest point on ATC curve (Nike swoosh shape).

MC Curve & ATC Curve

MC curve intersects ATC at its minimum point.

Average Product (AP)

Total product divided by input quantity.

AP Curve

Shows relationship between AP and input quantity.

Long Run Average Total Cost Curve (LRATC)

Shows ATC when fixed cost is minimized for each output level.

Economies of Scale

LRATC decreases as output increases (left side, downward-sloping).

Diseconomies of Scale

LRATC increases as output increases (right side, upward-sloping).

Increasing Returns to Scale

Output increases more than input proportion.

Decreasing Returns to Scale

Output increases less than input proportion.

Constant Returns to Scale

Output increases in direct proportion to input.

Sunk Cost

Already incurred and nonrecoverable; should not impact future decisions.

Profit Maximization

Find the output level where MC = MR.

When MPL > APL

APL increases.

When MPL < APL

APL decreases.

When MC < ATC

ATC decreases.

When MC > ATC

ATC increases.

Spreading Effect

AFC declines as output increases because FC is spread over more units.

MC Curve

Typically U-shaped; intersects ATC at minimum.

ATC Curve

U-shaped, above AVC and AFC.

AFC Curve

Always decreasing.

AVC Curve

U-shaped, below ATC but above AFC.

Fixed Costs

Do not change with output (e.g., rent, equipment).

Variable Costs

Change with output (e.g., labor, materials).

Effects of More Capital (Machines)

Higher total product compared to firms with less capital.

Returns to Scale

Determines efficiency of scaling production.