Analysis of Cost and Revenue

Short run
A period of time so short that the firm cannot alter the quantity of some of its inputs

Typically plant and equipment are fixed inputs in the short run Fixed inputs determine the scale of the firms operation

SHORT-RUN COSTS
Fixed costs and variable costs
Total costs
Short run fixed cost (SFC) Short run variable cost (SVC) Short run total cost (STC = SFC + SVC)

Costs

In buying factor inputs, the firm will incur costs Costs are classified as: Fixed costs costs that are not related directly to production rent, rates, insurance costs, admin costs. They can change but not in relation to output Variable Costs costs directly related to variations in output. Raw materials primarily

Costs

Total Cost - the sum of all costs incurred in production TC = FC + VC Average Cost the cost per unit of output AC = TC/Output Marginal Cost the cost of one more or one fewer units of production MC = TC n TCn-1 units

Example
Output Fixed cost SFC 30 30 30 30 30 30 Variable cost SVC 0 22 38 48 61 79 Total cost STC 30 52 68 78 91 109 22 16 10 13 18 Marginal cost SMC Average cost SAC 52 34 26 22.75 21.80

0 1 2 3 4 5

6 7
8 9 10

30 30
30 30 30

102 131
166 207 255

132 161
196 237 285

23 29
35 41 48

22 23
24.50 26.33 28.50

Total costs for firm X

100

STC
SVC TVC

80

60

40

20

SFC
0 0 1 2 3 4 5 6 7 8

Total costs for firm X

STC
100
SVC TVC

80

Diminishing marginal returns set in here

60

40

20

SFC

Average and marginal costs

SMC
SAC

SAVC

Costs ()

z y x

SAFC

Output (Q)

Marginal and Average Costs

As Q increases if
MC<AC AC is falling MC>AC AC is rising So, when MC=AC AC is at its minimum

The above also applies to MC and AVC

Long-run Cost Curves

Long-run cost curves all factors are variable, so there are no fixed costs and all costs are variable. Economies and diseconomies of scale

LR cost curves are U-shaped if a production process is characterized by first by economies of scale, and then diseconomies of scale. Since capital can be varied, the long-run cost curves describe the costs with changing the scale of operations (reducing or increasing plant size).

benefits to a larger scale of operations specialization, purchasing volume, efficient use of capital, design and development costs costs of a larger scale of operation coordination problems

The long-run cost curve is constructed from various short-run cost curves.

Remember increasing capital makes labor more productive, so increase plant size makes labor more productive and decreases marginal costs Even though marginal costs decline, average costs may go up or down because of the cost of capital and labor are added together to calculate average costs.

Figure 7 Average Total Cost in the Short and Long Run

Average Total Cost

ATC in short
run with small factory

ATC in short

ATC in short

run with run with medium factory large factory

$12,000

ATC in long run

1,200

Quantity of Cars per Day

Copyright 2004 South-Western

Figure 7 Average Total Cost in the Short and Long Run

Average Total Cost

ATC in short
run with small factory

ATC in short

ATC in short

run with run with medium factory large factory

ATC in long run

$12,000 10,000 Economies of scale

Constant returns to scale

Diseconomies of scale Quantity of Cars per Day

Copyright 2004 South-Western

1,000 1,200

Long-run average and marginal costs

Initial economies of scale, then diseconomies of scale
Costs

LRMC LRAC

Output

Short-Run & Long-Run Marginal Cost Curves $/output unit

SRMCs

MC(y) AC(y)

Revenue

Total revenue the total amount received from selling a given output TR = P x Q Average Revenue the average amount received from selling each unit AR = TR / Q Marginal revenue the amount received from selling one extra unit of output MR = TR n TR n-1 units

Profit

Profit = TR TC The reward for enterprise Profits help in the process of directing resources to alternative uses in free markets Relating price to costs helps a firm to assess profitability in production

Profit

Normal Profit the minimum amount required to keep a firm in its current line of production Abnormal or Supernormal profit profit made over and above normal profit Abnormal profit may exist in situations where firms have market power Abnormal profits may indicate the existence of welfare losses Could be taxed away without altering resource allocation

Profit

Sub-normal normal profit

Profit

profit

below

Firms may not exit the market even if subnormal profits made if they are able to cover variable costs Cost of exit may be high Sub-normal profit may be temporary (or perceived as such!)

Profit

Assumption that firms aim to maximise profit May not always hold true there are other objectives Profit maximising output would be where MC = MR