Chapter 7 - Theory of cost and profit.pptx

THEORY OF COST AND PROFIT

1. THEORY OF COST AND PROFIT

2. is DIFFERENT from expenses Cost is an amount that has to be paid or spent to buy or obtain something while expenses is a cost that is "paid" or "remitted", usually in exchange for something of value. Cost

3. Size of Plant Level of output Price of inputs State of technology Management & administrative efficiency Determinants of Cost

4. Explicit cost/Actual Cost  Opportunity cost / Implicit costs Sunk costs Incremental cost or differential cost Production cost ( direct cost and indirect cost) Selling cost. Outlay costs Classification of Cost

5. Cost Behavior Pattern Fixed cost Variable cost Semi-variable cost Stair step cost

6. Fixed Cost and Variable Cost Figure 7.1 Cost Behavior Pattern Quantity Cost FC (a) Fixed Cost Quantity Cost VC (b) Variable Cost

7. Semi-variable Cost and Stair step Cost Quantity Cost TC (c) Semi-variable Cost Variable cost of production Figure 7.1 Cost Behavior Pattern Quantity Cost (d) Stair-step costs

8. Cost Function TC = F (Q) Where, TC= Total Cost Q= Quantity produced F= Function

9. Different cost concept Total Fixed Costs (TFC) Total Variable Costs (TVC) Total Cost (TC) Average fixed cost (AFC) Average variable cost (AVC) Average total cost (ATC) Average total cost (ATC) Marginal (incremental) cost (MC) Formula TC= TFC + TVC AFC = TFC/Q AVC = TVC/Q ATC = TC/Q ATC = AFC + AVC MC = ΔTC/ΔQ  

10. Table 7.1 Short-run cost Units of Output TFC TVC TC AFC AVC ATC MC/unit 60 1 60 20 2 60 30 3 60 45 4 60 80 5 60 135 60 80 90 105 140 195 - 60 30 20 15 12 20 15 15 20 27 - 80 45 35 35 39 - 20 10 15 35 55 Formula TC= TFC + TVC AFC = TFC/Q AVC = TVC/Q ATC = TC/Q ATC = AFC + AVC MC = Δ TC/ Δ Q  

11. Short-run cost output relationship

12. Cost output relationship in the short-run with reference to different concept of cost

13. Table 7.1 Short-run cost Units of Output TFC TVC TC AFC AVC ATC MC/unit 60 60 - - - 1 60 20 80 60 20 80 20 2 60 30 90 30 15 45 10 3 60 45 105 20 15 35 15 4 60 80 140 15 20 35 35 5 60 135 195 12 27 39 55 AFC slopes down continuously. ATC curve is always higher than AFC and AVC curves Relationship of ATC to MC ATC will fall if its greater than MC ATC is constant if it is equals to MC ATC will rise if it is less than to MC Relationship of ATC to AFC & AVC ATC falling if AFC & AVC is falling ATC still decline if AFC > AVC ATC will increase if AVC> AFC

14. All costs are variable. Long run costs are accumulated when firms change production levels over time in response to expected economic profits or losses Long run cost

15. PROFIT MAXIMIZATION Profit = Total Revenue – Total Cost.

16. Explicit cost/Actual Cost/Total Revenue (TR) Formula: TR = Price X Quantity Total cost (TC) Formula: TC = TFC + TVC Marginal revenue (MR) Formula: MR = ΔTR/ΔQ Average Revenue (AR) Formula: AR = TR/Q Profit Function

17. Short run or long run process sales level where profits are highest. best output and price levels in order to maximize its return. Profit maximization

18. The company will usually adjust influential factors such as production costs, sale prices, and output levels as a way of reaching its profit goal. There are two main profit maximization methods used, and they are Marginal Cost-Marginal Revenue Method and Total Cost-Total Revenue Method. Profit maximization

19. Marginal Revenue and Price An increase in sales quantity (∆Q) changes revenue in two ways: Output expansion effect price reduction effect P MC Q MR Total profit Q 1 P 1 MR=MC MC>MR MR>MC Figure 7.2 Diagram of Profit Maximization

20. Two-step procedure for finding the profit-maximizing sales quantity Step 1: Quantity Rule – Identify positive sales quantities at which MR=MC – If more than one, find one with highest Step 2: Shut-Down Rule – Check whether the quantity from Step 1 yields higher profit than shutting down Profit-Maximizing Sales Quantity

21. Price takers Perfectly horizontal demand curve and not subject to the price reduction effect. Marginal revenue (MR) = Price (P) (for price takers). Use Price (P) = Marginal cost (MC) in the quantity rule to find the profit-maximizing sales quantity for a price-taking firm. Supply Decisions Quantity Price D

22. Table 7.2 The Profit-Maximizing Output for a Purely Competitive Firm: Total Revenue – Total Cost Approach (Price =   ₱ 131) (1) Quantity (Q) (2) Total Fixed Cost (TFC) (3) Total Variable Cost (TVC) (4) Total Cost (TC) (5) Total Revenue (TR) (6) Average Fixed Cost (AFC) (7) Average Variable Costs (AVC) (8) Average Total Cost (ATC) (9) Marginal Cost (MC) (10) Price = Marginal Revenue (MR) (6) Total Economic Profit (+) or Loss (-) Php 100 Php 1 100 90 2 100 170 3 100 240 4 100 300 5 100 370 6 100 450 7 100 540 8 100 650 9 100 780 10 100 930 100 190 270 340 400 470 550 640 750 880 1030 TC= TFC + TVC

23. Table 7.2 The Profit-Maximizing Output for a Purely Competitive Firm: Total Revenue – Total Cost Approach (Price =   ₱ 131) (1) Quantity (Q) (2) Total Fixed Cost (TFC) (3) Total Variable Cost (TVC) (4) Total Cost (TC) (5) Total Revenue (TR) (6) Average Fixed Cost (AFC) (7) Average Variable Costs (AVC) (8) Average Total Cost (ATC) (9) Marginal Cost (MC) (10) Price = Marginal Revenue (MR) (6) Total Economic Profit (+) or Loss (-) Php 100 Php Php 100 1 100 90 190 2 100 170 270 3 100 240 340 4 100 300 400 5 100 370 470 6 100 450 550 7 100 540 640 8 100 650 750 9 100 780 880 10 100 930 1030 Php 131 262 393 524 655 786 917 1048 1179 1310 TR= P X Q

24. Table 7.2 The Profit-Maximizing Output for a Purely Competitive Firm: Total Revenue – Total Cost Approach (Price =   ₱ 131) (1) Quantity (Q) (2) Total Fixed Cost (TFC) (3) Total Variable Cost (TVC) (4) Total Cost (TC) (5) Total Revenue (TR) (6) Average Fixed Cost (AFC) (7) Average Variable Costs (AVC) (8) Average Total Cost (ATC) (9) Marginal Cost (MC) (10) Price = Marginal Revenue (MR) (6) Total Economic Profit (+) or Loss (-) Php 100 Php Php 100 Php           1 100 90 190 131 2 100 170 270 262 3 100 240 340 393 4 100 300 400 524 5 100 370 470 655 6 100 450 550 786 7 100 540 640 917 8 100 650 750 1048 9 100 780 880 1179 10 100 930 1030 1310 Php 100 50 33.33 25 20 16.67 14.29 12.50 11.11 10 AFC= TFC/Q

25. Table 7.2 The Profit-Maximizing Output for a Purely Competitive Firm: Total Revenue – Total Cost Approach (Price =   ₱ 131) (1) Quantity (Q) (2) Total Fixed Cost (TFC) (3) Total Variable Cost (TVC) (4) Total Cost (TC) (5) Total Revenue (TR) (6) Average Fixed Cost (AFC) (7) Average Variable Costs (AVC) (8) Average Total Cost (ATC) (9) Marginal Cost (MC) (10) Price = Marginal Revenue (MR) (6) Total Economic Profit (+) or Loss (-) Php 100 Php Php 100 Php           1 100 90 190 131 Php 100 2 100 170 270 262 50.00 3 100 240 340 393 33.33 4 100 300 400 524 25.00 5 100 370 470 655 20.00 6 100 450 550 786 16.67 7 100 540 640 917 14.29 8 100 650 750 1048 12.50 9 100 780 880 1179 11.11 10 100 930 1030 1310 10.00 Php 90 85 80 75 74 75 77.14 81.5 86.67 93 AVC= TVC/Q

26. Table 7.2 The Profit-Maximizing Output for a Purely Competitive Firm: Total Revenue – Total Cost Approach (Price =   ₱ 131) (1) Quantity (Q) (2) Total Fixed Cost (TFC) (3) Total Variable Cost (TVC) (4) Total Cost (TC) (5) Total Revenue (TR) (6) Average Fixed Cost (AFC) (7) Average Variable Costs (AVC) (8) Average Total Cost (ATC) (9) Marginal Cost (MC) (10) Price = Marginal Revenue (MR) (6) Total Economic Profit (+) or Loss (-) Php 100 Php Php 100 Php           1 100 90 190 131 Php 100 Php 90.00 2 100 170 270 262 50.00 85.00 3 100 240 340 393 33.33 80.00 4 100 300 400 524 25.00 75.00 5 100 370 470 655 20.00 74.00 6 100 450 550 786 16.67 75.00 7 100 540 640 917 14.29 77.14 8 100 650 750 1048 12.50 81.5 9 100 780 880 1179 11.11 86.67 10 100 930 1030 1310 10.00 93.00 Php 190 135 113.33 100 94 91.67 91.43 93.75 97.78 103 ATC= AFC+ AVC ATC= TC/Q

27. Table 7.2 The Profit-Maximizing Output for a Purely Competitive Firm: Total Revenue – Total Cost Approach (Price =   ₱ 131) (1) Quantity (Q) (2) Total Fixed Cost (TFC) (3) Total Variable Cost (TVC) (4) Total Cost (TC) (5) Total Revenue (TR) (6) Average Fixed Cost (AFC) (7) Average Variable Costs (AVC) (8) Average Total Cost (ATC) (9) Marginal Cost (MC) (10) Price = Marginal Revenue (MR) (6) Total Economic Profit (+) or Loss (-) Php 100 Php Php 100 Php       1 100 90 190 131 Php 100 Php 90.00 Php 190 2 100 170 270 262 50.00 85.00 135 3 100 240 340 393 33.33 80.00 113.33 4 100 300 400 524 25.00 75.00 100.00 5 100 370 470 655 20.00 74.00 94.00 6 100 450 550 786 16.67 75.00 91.67 7 100 540 640 917 14.29 77.14 91.43 8 100 650 750 1048 12.50 81.5 93.75 9 100 780 880 1179 11.11 86.67 97.78 10 100 930 1030 1310 10.00 93.00 103.00 Php 90 8 7 6 7 8 9 11 13 15 MC = Δ TC/ Δ Q

28. Table 7.2 The Profit-Maximizing Output for a Purely Competitive Firm: Total Revenue – Total Cost Approach (Price =   ₱ 131) (1) Quantity (Q) (2) Total Fixed Cost (TFC) (3) Total Variable Cost (TVC) (4) Total Cost (TC) (5) Total Revenue (TR) (6) Average Fixed Cost (AFC) (7) Average Variable Costs (AVC) (8) Average Total Cost (ATC) (9) Marginal Cost (MC) (10) Price = Marginal Revenue (MR) (6) Total Economic Profit (+) or Loss (-) Php 100 Php Php 100 Php         1 100 90 190 131 Php 100 Php 90.00 Php 190 Php 90 2 100 170 270 262 50.00 85.00 135 80 3 100 240 340 393 33.33 80.00 113.33 70 4 100 300 400 524 25.00 75.00 100.00 60 5 100 370 470 655 20.00 74.00 94.00 70 6 100 450 550 786 16.67 75.00 91.67 80 7 100 540 640 917 14.29 77.14 91.43 90 8 100 650 750 1048 12.50 81.5 93.75 110 9 100 780 880 1179 11.11 86.67 97.78 130 10 100 930 1030 1310 10.00 93.00 103.00 150 Php 131 131 131 131 131 131 131 131 131 131 MR = Δ TR/ Δ Q

29. Table 7.2 The Profit-Maximizing Output for a Purely Competitive Firm: Total Revenue – Total Cost Approach (Price =   ₱ 131) (1) Quantity (Q) (2) Total Fixed Cost (TFC) (3) Total Variable Cost (TVC) (4) Total Cost (TC) (5) Total Revenue (TR) (6) Average Fixed Cost (AFC) (7) Average Variable Costs (AVC) (8) Average Total Cost (ATC) (9) Marginal Cost (MC) (10) Price = Marginal Revenue (MR) (6) Total Economic Profit (+) or Loss (-) Php 100 Php Php 100 Php           1 100 90 190 131 Php 100 Php 90.00 Php 190 Php 90 Php 131 2 100 170 270 262 50.00 85.00 135 80 131 3 100 240 340 393 33.33 80.00 113.33 70 131 4 100 300 400 524 25.00 75.00 100.00 60 131 5 100 370 470 655 20.00 74.00 94.00 70 131 6 100 450 550 786 16.67 75.00 91.67 80 131 7 100 540 640 917 14.29 77.14 91.43 90 131 8 100 650 750 1048 12.50 81.5 93.75 110 131 9 100 780 880 1179 11.11 86.67 97.78 130 131 10 100 930 1030 1310 10.00 93.00 103.00 150 131 Php-100 -59 -8 53 124 185 236 277 298 299 280 PROFIT = TR-TC

30. Table 7.2 The Profit-Maximizing Output for a Purely Competitive Firm: Total Revenue – Total Cost Approach (Price =   ₱ 131) (1) Quantity (Q) (2) Total Fixed Cost (TFC) (3) Total Variable Cost (TVC) (4) Total Cost (TC) (5) Total Revenue (TR) (6) Average Fixed Cost (AFC) (7) Average Variable Costs (AVC) (8) Average Total Cost (ATC) (9) Marginal Cost (MC) (10) Price = Marginal Revenue (MR) (6) Total Economic Profit (+) or Loss (-) Php 100 Php Php 100 Php 0           Php-100 1 100 90 190 131 Php 100 Php 90.00 Php 190 Php 90 Php 131 Php -59 2 100 170 270 262 50.00 85.00 135 80 131 -8 3 100 240 340 393 33.33 80.00 113.33 70 131 [phone] 25.00 75.00 100.00 60 131 [phone] 655 20.00 74.00 94.00 70 131 [phone] 786 16.67 75.00 91.67 80 131 [phone] 917 14.29 77.14 91.43 90 131 [phone] 1048 12.50 81.5 93.75 110 131 [phone] 1179 11.11 86.67 97.78 130 131 [phone] 1310 10.00 93.00 103.00 150 131 +280 Profit Maximization

31. Profit Maximization in the Short-run Cost and Revenue ₱ 200 150 100 50 1 2 3 4 5 6 7 8 9 10 Output Economic Profit MR = P MC MR = MC AVC ATC P = ₱ 131 (in thousand) Figure 7.3 short-run profit maximization for a purely competitive

32. MR=MC If price is below AVC then the firm should shut down and produce 0. If the price is equal to AVC, the firm should produce. If the price is above AVC but lower than ATC, the firm is at loss minimization . If the price is equal to ATC, the firm is at break-even point. If price is above ATC, the firm is at profit maximization Price and Output Determination

33. P 1 Cost and Revenues (Peso) Quantity Supplied MR 1 P 2 MR 2 P 3 MR 3 P 4 MR 4 P 5 MR 5 MC AVC ATC Q 2 Q 3 Q 4 Q 5 a b c d e Q 1 Figure 7.4 Pure competitive firm in the short run Shut-down Produce Break-even point Loss minimization Profit Maximization

34. Thank you!