Lesson 8 (Theory of Cost and Profit)

Total Revenue

• The amount that the firm receives to sell its product.

Total Cost

• The amount that the firm pays to buy inputs.

Firm’s Profit

• is often referred to as producer surplus.

• It is the amount a seller is paid minus costs,

• Profit= Total revenue - Total Cost

Firm’s Costs of Production

• it include all the opportunity costs of making its output of goods and services.

Explicit Costs

• Involve a direct money outlay for factors of production.

Implicit Costs

• Do not involve a direct money outlay.

Economists 

• include all opportunity costs when measuring costs.

Accountants

• measure the explicit costs but often ignore the implicit costs.

Economic Profit

• It is smaller than the accounting profit.

Firm’s Costs

• reflect its production process.

• it depend on the time horizon being considered.

Production Function and Total Costs

• The relationship between the quantity a firm can produce and its costs determines its pricing decisions.

• The total cost curve shows this relationship graphically.

Cost of Production

• may be divided into fixed costs and variable costs.

Fixed Costs

• are those costs that do not vary with the quantity of output produced.

Variable Costs

• are those costs that do vary with the quantity of output produced.

Average Costs

• can be determine by dividing the firm’s costs by the quantity of output produced.

• it is the typical cost of each unit of product.

Marginal Cost (MC)

• measures the increase in total cost that arises from an extra unit of production.

• it generally rises with the quantity of output; average total cost first falls as output increases and then eventually rises with further output.

Low levels of output

• an increase in production will occur at a relatively small cost. 

Increasing output

• is more costly when the amount being produced is already high.

Very low levels of output

• average total cost is high because fixed cost is spread over only a few units.

Average total cost

• declines as output increases.

• starts rising because average variable cost rises substantially.

• is total cost divided by the quantity of output.

Short run

• some costs are fixed.

Long run

• fixed costs become variable costs.

Economies of Scale

• occur when long-run average total cost falls as the quantity of output increases.

Diseconomies of Scale

• occur when long-run average total cost rises as the quantity of output increases.