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COST, REVENUE AND PROFIT
CONCEPTS IN ECONOMICS
URL: http://www.spatialgovernance.com/economics/611lec02A.htm
© John S. Cook - Created on 9 July 2004
Last modified
27/07/06 18:00
Australian EST |
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1. FIXED, VARIABLE AND TOTAL COST CONCEPTS |
Introduction
Costs encountered in business, government and domestic
transactions are flows and occur over a period of time. People
often talk about costs without referring to a time period in
which the costs are incurred. However, the price that someone is
prepared to pay for a lasting asset such as a lot of land
establishes its value to the purchaser at that instant - a stock
concept. In contrast, the price that someone is prepared to pay
for a particular meal needs to be seen in the context of what it
costs per week or per annum to be fed. The prices that people
pay for things are either current or capital costs, depending on
the circumstances. This difference is fundamental to accounting
practice.Fixed Costs
(FC)
Costs incurred irrespective of the level
of output. Examples include things such as office rental, and
annual charges such as insurance and motor vehicle registration.
Diagram 2-1shows the fixed cost as a horizontal
blue line.
Variable Costs
(VC)
Costs that vary directly with the level
of output. Examples include fuel and materials used in production
or transportation. Diagram 2-1 shows variable cost as a green
line.
Total Costs (TC)
The sum of fixed and variable costs. i.e., TC = FC + VC
Diagram 2-1 shows total cost as a red
line. |
DIAGRAM 2-1
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Average Fixed Costs
(AFC)
Fixed costs (FC) divided by the level
of output (q). i.e., AFC = FC ÷ q
Diagram 2-2 shows the average fixed cost as a blue
line.Average Variable Costs
(AVC)
Variable costs (VC) divided by the
level of output (q)
i.e., AVC = VC ÷ q
Diagram 2-2 shows average variable cost as a green
line.
Average Total Costs (ATC)
Total costs (TC) divided by the level
of output (q). i.e., ATC = TC ÷ q = AFC + AVC
Diagram 2-2 shows average total cost as a red
line.
Marginal Costs
(MC)
Marginal cost is the cost of producing
an additional unit of output. Thus as output rises from q to
q+1, the marginal cost is the TC for producing q+1 units minus
the TC for producing q units. Where individual units of output
are sufficiently small compared with overall output, the slope
of the TOTAL COST curve approximates MARGINAL COST. |
DIAGRAM 2-2
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Recommended Reading on Costs:
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2. OTHER COST CONCEPTS |
The Nature of
Opportunity Cost
Opportunity cost is the benefit foregone in devoting resources
to one cause rather than another. Thus an investor can invest in a
profit-making venture by foregoing the interest that would accrue
if the money were left in an interest bearing deposit. The
incentive to invest occurs when the return on investing in a new
venture exceeds the return available from the existing use of a
resource. Thus, opportunity cost is usually the second- or
next-best option in the use of a resource. Moreover, a high rate
of interest becomes a disincentive to investment.
Ubiquity of Opportunity Costs
Opportunity cost has wide application as a concept. The
opportunity cost to a university student in learning something new
is the income that would have been available through using the
existing state of knowledge. Thus, to an economist, the cost of
education is more than the costs involved in payment of tuition
fees and should include the opportunity cost of the wages foregone
while undergoing tuition. |
Sunk Costs and Asset
Specificity
A number of other cost concepts
have special uses. As an example a 'sunk cost' is one involving
expenditure, however useful it may be, where there is no
salvage value or value on resale. As an example, the costs of
learning cannot be recovered by divesting oneself of that
learning. Similarly, investment in physical infrastructure
involving earthworks, pipelines, transmission lines, dams and particular
buildings may have negligible salvage value. In many instances, these
assets are usually not readily convertible to alternative uses. This
inability to allocate assets to a variety of alternative uses is often
referred to as 'asset specificity'.Private, Social and External
Costs
A separate page entitled 'The problem of externalities' introduces other
cost concepts such as 'external costs' and 'social costs'. These
terms are quite general and include more particular ideas such as 'environmental costs'. |
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References:
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3. REVENUE CONCEPTS |
Source of a Firm's
Revenue
A firm's ability to sell its goods and services depends on the
demand for the firm's product and the degree of market power
that the firm possesses within a particular market. Market power
relates to market share and market structure or how much one
firm contributes to the overall output of a whole industry.
The Nature of Competitive Markets
The archetypical model of 'perfect competition' involves a
'large number' of firms producing output for a market. A 'large
number' means sufficient for the decisions of a single firm to
have no appreciable effect on other buyers or sellers in the
market. The product of one competitive firm is much the same as
the product of other firms. Firms are free to enter and exit the
market if conditions are profitable. No firm has any lasting
advantage in production techniques or other knowledge that other
firms are unable to emulate or obtain. Markets in agricultural
produce often closely approximate the model of perfect
competition.
Monopoly Power
A firm has monopoly power if it produces a product for which
there is a high and continuous demand with no alternative
supplier of the same product nor suppliers of close substitutes
that can serve as a suitable alternative.
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Case 1 - Revenue
for Competitive Firms
A number of consequences flow from assuming the archetype
model of 'perfect competition'. Firms will make no sales or
revenue if they try to sell at more than the market price and
have no incentive to sell at a lesser price. This situation is
known as 'consumer sovereignty' where firms are 'price takers'
who take the price offered in the market.The revenue available to a 'perfectly
competitive' firm is equal to the price per unit of production
as determined by the market multiplied by the level of firm's
level of output. The firm has no incentive to limit its output
provided that the revenue per unit of production exceeds the
average cost of production. This potential revenue
Case 2 - Revenue for Monopolistic Firms
The archetypical conditions of 'pure monopoly' are that only
one firm produces for a whole market. Moreover, restrictions on market entry and exit apply to preserve the
monopoly.
Generally, demand for a product will increase
as price reduces. A graphical representation of this
relationship will show a demand curve that slopes downwards to
the right. Thus, the price available to a monopolistic firm is a
function of its output. A consequence is that the monopolist can
have access to a range of prices for its product and can limit
its level of output to maximise its profits. |
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References:
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4. PROFIT CONCEPTS AND PROFIT
MAXIMISING CONDITIONS |
Profit, Break-even
and Loss
TOTAL REVENUE and
TOTAL COST are flow concepts in that they occur over a
particular accounting period. In such a period, three situations are possible:
 | Profit making, where TOTAL REVENUE
is greater than TOTAL COSTS; i.e., TR > TC |
| Breaking even, where TOTAL REVENUE
equals TOTAL COST;
i.e., TR = TC |
| Making a loss where TOTAL REVENUE is
less than TOTAL COSTS;
i.e., TR < TC
(The ability to actually sustain a loss depends on being able
to draw on a store of the firm's capital or in borrowing from
another source) |
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Assuming a profit making situation
where TR > TC, three situations are possible:
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increasing profit, where MARGINAL
REVENUE is greater than MARGINAL COST; i.e., MR
> MC |
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profit maximisation, where MARGINAL
REVENUE equals MARGINAL COST; i.e., MR =
MC (at this point there is maximum departure measured
vertically between the TOTAL REVENUE and TOTAL COST
curves) |
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decreasing profit where MARGINAL
REVENUE is less than MARGINAL COST; i.e., MR
< MC |
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References:
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5. VALUE-ADDING PROCESSES |
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6. ECONOMIES AND DISECONOMIES OF
SCALE |
Nature and Genesis of Economies
of Scale
Economies of scale occur when
average costs of production decrease as output increases. An
important contribution to economies of scale resides in the nature
of knowledge and skills. There is often a substantial cost
associated with learning to do something for the first time and a
much smaller cost associated with using that knowledge on
subsequent occasions. Moreover, the knowledge and skills can
actually improve with practice. Similarly, there is often a high
cost associated with building a machine - or a computer program -
that can do something for the first time compared with the cost of
using the machine to perform the same function on subsequent
occasions. |
Diseconomies of Scale
Diseconomies of scale occur when
average costs of production increase as output increases. |
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References:
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7. NATURAL MONOPOLY |
The Nature of
Natural Monopoly
Natural monopolies occur when large scale production allows one
firm to produce the entire output for a market at a lower
average cost than any one of a number of firms producing part
only of the output for the market.Natural monopoly conditions often occur in
provision of reticulated services such as telephone,
electricity, water supply and sewerage. Duplication of
infrastructure is wasteful if it leads to under- utilisation of
existing infrastructure. (Under- utilisation of infrastructure
also provides an argument for increasing the density of urban
development.)
The high costs in establishing infrastructure
together with the strategic nature of investment in these
services from a social point of view means that governments
often:
| own the infrastructure, or |
| place the provision of these services under
some regulatory regime aimed at preventing abuse of monopoly
power |
Under competition policy, |
DIAGRAM 2-?
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Government Owned
Enterprises
Government Owned Enterprises (GOE's) or Government Business
Enterprises (GBE's) often come into being under conditions of
natural monopoly. In some instances, the technological or market
conditions that gave rise to conditions favouring natural
monopoly may change. Thus, in telecommunications, fibre
optics or satellite communications can compete with traditional
technology in existing physical infrastructure. |
Community Service
Obligations
Arrangements to corporatise or privatise former public
monopolies (often called government owned enterprises or GOEs) are usually subject to various
Community Service Obligations. In Australia, the part sale of
Telstra introduces tensions by trying to maintain community
service obligations involving some cross subsidisation. In
addition, a government licensing of activities such as banking
may restrict entry to a market, but governments may expect banks
to provide a level of service as a social obligation. |
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References:
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8. MARKET MECHANISMS |
Conventional thinking might suggest that a single firm may be able
to increase its profits if its is able to decrease its costs.
However, if there are numerous competing firms that can also
decrease their costs similarly, the most likely outcome is decreased
prices to consumers rather than increased profitability for
producers.
An outcome that is contrary to normal
expectations is often described as counter-intuitive. This counter-intuitive aspect of economics occurs
because there is not merely on a single isolated action a myriad of
second and subsequent rounds of actions and reactions. Thus, the
fact that one person can have no difficulty finding a job, for
example, does not mean that all unemployed people should have no
difficulty in finding a job. This fallacy is known to economists as the fallacy
of composition. |
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References:
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9. SUGGESTED FURTHER READING |
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