Production, Revenue, Costs and Profits

By the end of this Section you should be able to

calculate, discuss, depict and define
Production
Total Product (TP)
Marginal Product (MP)
 Increasing, decreasing and negative marginal returns
 Discuss and apply the Law of Diminishing Marginal Product

Revenue
Total Revenue (TR)
Marginal Revenue (MR)
Costs
Total Cost (TC)
Marginal Cost (MC)
Average Cost (AC)
Relationship between MC and AC
2 kinds of Profit
2 kinds of associated costs
Discuss and “prove” why firms will produce where MC = MR
Discuss and identify Economies of Scope
 Production
Factors of Production are inputs or ingredients mixed
together by a firm through its technology to produce
output.
For our purposes, all inputs are variable.
The Production Function is a relationship between
inputs and output that identifies the maximum output
which can be produced per time period by each specific
combination of inputs.
Q=f(K,L) – a simple production function in which there are
only two inputs, capital and labor.
Total product- the total amount of output produced as
calculated by the production function. It is dependent
on the amount of each input used.
 Marginal Product
Marginal Product is the change in total product due to a
one unit increase in a factor of production. For example, it
is the change in TP due to a one unit increase in labor.
MPL= TP
Labor
Depending on the value of the MP, it will tell us if we
have increasing, decreasing of negative marginal returns.
Total and Marginal Product
Increasing
Marginal
Returns
Production
Function

Marginal
Product
 Increasing Marginal Returns
Increasing Marginal Returns is when the marginal
product of an additional worker exceeds the
marginal product of the previous worker.
When there are few workers, they can’t get everything
done. As you hire more workers, the work gets done
(there is an increase in quantity produced per worker).
MPcurrent > Mppreviously when an additional input
(labor) is added; TP is increasing at an increasing
rate.
Total and Marginal Product

Increasing Decreasing
Marginal Marginal Returns Production
Returns Function

Marginal
Product
 Decreasing Marginal Returns
Decreasing Marginal Returns is when the marginal
product of an additional worker is less than the
marginal product (MP) of the previous worker.
Each additional worker is not helping as much as the
previous worker, but they do help and positively increase
output.
MPcurrent < Mppreviously when an additional input
(labor) is added; TP is increasing at an decreasing
rate.
 Total and Marginal Product

Increasing Decreasing Negative Marginal

Marginal Marginal Returns Returns
Returns
Production
Function

The type of return (Increasing, Decreasing or

Marginal
Negative) is determined by the slope of the
total product line. Product
 Negative Marginal Returns

Negative Marginal Returns is when an additional

person decreases the amount of quantity produced.
Too many cooks in the Kitchen, New Workers Distract, etc.
MPcurrent < 0 when an additional input (labor) is
added; TP is decreasing.
 Revenue
Revenue is a measure of the amount of money a seller
accepts in exchange for a good(s) or service(s).
Total Revenue: The total amount of money accepted in
exchange for goods and services.
TR = P*Q
Marginal Revenue is the additional amount of money
received from producing (and we assume selling) the last
unit of a good or service.
MR = TR
Q
 Law of Diminishing Returns

 The law of diminishing returns:

as successive units of a variable resource are added
to a fixed resource, the marginal product of the
variable resource will eventually decline.
 Because there are fixed things (plant size) in the
short run, increasing variable inputs such as labor
will lead to diminishing returns.
 Costs Overview
Costs are looked at in different ways in the short run and
in the long run.
The short run is a time period in which
producers are able to change the quantities of
some but not all of the resources they employ.
A firm can adjust the number of workers but not the
plant’s capacity in the short run.
The long run is a time period sufficiently long
to enable producers to change the quantities of
all the resources they employ.

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 Short Run Costs
Total Cost: the cost of all the factors of production used
by a firm.
TC = FC + VC

Total Fixed Costs are the costs of Total Variable Costs are the
fixed factors of production used by a cost of the variable factors of
firm. These factors can not be production used by a firm.
changed in the short run. Examples Example quantity of labor
include capital, cost of land, etc. employed.
****There are no fixed costs in the
long run. 14
Marginal Cost
Marginal Cost is the change in total cost that results
from a one unit increase in output.
It is the cost of producing one extra unit of output.
MC = TC = TC1 – TC2
Q Q1 - Q2
See how TC changes as output changes.
 Average Costs
Average total costs: ATC=TC/Q

Note: TC=Q * ATC

Note: ATC and MC are different-

ATC – in general, what is the total cost of

producing each unit
MC- what was the cost of producing the last unit

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 Average and Marginal Cost Curves
$200 First unit:
Sps ATC = 200
MC & MC = 95
150
Then
TC = 200 (ATC*1)

Second Unit:
Costs

ATC
100 Sps ATC = 135
& MC = 70
Then
50 TC = 270 (ATC*2)
Third Unit:
Sps MC = 50
0 1 2 3 4 5 6 7 8 9 10 QThen
TC = 320 (TC at 2
+ MC)
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& ATC = 320/3
 Things to know about all market systems
1. An equilibrium is where no one has an
incentive to change their production.
In market systems:
if a firm can increase their profit by changing the price
or quantity of their goods, they will.
They will stop changing these factors when they have
reached the maximum amount of profit they possibly can
achieve, given the current conditions of the market.
This profit maximizing output and price is the
equilibrium.

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 Things to know about all market systems
2. Firms will produce where MR=MC: we prove this by eliminating all other
possibilities
 If MC<MR, a firm can make a higher profit by increasing their output.
 The additional revenue from selling one more unit is more than the extra cost to
produce that unit.
 So, a firm’s profit will increase if output increases, therefore the firm producing
where MC<MR has an incentive to change their price and/or output.
 If MC>MR, a firm can make a higher profit by decreasing their output.
 The additional revenue from selling one more unit is less that the extra cost to
produce that unit.
 So, a firm’s profit will increase if output decreases, therefore the firm producing
where MC>MR has an incentive to change their price and/or output.
 If MC=MR, a firm is making the highest profit possible.
 At this point, each firm does not have a way to increase profit more, so they have
no incentive to change their price and/or output.

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 Profit
Firm’s main goal is to maximize profit.
Profit is defined as Total Revenue (TR) minus Total Cost (TC).
TR=price*quantity=PQ
TC – depends
There exists two types of costs:
Explicit Cost: A Cost paid in Money.
Implicit Cost: Expenses an owner does not have to pay out of
pocket, such as Opportunity Cost, Owner Provided Capital (K), and
Owner Provided Labor (L).
Opportunity Cost- the highest valued, next best alternative that
must be sacrificed to obtain something or to satisfy a want.
Opportunity Cost- The cost of something is what you give up to get
it….
This cost measures the value of foregone opportunities to get
something.
 Types of Profit
Accounting Profit: looks at revenue as money taken in and
costs as the money it takes to produce things.
Defines Total Costs as explicit costs.
Acct Profit = TR – Explicit Costs

Economic Profit: looks at revenue as money taken in and

costs as the money it takes to produce things and expenses
an owner does not payout of pocket.
Defines Total Costs as explicit and implicit costs.
Econ Profit = TR – Explicit Costs – Implicit Costs
Econ Profit = Acct Profit – Implicit Costs
OR Acct Profit = Econ Profit + Implicit Costs
This means Accounting Profit will always be bigger than
Economic Profit
 A Simple Example of Types of Profit
Suppose Sam owns a smoothie shop:
TR: $150,000
Explicit Costs:
 Cost of fruit and yogurt: $20,000
 Cost of wages: $22,000
Implicit Costs:
 Sam’s forgone wages (owning a smoothie shop and not working
somewhere else): $34,000
Accounting Profit:
TR – EC = 150,000-20,000-22,000 = 108,000
Economic Profit:
TR – EC – IC = 150,000-42,000-34,000 = 74,000
 Economies of Scope
In making cost decisions, firms not only must evaluate how
much of one product to produce and how much input to use
to produce that product but also how many different types of
products to produce.

Economies of Scope are present if it is cheaper for one firm

to produce products jointly than it is for separate firms to
produce the same products independently.
TC(Q1, Q2) < [ TC(Q1,0) + TC(0,Q2)]

Diseconomies of Scope is where it is cheaper for separate

products to be produced independently than for one firm to
produce the same products jointly.
TC(Q1, Q2) > [ TC(Q1,0) + TC(0,Q2)]