Download Economics I

Cost, Revenue, and
Profit
Glen Whitman
Dept. of Economics
CSUN
Types of Cost
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Reminder: All costs are opportunity costs!
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Fixed costs: costs that do not change with the
level of production (or activity)
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Variable costs: costs that do change with the
level of production (or activity)
Fixed v. Variable Costs:
a philosophical look
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Not always the same as accountants’ use of
these same terms.
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Accountants need to classify certain expenditures as
fixed or variable for recording and administration.
Difference depends on period of time in
question.
Difference also depends on the decision being
made.
Marginal Decision-Making
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Marginal means next, additional, or incremental.
Refers to the change in something that results
from doing a little more of some activity.
Examples:
Marginal cost
 Marginal revenue
 Marginal utility
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Why Think Marginally?

Most decisions are made at the margin.
Will your firm increase or decrease production?
 Will you study an additional hour for your exam?

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Marginal analysis is crucial for maximization of
net benefits (profits).
Cost-benefit analysis of totals: only tells you
whether to do an activity or not.
 Cost-benefit analysis at the margin: tells you how
you can affect the totals.

Mathematically:
MC = ΔTC/ΔQ
MR = ΔTR/ΔQ
Using Marginal Cost and Marginal
Revenue to Maximize Profits

If MR > MC, do more.
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If MR < MC, do less.
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In short, get as close to MR = MC as possible.
Production Example
Quantity
Price
Total
Marginal Marginal
Revenue Revenue
Cost
500
100
21
5
100
10
90
900
80
27
15
80
1200
60
33
20
70
1400
40
39
25
60
1500
20
45
30
50
1500
0
51
The Case of Continental Airlines
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Other airlines would run an additional flight
only if they could fill 65% of the seats, which
was the breakeven point.
In the early 1960s, Continental began running
flights with 50% or fewer seats filled.
Continental outperformed its competitors. How
is this possible?
Source: Hall & Lieberman, Microeconomics: Principles and Applications, South-Western College
Publishing, 1998, p. 199.
Continental, continued
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Continental was basing decision on marginal
cost; others were using average cost.
Fixed costs of flights: reservation system, fees
for landing rights, interest on debt, etc.
Marginal costs of running flights: jet fuel, inflight meals, pilot hours, flight attendant hours.
Only the latter are relevant for the decision of
how many flights to run!
Continental, continued

Once you’ve decided to run a flight, what price
should you charge?
Jet fuel and pilot hours are all irrelevant now.
 What is relevant? Meals, maybe flight attendants (if
more are needed for more customers).
 Could make sense to charge very low prices to fill up
seats.
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Costs may be “fixed” for some decisions and
“variable” for others.
Other Applications

Television commercials
How many times should you run a commercial?
 How many different commercials should you make?
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Hiring decisions
How many labor hours should you hire?
 How many different workers should you hire?
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Number of store locations
Hours of operation
Typical Behavior of MC
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May be constant if you buy in a competitive
market.
But usually it’s increasing, for two reasons:
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Workers have diminishing marginal productivity.
You may have to pay higher prices to attract more
labor and other resources from alternative uses.
Typical Behavior of MR
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May be constant if you sell in certain types of
highly competitive market.
But it’s usually decreasing for two reasons:
You have to lower price to sell more.
 You face diminishing returns to your efforts.

duplication of effort
 diversion of previous revenues
 reaching most likely targets first
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What If Your Costs and Benefits
Don’t Arrive at the Same Time?
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The time value of money: a given quantity of
money is worth more now than later, because
money now can earn money later.
Example: $1000 today with a 15% annual
interest rate is $1150 next year. So I’d rather
have $1000 now than $1000 later.
To compare monetary quantities, you must put
them all in the same time period.
Present and Future Values

If you have an amount PV and invest it at
interest rate r for i periods, then its future value
FV is:
FV = PV(1 + r)i
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If you will receive an amount FV i periods in the
future, then its present value PV is:
PV = FV/(1 + r)i
Using Present & Future Values
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Use an appropriate interest rate.
What if you’re borrowing money for a present
cost, in expectation of future benefits?
What if you’re using your own money for a
present cost, in expectation of future benefits?
Interest rate depends on degree of risk.
If there is a stream of costs or benefits, discount
each year separately (or use a table).