CHAPTER 6

THE THEORY OF COST AND PROFIT

The producer in this chapter is presented as one whose objective is profit maximization. To attain this objective,
the pro-ducer is equipped with explicit concepts in order to arrive at a more refined and rational decision.
Moreover, these concepts help in understanding market behavior as discussed in the succeeding chapters.
The framework of discussion is the concept of business which defines cost and profit. This definition serves to
identify the components of cost output as well as revenue output relationships which in turn lead to the concept
of maximum profit.
GENERAL CONCEPT
From the point of view of an entrepreneur, a business or firm exists to reward entrepreneurial efforts. To render
this reward, the firm undergoes a production process the outcome of which serves the consumers or buyers.
Production embraces the whole process of making the product available to consumers which therefore, includes
the final process of distribution. In so doing, the firm pays a price by using its stock of assets, and the value
foregone is called cost. At the end of the said process, the firm earns revenues through the sale of goods or
services. The positive net effect or difference between revenue and cost is called profit and accrues as said
reward to the entrepreneur.
Hence, profit is a creation of entrepre neurship. With the revenue earned, the firm can recover what it foregoes
in the process of production and the excess is simply the profit created. To retain this profit is to increase the
firm's stock of assets. Conversely, the negative difference between revenue and cost results in a loss which
erodes this stock of assets.
Thus a buy and sell business is also involved in production which is the service of bringing supplies from the
source to the users.
COST CONCEPTS
A firm maintains a stock of assets that it can use for production. Assets are in real and monetary forms. Examples
of real assets are machinery, buildings, materials, and supplies. On the other hand, monetary assets are in the
forms of money and near money part of which the firm transforms into real assets through purchases or
acquisition.
The firm incurs cost by using these assets for production. It should be noted that an expenditure does not
constitute a transformation of an asset from one form to another but, rather the giving up of values for the
production process.
Hence, a firm incurs cost not in the paying for the acquisition of real assets but rather in their use. Likewise, the
use of resources in the production of unsold goods is not considered cost as the meaning of production covers
a broader perspective. The resources used are simply transformed into these unsold goods which become part
of the firm's stock of assets called inventories. On the other hand, the depletion of monetary assets only
constitutes cost when used as payments for the utilization of the other resources, such as labor, as well as for
the other obligations of the firms, such as some forms of taxes.
Table 17 presents a simple statement of cost and profit. The reasons for the inclusion of the types of cost
presented are discussed in the succeeding sections.
OPPORTUNITY COST
As a concept, opportunity cost is the fore gone opportunity of choosing an alternative. The difference between
the opportunity gained from the alternative and its opportunity cost is the net gain (loss) from said choice. Simply
put, it is how much more and the owner's foregone earnings which (less) one gains in giving up alternatives to
benefit from a choice. Ideally, the concept should help us change decisions for the best. In the real world,
however, it should, at least, help us make better decisions. In business, the use of stock of assets for production
is oppurtunity cost since such assets could have been used for something else. Also included as oppurtunity
cost are their and the owner’s forgeone earnings which are what they could earn alternatively. One example is
the interest income that owner's money could have earned from money market placement. Another example is
the em ployment income the entrepreneur lost by not working somewhere else.
Table 17 matches business gross income (sales) with opportunity cost in the forms of business cost (goods,
operation) and fore- gone earnings of owner's money and entre- preneurial activity. The business earns the gross
amount of 1,175,352 by using the cur rent asset stock and entrepreneurial skill. However, it gave up 792,491 as
foregone earnings of investment funds and entre- preneurial activity to earn 382,861 more which is a better
choice.
In a broader perspective, cost is the foregone opportunity of the stakeholders in the business such as the
owner(s)/stock- holder, creditors, employees, and suppliers. The net gain of production (net of opportu- nity cost)
is also theirs as they forego oppor- tunities to earn more. The opposite is true when the business incurs losses.

IMPUTED COST
The business is a separate entity as it rewards its stakeholders. Therefore, it should pay any use of resources
and other assets to determine gains (losses) even be- fore making the best investment choice. But accounting
records exclude uses which involve no cash outlay which is cost, none- theless. These uses should have
assigned values called imputed cost. One example is the imputed salary of the entrepreneur who doubles as the
general manager of the business. Other examples are imputed rent for the use of personal properties for
production and the interest income for the opportunity of using owner's money. Inci- dentally, accounting records
impute depre- ciation charges to the use of fixed assets.
Since said uses have alternative uses, their imputed costs should approximate their opportunity costs. Therefore,
all im puted costs are opportunity costs albeit not necessarily true vice versa since most costs involve cash
outlays.

COST-OUTPUT RELATIONSHIP IN THE SHORT-RUN

Given a certain level of optimum input and maximum output, cost-output relationship assumes different forms.
These are short run cost functions since plant size and capacity are fixed. Table 18 presents the different forms
of this cost-output relation- ship and serve as a reference in the succeed- ing discussions.

FIXED AND VARIABLE COSTS

Total Cost (TC) has two basic compo- nents namely Fixed and Variable Costs. Total Fixed Cost (TFC) does not
vary with output; whereas Total Variable Cost (TVC) does in direct proportion. The following equation illustrates:
TC = TFC + TVC
where:
TC = Total Cost
TFC = Total Fixed Cost
TVC = Total Variable Cost
The items presented in the income state- ment in Table 17 are classified into fixed and variable costs.
Depreciation, salaries, and wages fall under Fixed Cost although the utilization of the corresponding resources
varies with output. Depreciation of fixed assets is something difficult to measure and expressed in monetary
terms although imputed with a fixed amount. On the other hand, a business is not flexible to vary its labor inputs
in the short-run and hence, maintains a maximum work force size, the I remuneration of which is likewise in the
form of Fixed Cost. Furthermore, the other cost items like supplies and utility expenses are partly classified as
Variable as they also consist of direct inputs of production and marketing, whereas the rest are classi- fied as
fixed, being supportive or indirect inputs.
Figure 50 illustrates the functional rela- tionship between output and each of the aforementioned cost concepts
(i.e., TC, TFC, and TVC) from Table 18 TFC assumes a horizontal line since it does not vary with output.
Moreover, the TC and TVC curves are parallel as the difference between them at any level of output is the
constant value of Total Fixed Cost (TFC) since:
TFC-TC-TVC

"Marginal Cost"
The following are the marginal cost concepts with the equations that define them:

Therefore: MC = MVC
where:

Note: MC is equal to MVC since TFC constant and TVC is the only component that causes TC to change.
Figure 51 presents the MC curve in rela- tion to the TC and TVC curves based on Table 18. The symbol for
change carries a positive sign if the variable increases and a negative sign if the variable decreases. However,
MC or MVC always carries a positive sign which means that Total Cost (TC) increases with output. Moreover,
MC or MVC is also the cost of the additional or last unit of output. For example, the table shows that MC or MVC
is P2 which is the increase in TC or TVC when output level increases from 3 to 4 units. This marginal level is
simply the cost of the 4th or last unit when producing 4 units of output.
To further illustrate the derivation of the MC curve from the TC curve, point J along the MC curve in Figure 51
registers a value equal to 30 when output is equal to 10 units. On the other hand, the correspond- ing change in
the TC or TVC curve in pro- ducing the 10th unit along the same point is likewise equal to 30. In addition, the
beha vior of the MC curve determines the shape of the TC curve. From its point of origin, the MC curve initially
declines causing the increase in TC for every additional unit of output to diminish. Eventually, the MC curve
increases causing TC to accelerate instead. The lowest point of the MC curve corresponds to the turning point
of the TC curve. The same behavior is also true of the TVC curve sincé MC is equal to MVC.
On the other hand, the MC values cor- responding to all the units of a certain output level sums up to TVC.
Referring again to Figure 51, the output level equal to 10 units corresponds to a TVC value equal to 155. This
value is also represented by the shaded portion under the MC curve representing the MC values from the 1st to
the 10th unit of output. Hence, the alter- native expressions of the TC and TVC func- tion are as follows:
*where Σ is the symbol for summation
Finally, the MC curve exhibits a dec- reasing and then increasing pattern as output increases due to the same
pattern. of change of the marginal input and there- fore, marginal cost as output increases in the production
function. Referring again to Chapter 5, the relationship holds true as input and output increase in the production
function.
Initially, Total Cost (TC) increases at a slower pace since less and less is added to it with a decrease in Marginal
Cost (MC).
This implies that production becomes more and more efficient before the threshold of diminishing returns as the
cost of produ cing an additional unit of output decrea ses. Eventually, production becomes less and less efficient,
thus, increasing the cost of producing an additional unit of output with the increase in MC and faster increase in
TC. It should be noted at this point that the production function influences the behav ior of the MC curve through
the cost of the variable inputs related to resource use (e.g., electricity and fuel).

AVERAGE COST
Average cost is cost per unit of output which assumes the following terms:

Figure 52 illustrates the three forms of average cost based on Table 18. The ATC curve is above its AFC and AVC
components. The ATO curve decreases with its compo nents to point I where output equals 10. But beyond this point
it increases as AVC increases faster than AFC decreases con- tinuously. The ATC curve is bell-shaped upside down
due to production efficiency factors as explained in the next section.

Finally TC, TVC and TFC can be derived from ATC, AVC and AFC, respectively, by simply multiplying the latter by
(output).
Assuming the quantity level to be Q in Figure 53, TC, TFC and TVC, are repre- sented, respectively, by the shaded
rectan- gular areas bounded by (average cost) and (output).

The lowest point of an average cost curve (i.e., ATC or AVC) corresponds to the output level between the phases
where it registers decreasing and then increasing trends from the point of origin of the graph. At this point:

It should be noted, however, that the points at which MC intersects the ATC and AVC curves differ.

UNIT COST AND PRODUCTION EFFICIENCY

Abstracting from Figure 52, the Average Total Cost (ATC) curve exhibits a decreas ing and then increasing pattern as
output increases. The general decrease in ATC means production becomes more and more efficient in the use of
resources because of two factors. First, the increase in the Mar- ginal Product (MP) and hence, product. ivity as input
increases in the production function (Chapter 5) decreases the Margi nal Cost (MC) and Average Variable Cost (AVC)
in Figure 54. Second, more use of a fixed plant size spreads out Fixed Cost to more output, thus, decreasing loss of
capa- city and Average Fixed Cost (AFC). In Fig. ure 52, ATC decreases due to the same change in its AVC and AFC
components. This pattern continuous up to point I despite an increase in AVC because of the offsetting effect of AFC
decreasing which is initially high. The decrease in AFC outweighs the increase in AVC causing the ATC to contin-
uously decrease and making a unit of out- put cheaper to produce.

Eventually, production becomes less and less efficient with the offsetting effect of the increase in MC and AVC due
to the Law of Diminishing Returns. Figure 52 shows that beyond point I, the increase in AVC outweighs the decrease
in AFC making a unit of output costlier to produce.

The most efficient point of plant use is I which is the lowest point of the ATC curve. Producing before this point means
underusing fixed resources and increasing use towards point I means increasing ef ficiency of their use due to the
decrease in idle capacity. On the other hand, producing beyond this point means overutilization and less efficient
use of resources (diminish- ing returns).

This contrast explains why, for exam- ple, electricity rates in the provinces are higher than that in Metro Manila. The
basic assumption is that an electricity-producing plant and its installations are not highly divisible. As such, a small
provincial plant might be relatively large to serve a limited market in a sparsely populated area as compared to a big
plant to serve the big demand of a densely populated metropolis. In effect, a provincial plant may be under- utilized
as in point B in Figure 52 with a higher per unit cost of output and thus, a higher rate. However, the plant in Metro
Manila is either optimally utilized as in point I or slightly overutilized as in point J having a lower cost per unit of output
and thus, lower rate. Therefore, the behavior of MC and AC, i.e., within a fixed plant size, reflects resource utilization
and efficiency, in the context of diminishing returns.

Cost-Output Relationship in the Long-run

The overall level of the ATC curve varies as plant size expands in the long-run due to changing returns to scale and
plant effi- ciency. As a reference, assume plant expansion with constant returns to scale and no change in plant
efficiency. In Figure 55, the average cost remains the same at the same rate of plant use as at points A, and A, des-
pite plant expansion from AVC, to AVC1. Plant efficiency (output/input) and input efficiency (input/output) which
influence average cost are constant due to constant returns to scale. Maintaining AVC despite plant expansion is
likened to enlarging one's photo without distorting body proportions. But the average cost curve is lower (AVC2) as
returns to scale increases with higher plant efficiency and lower (input/output) ratio. The opposite is true as returns
to scale decreases at AVC,.

The long curve in Figure 56 is the trend of the short-run ATC curve as plant size expands in the long-run. Increasing
returns to scale account for its decline. initially, while decreasing returns cause it to increase eventually. The most
efficient plant is ATC and operating it most effi ciently at E makes production most effi- cient in the long-run (shown
in Figure 57).

As already mentioned in Chapter 5, size conduces to efficiency but becomes a liability with more expansion in the
absence of innovation. While big firms can be more cost-efficient and price-competitive than small firms,
decreasing returns can catch up with complacency. Reconstructing the long-run average cost curve in Figure 56,
continuing innovation can prolong the stage of increasing returns and postpone the decline of production and cost
efficiencies due to decreasing returns.

Average and Marginal Cost Curves

Referring again to Figure 54, the MC (Marginal Cost) curve intersects the ATC (Average Total Cost) and AVC (Average
Var- iable Cost) curves at their lowest levels. An increase in MC increases cost faster than output to slow down the
decline in ATC and AVC until it meets them at their lowest. points. Therefrom, continued increase in MC leads the
two curves upward as it now costs more to produce a unit of output due to diminishing returns.

PROFIT CONCEPT

Total and Marginal Revenues

The following are the concepts of Reve- nue-Output relationship with the equations that define them:
Figure 58 illustrates the aforemen- tioned concepts assuming constant price at any level of output. Change
carries a positive sign if the variable increases and a negative sign if the variable declines. How- ever, MR always
carries a positive sign since revenue increases with output. More- over, MR is also the revenue from the add-
itional or last unit of output. For example, the figure shows that MR is "a" which is the increase in TR when its
level increases from Q to Q. This level of MR is also the revenue from Qath or last unit of output.
The TR curve increases at a constant rate with every additional unit of output im- plying that the resulting
additional revenue (MR) is equal to price (AR) since the latter is constant at any level of output. To restate the
following as equal and constant assum- ing constant price at any level of output.

Maximum Profit and the Marginal Approach

This section presents the concept of maximizing profit in the short-run (fixed plant size) and for simplicity,
assumes a constant price at any level of output.
Profit is simply defined as TR (Total Rev- enue) less TC (Total Cost) with TVC (Total Variable Cost) and TFC
(Total Fixed Cost) as the latter's components. The profit func- tion is alternatively expressed as follows.

Since TR and TVC are simply the sums of their marginal values (MR and MC) and TFC is fixed, the profit function
is further expressed as follows.

So long as MR is greater than MC, producing more increases profit through (TR TVC) in equation 1 or Summation
(MR-MC) in equation 2. In Figure 59, profit is maximized or loss is minimized, depending on the value of TFC,
at the point where the MC equals MR. Beyond this point, pro- ducing more decreases profit through the same
component of the profit function since MC has now increased beyond MR. Dimin- ishing returns and decreasing
efficiency of plant use catches up with profit as it is now costlier to produce an additional unit of out- put beyond
product price.
Average Profit is profit per unit of out- put which is equal to Total Profit divided by Q (output). Therefore, Total
Profit is equal to Average Profit multiplied by Q (output). Figure 60 illustrates Maximum Profit as the area bounded
by (p-c) representing Ave- rage Profit and Q representing output. At no point is profit maximized except at E
where MR is already equal to MC.
In addition, change in price can change the level of output and maximum profit. As an example in Figure 61,
price increases from P1 to P2 resulting in more production and profit. There is now more latitude for price to
outrun diminishing returns and increasing unit cost to increase output and maximize profit. The opposite is true
when price decreases.