Cost and Profit

1
• Cost = what you give up
• Examples
– Cost of raw material
– Cost of launching a new product
– Cost of running your own business
– Cost associated with inventory
– Cost associated with equipment
– Cost associated with labor

2
 Types of costs
• Explicit cost involves actual payments to the other parties.
• Implicit cost does not involve actual payments but its an
integral part of production.
• Sunk cost are the expenditures that have been made inn the
past and they must be paid in the future. Like inventory cost
or rental payments
• Incremental cost refers to the additional cost of implementing
a managerial decision. Like new product line, acquisition. MC
is a subgroup of IC
• Fixed Cost do not change with the level of output. FC belong
to the subgroup of Sunk cost.
• Variable cost varies directly with the level of output.
• Normal profit is involved in cost.

3
 Cost in the Short Run
• Fixed costs do not change with changes in
output
• Variable costs increase as output increases.
• Total cost of production equals the fixed cost
plus the variable cost

TC  FC  VC
4
 Cost in the Short Run
• Average Total Cost (ATC) is the cost per unit of
output, or average fixed cost (AFC) plus
average variable cost (AVC). This can be
written:

TFC TVC
ATC  
Q Q
TC
ATC  AFC  AVC or
Q 5
 Cost in the Short Run
• Marginal Cost (MC) is the cost of expanding
output by one unit. Since fixed cost have no
impact on marginal cost, it can be written as:

VC TC
MC  
Q Q
6
 The Various Measures of Cost:

Average
Variable Average Variable Average Marginal
Quantity Total Cost Fixed Cost Cost Fixed Cost Cost Total Cost Cost
0 3.00 3.00 0.00 --------- --------- ---------
0.30
1 3.30 3.00 0.30 3.00 0.30 3.30
0.50
2 3.80 3.00 0.80 1.50 0.40 1.90
0.70
3 4.50 3.00 1.50 1.00 0.50 1.50
0.90
4 5.40 3.00 2.40 0.75 0.60 1.35
1.10
5 6.50 3.00 3.50 0.60 0.70 1.30
1.30
6 7.80 3.00 4.80 0.50 0.80 1.30
1.50
7 9.30 3.00 6.30 0.43 0.90 1.33
1.70
8 11.00 3.00 8.00 0.38 1.00 1.38
1.90
9 12.90 3.00 9.90 0.33 1.10 1.43
2.10
10 15.00 3.00 12.00 0.30 1.20 1.50
7
 Short run Cost Curves for a Firm

P
• Unit Costs 100 MC
– MC must rise with Q
75
eventually
– MC = ATC at minimum 50
ATC
ATC AVC
25
AFC
0 1 2 3 4 5 6 7 8 9 10 11
Output

8
 Profit
• Profit = Total revenue – Total cost

• TR = TC the firm is at breakeven.

• P = AVC is the Shutdown point.
• Normal profit is the part of cost and this is
must for the firm to operate in the long run.

9
 Economies of Scale
• The cost of producing and marketing products
depends both on the scale (amount of labor
and capital employedof the firm’s operation.
• Economies mean the advantages that a firm
derives from large scale operation
• Diseconomies mean the disadvantages from
large scale operation.

10
 Economies of Scope
• Combining different types of firms to reduce
cost or create new product is economies of
scope (the array of different goods and
services produced).

11