Costs Analysis

Revenues Analysis

Profit Maximization
Lecture Notes

234
 Costs Analysis

Because businesses want to produce efficiently, they must keep an eye

on their costs. Here, we have to say that we will focus on costs analysis
in the short-run.

In the short-run, we can classify production costs to three types:

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Lecture Notes

236
Total cost takes into account all of the costs a business faces in the
course of its operations.

Total Cost = Total Fixed Cost + Total Variable Cost

TC = TFC + TVC

The costs that an organization incurs even if there is

Total Fixed little or no activity. It makes no difference whether
Cost (TFC) the business produces nothing, very little, or a large
amount.

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Total Fixed The costs that remain the same regardless of level of
Cost (TFC) production or services offered.

OR Total fixed cost doesn’t change as output changes. TFC

graphs as a horizontal line (look at figure 47).

EX. Rent, interest on bonds and salaries paid for executives.

production costs that change when production levels

Total variable change. As shown from figure (47), Total variable cost
increase by output increasing, and it decrease by output
Cost (TVC)
decreasing. If output equal zero, Total variable cost
equal zero.

EX. Labor wages and raw materials costs.

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 TC
TC,
TFC,
TVC TVC

TFC

output
Figure (47): Total Costs

Note When the output equal zero, The total cost curve begins from total
fixed cost because there is not variable cost and all costs are fixed cost.

The vertical distance between the total cost curve and the total
Note
variable cost curve is total fixed cost.

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Lecture Notes

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 The most useful measure of cost is marginal cost which means: the extra
cost incurred when producing one more unit of output.

Marginal cost is more useful than total cost because it shows the
Note
change in total variable costs when output increases.

𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒕𝒐𝒕𝒂𝒍 𝒄𝒐𝒔𝒕

Marginal Cost =
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒐𝒖𝒕𝒑𝒖𝒕

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Lecture Notes

242
 There are three average cost concepts:

Average fixed Average variable Average total

cost (AFC) cost (AVC) cost (ATC)

(AFC) is the total (AVC) is the total (ATC) is the total

fixed cost per variable cost per cost per unit of
unit of output. unit of output. output.

𝑻𝒐𝒕𝒂𝒍 𝒇𝒊𝒙𝒆𝒅 𝒄𝒐𝒔𝒕 𝑻𝒐𝒕𝒂𝒍 𝒗𝒂𝒓𝒊𝒂𝒃𝒍𝒆 𝒄𝒐𝒔𝒕 𝑻𝒐𝒕𝒂𝒍 𝒄𝒐𝒔𝒕

𝒐𝒖𝒕𝒑𝒖𝒕 𝒐𝒖𝒕𝒑𝒖𝒕 𝒐𝒖𝒕𝒑𝒖𝒕

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ATC, AFC,
AVC, MC MC ATC
AVC

AFC

output

Figure (48): Average and marginal costs

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 Average fixed cost (AFC) slopes downward.
 Average variable cost (AVC) and average total cost (ATC) are U-
shaped, it decrease and reach the minimum point then increase.
 The vertical distance between (AVC) and (ATC) curves is equal to
average fixed cost (that distance shrinks as output increases
because average fixed cost decreases with increasing output).
 The marginal cost curve intersects (AVC) and (ATC) curves at their
minimum points.
 When marginal cost is less than average cost, average cost is
decreasing; When marginal cost exceeds average cost, average
cost is increasing.

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Lecture Notes

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 Revenues Analysis

Businesses use two key measures of revenue to find the amount of

output that will produce the greatest profits. The first is total revenue,
and the second is marginal revenue.

The total revenue is all the revenue that a business receives. It is total
amount earned by a firm from the sale of its products.

Total revenue is equal to the number of units sold multi plied by the
average price per unit.
TR = quantities x price

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 Price is determined by the intersection of market demand and market
supply; individual firms do not have any influence on the market price
in perfect competition. Once the market price has been determined by
market supply and demand forces, individual firms become price takers.

P D P
S

Q Q
Figure (49): Price in perfect competition market

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 Note
Because of individual firms in perfect competition market do not have any influence on
the market price (the price is constant), total revenue is a straight line.

Quantity 0 1 2 3 4 5 6 7 8 9 10 11 12
Price 10 10 10 10 10 10 10 10 10 10 10 10 10
Total revenue 0 10 20 30 40 50 60 70 80 90 100 110 120
Marginal revenue - 10 10 10 10 10 10 10 10 10 10 10 10
Average revenue - 10 10 10 10 10 10 10 10 10 10 10 10
Table (12): Price and Total revenue in perfect competition
P market TR
TR

P = AR = MR

Q Q
Figure (50): Price and Total revenue in perfect competition
market
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Lecture Notes

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For a monopoly firm that is a price maker rather than price
taker, market control means the firm faces a negatively-sloped demand
curve. As such, the price received is not fixed, but depends on the
quantity of output sold.

Table (13) and figure (51), both show a case in which there is a monopoly
firm (who is the sole seller of its product, and where there are no close
substitutes). This firm faces a negatively-sloped demand curve. To sell a
larger quantity of a product, it must lower the price.

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 Quantity 0 1 2 3 4 5 6 7 8 9 10 11 12
Price 10.5 10 9.5 9 8.5 8 7.5 7 6.5 6 5.5 5 4.5
Total revenue 0 10 19 27 34 40 45 49 52 54 55 55 54
Marginal revenue - 10 9 8 7 6 5 4 3 2 1 0 -1
Average revenue - 10 9.5 9 8.5 8 7.5 7 6.5 6 5.5 5 4.5

Table (13): Price and Total revenue in monopoly market

P TR

TR

P = AR
MR

Q Q
Figure (51): Price and Total revenue in monopoly market

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 The more important measure of revenue is marginal revenue, which
means the extra revenue a business receives from the production and
sale of one additional unit of output.

𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒕𝒐𝒕𝒂𝒍 𝒓𝒆𝒗𝒆𝒏𝒖𝒆

Marginal Revenue =
𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒐𝒖𝒕𝒑𝒖𝒕
EX.
From table (13), when the firm produces 5 units of output it generates $40 of
total revenue. If the output increases to 6 units, total revenues increase to
$45. If we divide the change in total revenue ($5) by the change in output (1
unit), we have marginal revenue of $5.

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Lecture Notes

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 Profit Maximization

There are two approaches used to determine the output which

maximize profit; total approach and marginal approach.

According this approach, a firm produce the output where the distance
between total revenue and total cost (profit) as big as possible.

EX.
From table (14), When we put production schedule with both costs and
revenues, we find that the profit reach the biggest number when the firm
employ the seventh worker, since profit become 485. At any output less or
more than 125 using 7 workers, profits would decrease.

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Lecture Notes

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 PRODUCTION SCHEDULE Costs Revenues

Total Total
Regions Total Marginal Total Marginal Total Marginal profit
labor fixed variable
of product product cost t cost revenue revenue
cost cost al
production
0 0 -- 40 0 40 0 0 9 -40

1 10 10 40 60 100 6 90 9 -10

Stage 1 2 25 15 40 135 175 5 225 9 50

3 50 25 40 235 275 4 450 9 175

4 80 30 40 340 380 3.5 720 9 340

5 100 20 40 420 460 4 900 9 440

6 115 15 40 510 550 6 1035 9 485

Stage 2
7 125 10 40 600 640 9 1125 9 485

8 125 0 40 730 770 13 1125 9 355

Stage 3 9 120 -5 40 750 790 -- 1080 9 290

Table (14): Production, costs, revenues and profits

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Most people, as well as most businesses, use marginal analysis, a type
of decision making that compares the extra benefits of an action to
the extra costs of taking the action.

According the marginal analysis, a business adds more variable inputs

(workers) and then compares the extra benefit (marginal revenue) to the
additional cost (marginal cost). If the extra benefit exceeds the extra cost,
then the firm hires another worker.

The profit-maximizing quantity of output is reached when marginal cost and

marginal revenue are equal, as shown from table (14), that achieved at the
output (125) when the firm employs the seventh worker, since marginal
revenue equal marginal cost (9). In the last column in the table, other levels of
output may generate equal profits, but none will be more profitable.

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