1.   Total Revenue, Total Cost, and Profit

1.   The goal of a firm is to maximize profit.

2.   Definition of total revenue: the amount a firm receives for the sale of its output.

3.   Definition of total cost: the market value of the inputs a firm uses in production.

4.   Definition of profit: total revenue minus total cost.

B.   Costs as Opportunity Costs

The costs of producing an item must include all of the opportunity costs of inputs used in production.

Total opportunity costs include both implicit and explicit costs.

a.   Definition of explicit costs: input costs that require an outlay of money by the firm.

b.   Definition of implicit costs: input costs that do not require an outlay of money by the firm.

c.    The total cost of a business is the sum of explicit costs and implicit costs.

d.   This is the major way in which accountants and economists differ in analyzing the performance of a business.

e.   Accountants focus on explicit costs, while economists examine both explicit and implicit costs.

      Economic Profit versus Accounting Profit

Definition of economic profit: total revenue minus total cost, including both explicit and implicit costs.

a.   Economic profit is what motivates firms to supply goods and services.

Definition of accounting profit: total revenue minus total explicit cost.

If implicit costs are greater than zero, accounting profit will always exceed economic profit.

II.   Production and Costs

A.   The Production Function

1.   Definition of production function: the relationship between quantity of inputs used to make a good and the quantity of output of that good.

      Definition of marginal product: the increase in output that arises from an additional unit of input.

4.   We can draw a graph of the firm's production function by plotting the level of labor (x-axis) against the level of output (y-axis).  This is a simple version with only crowding and no specialization.

B.   From the Production Function to the Total-Cost Curve

1.   We can draw a graph of the firm's total cost curve by plotting the level of output (x-axis) against the total cost of producing that output (y-axis).

a.   In this example I will use the simple production function; therefore, I will have a simple cost function.  The total cost curve gets steeper and steeper as output rises.

III. The Various Measures of Cost

1.   Definition of fixed costs: costs that do not vary with the quantity of output produced.

2.   Definition of variable costs: costs that do vary with the quantity of output produced.

      Total cost is equal to fixed cost plus variable cost.

C.   Average and Marginal Cost

1.   Definition of average total cost: total cost divided by the quantity of output.

2.   Definition of average fixed cost: fixed costs divided by the quantity of output.

3.   Definition of average variable cost: variable costs divided by the quantity of output.

4.   Definition of marginal cost: the increase in total cost that arises from an extra unit of production.

5.   Average total cost tells us the cost of a typical unit of output and marginal cost tells us the cost of an additional unit of output.

D.   Cost Curves and Their Shapes

1.   Rising Marginal Cost

a.   This occurs because of diminishing marginal product.

b.   At a low level of output, there are few workers and a lot of idle equipment. But as output increases, the coffee shop gets crowded and the cost of producing another unit of output becomes high.

2.   U-Shaped Average Total Cost

a.   Average total cost is the sum of average fixed cost and average variable cost.                                           

b.   AFC declines as output expands and ATC and AVC increase as output expands. AFC is high when output levels are low. As output expands, AFC declines pulling ATC down. As fixed costs get spread over a large number of units, the effect of AFC on ATC falls and ATC begins to rise because of diminishing marginal product.

3.   The Relationship between Marginal Cost and Average Total Cost

a.   Whenever marginal cost is less than average total cost, average total cost is falling. Whenever marginal cost is greater than average total cost, average total cost is rising.

b.   The marginal-cost curve crosses the average-total-cost curve at minimum average total cost (the efficient scale).

4.   Typical Cost Curves

a.   Marginal cost eventually rises with output.

b.   The average-total-cost curve is U-shaped.

c.    Marginal cost crosses average total cost at the minimum of average total cost.

THIS SECTION IS NOT ON THE TEST--Costs in the Short Run and in the Long Run

PERFECT COMPETITION CHAPTER

I.    What Is a Competitive Market?

A.   The Meaning of Competition

1.   Definition of competitive market: a market with many buyers and sellers trading identical products so that each buyer and seller is a price taker.

2.   There are three characteristics of a competitive market (sometimes called a perfectly competitive market).

a.   There are many buyers and sellers.

b.   The goods offered by the sellers are largely the same.

c.    Firms can freely enter or exit the market.

B.   The Revenue of a Competitive Firm

1.   Total revenue from the sale of output is equal to price times quantity.

2.   Definition of marginal revenue: the change in total revenue from an additional unit sold.

II.   Profit Maximization and the Competitive Firm's Supply Curve

      The profit-maximizing quantity can be found by comparing marginal revenue and marginal cost.

a.   As long as marginal revenue exceeds marginal cost, increasing output will raise profit.

b.   If marginal revenue is less than marginal cost, the firm can increase profit by decreasing output.

c.    Profit-maximization occurs where marginal revenue is equal to marginal cost.

a.   If marginal revenue is greater than the marginal cost, the firm should increase its output.

b.   If marginal cost is greater than marginal revenue, the firm should decrease its output.

c.    At the profit-maximizing level of output, marginal revenue and marginal cost are exactly equal.

C.   The Firm's Short-Run Decision to Shut Down

1.   In certain circumstances, a firm will decide to shut down and produce zero output.

2.   There is a difference between a temporary shutdown of a firm and an exit from the market.

a.   A shutdown refers to a short-run decision not to produce anything during a specific period of time because of current market conditions.

b.   Exit refers to a long-run decision to leave the market.

c.    One important difference is that, when a firm shuts down temporarily, it still must pay fixed costs. If a firm exits the industry in the long run, it has no costs.

3.   If a firm shuts down, it will earn no revenue and will have only fixed costs (no variable costs).

4.   Therefore, a firm will shut down if the revenue that it would get from producing is less than its variable costs of production:

Shut down if TR < VC (Below the shutdown point).

5.   Because TR = P x Q and VC = AVC x Q, we can rewrite this condition as:

Shut down if P < AVC (Below the shutdown point).

6.   We now can tell exactly what the firm will do to maximize profit (or minimize loss).

a.   If the price is less than average variable cost, the firm will produce no output.

b.   If the price is above average variable cost, the firm will produce the level of output where marginal revenue (price) is equal to marginal cost.

D.   The Firm's Long-Run Decision to Exit or Enter a Market

1.   If a firm exits the market, it will earn no revenue, but it will have no costs as well.

2.   Therefore, a firm will exit if the revenue that it would earn from producing is less than its total costs:

Exit if TR < TC.

3.   Because TR = P x Q and TC = ATC x Q, we can rewrite this condition as:

Exit if P < ATC (Below Zero Profit Point).

4.   A firm will enter an industry when there is profit potential, so this must mean that a firm will enter if revenues will exceed costs:

Enter if P > ATC (Below Zero Profit Point).

5.   Because, in the long run, a firm will remain in a market only if P ≥ ATC, the firm's long-run supply curve will be its marginal cost curve above ATC.

E.   Measuring Profit in Our Graph for the Competitive Firm

1.   Recall that Profit = TR −TC.

2.   Because TR = P x Q and TC = ATC x Q, we can rewrite this equation:

Profit = (P – ATC) x Q.

3.   Using this equation, we can measure the amount of profit (or loss) at the firm's profit-maximizing level of output (or loss-minimizing level of output).

B.   The Long Run: Market Supply with Entry and Exit

1.   If firms in an industry are earning profit, this will attract new firms.

a.   The supply of the product will increase (the supply curve will shift to the right).

b.   The price of the product will fall and profit will decline.

2.   If firms in an industry are incurring losses, firms will exit.

a.   The supply of the product will decrease (the supply curve will shift to the left).

b.   The price of the product will rise and losses will decline.

3.   At the end of this process of entry or exit, firms that remain in the market must be earning zero economic profit.

4.   Because Profit = TR –TC, profit will only be zero when:

TR = TC.

5.   Because TR = P x Q and TC = ATC x Q, we can rewrite this as:

P = ATC.

6.   Therefore, the process of entry or exit ends only when price and average total cost become equal.

7.   This implies that the long-run equilibrium of a competitive market must have firms operating at their efficient scale.