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revenue, cost and profit.

revenue, cost and profit. Revenue $100 Fixed costs $ 20 Variable costs $ 70 Profit $ 10 revenue minus cost equals profit. Handout Visual 3.2. Understand the relationships among total, marginal and average costs.

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revenue, cost and profit.

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  1. revenue,cost and profit. • Revenue $100 • Fixed costs $ 20 • Variable costs $ 70 • Profit $ 10 • revenue minus cost equals • profit.

  2. Handout Visual 3.2

  3. Understand the relationships among total, marginal and average costs. • Be sure to understand how the law of diminishing marginal returns affects output and, correspondingly, cost. This is critical to your future success in this unit.

  4. implicit costs: The money income a firm sacrifices when it employs a resource it owns rather than selling it to someone else • explicit costs: The money payment a firm must make to an outsider to obtain and use a resource

  5. Handout visual 3.3 • define and show the relationships among FC, VC and TC.

  6. Insert visual 3.4 to define and show the relationships among AFC, AVC, ATC and MC. • Also use Visual 3.4 to explain why MC crosses ATC at its minimum point.

  7. In Part A, the return on investment is a loss when opportunity cost is included. This gives a negative rate of return if “psychic income” from being in business for yourself is ignored.

  8. In Part B, marginal cost is plotted at the midpoints of the quantity intervals, and the quantity intervals are 100 units, not one unit. • We will plot marginal cost and marginal revenue at the midpoints.

  9. First calculate marginal cost from the chart. Marginal cost is ΔTC / ΔQ or ΔTC / 100. To find MC as output increases from 500 units to 600 units, find the change in total cost over this interval: $4,320 – $3,600 = $720. Divide by the change in quantity (100), and MC = $7.20 at an output of 550 units

  10. Activity 26 • The accountant’s concept of “profit” differs from the economist’s because the economist’s concept includes implicit opportunity costs. When M.I. Fortunate goes into business for herself, she incurs two implicit opportunity costs: • (i) Her former salary of $50,000 • (ii) The 8 percent return on $100,000, which is $8,000

  11. Activity 26 • The second is incurred because the$100,000 must be used to invest in the new business. While it earns some return, it does not earn the previous $8,000 realized when it was invested in securities. The “net income” of $55,000 is gross return net of explicit cost only, and it gives an accounting profit only. To find economic profit, the opportunity cost of $58,000must also be subtracted.

  12. Activity 26 • The possibility of “psychic income” from being in business for herself is not considered in establishing her total income of $55,000 after all expenses. If “psychic income” is considered, she may not lose $3,000.

  13. Activity 26 Part B. Students must use these formulas: Total Cost = Fixed Cost + Variable Cost • Average Fixed Cost (AFC) = Fixed Cost = FC Quantity Q • AVC = VC ATC = TC Q Q • MC = Change in Total Cost = ΔTC Change in Quantity = ΔQ

  14. Activity 26 • Question 6 answer: If marginal cost is below average cost, average cost is falling because the marginal, or additional, cost is pulling AC down. If marginal cost is above average cost, average cost is rising because the marginal, or additional, cost is pulling AC up. Because AC declines and then rises, MC crosses AC at the lowest point on the average cost curve.

  15. Activity 26 • Part B • 4. How is marginal cost (ΔTC / ΔQ) represented in Figure 26.2? It is the slope of the TC curve. • 5. On Figure 26.3, total cost per unit (TC / Q or average total cost) is at a minimum at an output level of between 500 and 600 units.

  16. Activity 26 • 6. On Figure 26.3, variable cost per unit (VC / Q or average variable cost) is at a minimum at an output level of between 300 and 400 units. • 7. On Figure 26.3, what is the relation between marginal cost (ΔTC / ΔQ) and average total cost (TC / Q) when average total cost is at its minimum? They are equal.

  17. Activity 26 • 8. On Figure 26.3, what is the relation between marginal cost (ΔTC / ΔQ) and average variable cost (VC / Q) when average variable cost is at its minimum? They are equal.

  18. Activity 27 • 9. Explain why marginal cost on a unit-cost graph always intersects average total cost and average variable cost at their minimum points. A minimum is the lowest point. If ATC ( TC/Q ) and AVC ( VC/Q ) fall when MC ( ΔTC ΔQ / ) is below them (as they must since the cost of one additional unit is less than the average, it pulls average cost down), and if ATC and AVC increase when MC is above them (as they must since the cost of one additional unit is more than the average, it pulls average cost up), and if MC is rising, ATC and AVC must be at a minimum when they are equal to MC since you have to pass through a minimum when you stop falling and start rising. Let’s say that a basketball player is averaging 10 points a game. In the next game, she scores eight points. Because the marginal (additional) points are less than her average, her average must fall. On the other hand, what if she scored 12 points? Then her average would rise because the marginal points would be greater than her average.

  19. Activity 27 • 10. On Figure 26.3, what does the vertical distance between the TC / Q curve and VC / Q curve represent? FC Q or average fixed cost

  20. Activity 27 • 11. Explain why fixed cost has no influence on marginal cost. Fixed cost, by definition, does not change as output changes. Marginal cost, by definition, is the change in total cost as output changes. Therefore, fixed cost, which does not change, can have no influence on the changes in cost measured by marginal cost.

  21. For Activity 27 quick review of costs and basic concepts: Average fixed cost (AFC): Fixed cost / output Average total cost (ATC): Total cost / output • Average variable cost (AVC):Variable cost / output • Economic cost: Any cost that must be incurred to obtain and use a resource • Economic profit: The amount of a firm’s total revenue that exceeds all its economic costs including both explicit and implicit costs.

  22. For Activity 27 • Explicit cost: The money payment a firm must make to an outsider to obtain and use a resource. • Fixed cost (FC): A cost that does not change with output. • Implicit cost: The money income a firm sacrifices when it employs a resource it owns rather than selling it to someone else.

  23. Activity 27 • Law of diminishing marginal returns: As equal amounts of variable resources are added to a fixed resource, eventually the marginal product (extra output) will decline. • Long run: A period of time long enough to change all inputs. All inputs are variable in the long run. • Marginal cost (MC): The extra cost of producing one more unit of output, ΔTC/ΔQ

  24. Activity 27 • Normal profit: A measure of the opportunity cost of capital; a profit that is equal to a firm’s implicit costs; the minimum profit needed to stay open in the long run. • Short run: A period of time when at least one input is fixed, when existing firms can increase the quantity of their output with their existing plants.

  25. Activity 27 • Total cost (TC): All of the costs of the firm both fixed and variable costs. • Variable cost (VC): The cost of variable resources (resources that change with output).

  26. Visual 3.5 questions • Use Visual 3.5 to show the perfectly competitive firm and industry in short-run equilibrium. • How is the price established at which the firm sells? Visual 3.5 answer 1 • How much control does the firm have over this price? Visual 3.5 answer 2

  27. Visual 3.5 questions 3. Why do we say a perfect competitor is a price taker?Visual 3.5 answer 3 4. Why does a perfect competitor maximize profits where Price = MC?Visual 3.5 answer 4 5. Is this perfect competitor making a profit? Why or why not?Visual 3.5 answer 5

  28. Visual 3.6 questions Now, use Visual 3.6 to illustrate profit, loss and shutdown for a perfectly competitive firm. 1. At what output will the firm operate at price P4? Will it make a profit?Visual 3.6 answer 1 2. At price P3, will the firm make a profit, break even or have an economic loss? What does it mean to break even?Visual 3.6 answer 2

  29. Visual 3.6 questions 3. At P2, will the firm make a profit, break even or have an economic loss? Will it continue to produce? Why or why not?Visual 3.6 answer 3 4. At P1 , will the firm make a profit, break even or have an economic loss? Will it continue to produce? Why or why not?Visual 3.6 answer 4

  30. Visual 3.7 questions Use Visual 3.7 to illustrate long-run equilibrium for a perfect competitor. Emphasize these points: • The market price is determined by supply and demand in the industry. • Once the price is established, every firm must sell at that price or not sell at all. There is no reason for a firm to lower its price since it can already sell as much as it wants.

  31. Visual 3.7 questions • If firms are making economic profits, more firms will enter the industry-an event that reduces price and makes profits disappear. • If firms have economic losses, firms will exit the market-an event that will cause the price to rise. • A perfectly competitive firm in long-run equilibrium is good for society because there is productive and allocative efficiency when the firm is at the lowest point on its average total cost curve.

  32. Activity 27 answers • 1. What is the relationship between MC and output as shown on your graph? As output increases, marginal cost decreases, reaches a minimum and then increases. • 2. Explain why MC falls and then rises as output increases. According to the law of diminishing marginal returns, as variable inputs are added to fixed inputs, output increases at a fast rate (marginal product increases), so the marginal costs of that output decrease. But when MP falls, the marginal cost of producing that output will increase.

  33. Activity 27 answers 3. Graph FC, VC and TC on Figure 27.4. Label each curve. Then answer the questions. • (A) What is the difference between fixed and total costs? Variable cost • (B) Why does VC rise as output increases? In order to increase output, the firm must hire more variable inputs (labor). So the cost of this input (variable cost) must increase. • (C) Why is FC a horizontal line? Because fixed costs are constant, regardless of the level of output • (D)Why does the TC curve have the same slope as the VC curve? The difference between the TC curve and the VC curve is FC, which is constant.

  34. Activity 27 answers 4. Graph AFC, AVC, ATC and MC on Figure 27.5 (be sure to plot MC on the midpoints of output). Label each cost curve. Then answer the questions. (A) What happens to AFC as output rises? Why? AFC decreases because total fixed cost is constant. To get AFC, one divides FC by Q, so AFC must decrease.

  35. Activity 27 answers (B) What happens to AVC as output rises? Why? AVC decreases and then increases. When MC is less than AVC, AVC decreases. When MC is greater than AVC, AVC increases. (C) What happens to ATC as output rises? Why? ATC decreases and then increases. When MC is less than AVC, ATC decreases. When MC is greater than ATC, ATC increases. (D)What happens to MC as output rises? Why? MC decreases and then increases. This is because of increasing returns and then diminishing returns.

  36. Activity 27 answers (E) At what unique point does marginal cost cross AVC and ATC? Why? At the minimum of AVC and ATC. If marginal cost is less than average cost, average cost falls. If marginal cost is greater than average cost, average cost will rise, so they are equal when average cost is at its minimum. (F) Why is MC the same whether computed from TC or VC? Fixed costs don’t change, and marginal cost is the change in costs divided by the change in output. Change in variable cost always equals the change in total cost.

  37. Visual 3.5 answer 1 1. By the intersection of the industry supply and demand curves. Back

  38. Visual 3.5 answer 2 2. None Back

  39. Visual 3.5 answer 3 3. Because the firm has no control over the price and has to “take” the price established in the industry. Back

  40. Visual 3.5 answer 4 4. All firms maximize profit by producing at the quantity where MR = MC, and for a perfectly competitive firm P = MR since a firm can sell all it wants at the price determined by the industry. Back

  41. Visual 3.5 answer 5 5. Yes. P > ATC and TR > TC. Back

  42. Visual 3.6 answer 1 • At what output will the firm operate at price P4? Q4 .Will it make a profit? Yes Back

  43. Visual 3.6 answer 2 2. At price P3, will the firm make a profit, break even or have an economic loss? Break even. What does it mean to break even? TR just covers TC. Back

  44. Visual 3.6 answer 3 3. At P2, will the firm make a profit, break even or have an economic loss? Economic loss. Will it continue to produce? It will continue to produce. Why or why not? Price is greater than AVC or TR > TVC. Back

  45. Visual 3.6 answer 4 4. At P1 , will the firm make a profit, break even or have an economic loss? Economic loss. Will it continue to produce? Indifferent. Why or why not? If firm produces, revenue covers variable costs, but firm must pay fixed costs out-of-pocket. Price = AVC or TR = TVC Back

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