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Production Theory
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Defining Costs
This page defines profit, revenue, and cost, including total cost, average cost and marginal cost.
Profit
The discussion of production theory is based on the premise that the business manager will decide to pursue strategies and practices that maximize profit. However, the discussion of MVP and MIC on a previous page does not provide enough information to determine profitability. Accordingly, this page describes an analysis whereby profit can be calculated.
Although the definition is obvious, it is helpful to restate that profit is the difference between total revenue (TR) and total cost (TC).
Total Revenue (TR): same as VTP; they are the same -- but when illustrated, revenue is measured in term of the units of output, rather than units of input. Now, the axes of the graphs are dollars and quantity of output.
TR is illustrated as a straight line if perfect competition is assumed
- When assuming perfect competition, Py is constant regardless of level of output (even though this assumption can be challenged).
Total Cost is a combination of cost of fixed inputs and the cost of variable inputs.
TC = TFC and TVC
Total fixed cost (TFC) is constant regardless of how many units of output are being produced. Fixed cost reflect fixed inputs.
Total variable cost (TVC) reflects diminishing marginal productivity -- as more variable input is used, output and variable cost will increase. As the additional variable input leads to a smaller increase in production (diminishing marginal productivity), a business must spend more on variable inputs to produce one more unit of output.
- TVC is the same shape as TPP except it is flipped because the axes are changed; but in both situations, the graph illustrates the relationship between variable input and output.
- Variable cost reflect variable inputs.
Total cost is illustrated as a vertical summation of the TFC and TVC.
Is it appropriate to describe the total cost curve as illustrating a series of enterprise analyses wherein each analysis represents a different quantity of variable input and the resulting change in the quantity of output?
Profit is maximized at the level of output on the graph where the vertical distance between TR and TC is the greatest.
More Thoughts about Profit
We also can consider the profit-maximizing question on a per unit basis; that is, revenue per unit and cost per unit.
- Revenue per unit is the market price for the output if the firm is in perfect competition. This is illustrated as a horizontal line; a business has the same selling price for its output regardless of how many units are produced
- Cost per unit, that is, average total cost, will change as the number of units produced (as the amount of output) increases.
Average total cost -- TC/y = ATC which is cost of production; some similarity to breakeven price in that total cost is divided by expected production; but instead of considering only one level of production, we are considering several levels of production at one time.
Recall -- ATC can be subdivided into AFC and AVC just as TC is comprised of TFC and TVC.
Average fixed cost -- AFC = TFC/y is the cost of each unit of production due to fixed cost; note that as the amount of output increases, the AFC decreases; once the firm reaches maximum production, and the firm moves into stage III, AFC retraces its curve.
Average variable cost -- AVC = TVC/y is the cost of each unit of production due to variable inputs; at low levels of production, AVC is decreasing, it will reach a minimum then increase; that range of increasing AVC corresponds to stage II of the production function.
ATC is sum of AFC and AVC; ATC = AFC + AVC; or ATC = TC/y
This information still does not reveal at what level of output the firm will maximize profit
A firm will continue to increase the level of output as long as the revenue from the additional output (marginal revenue, MR) is greater than the cost of producing that additional output (marginal cost, MC)
Marginal revenue -- additional revenue due to producing and selling one more unit of output
MR = (TR2 - TR1)/(Y2 - Y1) = Po
Marginal cost -- additional cost due to producing one more unit of output
MC = (TC2 - TC1)/(Y2 - Y1) = (TVC2 - TVC1)/(Y2 - Y1)
When graphing the MC, it will equal AVC at its minimum, ATC at its minimum, and then goes to infinity at the level of output where TPP is maximized. The level of output where MC is minimum is the level of output where MPP is at its maximum (inflection point); this is in Stage I, however.
In summary
- Profit is the difference between TR and TC.
- Profit per unit of output is the difference between market price and ATC.
- The firm will maximize profit by producing at the level of output where MR = MC.
The next section addresses profit maximizing level of output.
Last Updated October 22, 2009
Email: David.Saxowsky@ndsu.edu
This material is intended for educational purposes only. It is not a substitute for competent professional advice. Seek appropriate advice for answers to your specific questions.
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