ECO204 Week3 D2

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8 Costs and Profits

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Learning Outcomes

After reading this chapter, you should be able to

• Explain the difference between accounting profit and economic profit.

• Calculate the various short-run cost measures and illustrate their relationships graphically.

• List the reasons for economies and diseconomies of scale.

• Determine the profit-maximizing level of production.

172

Introduction

Introduction In 1978 the Airline Deregulation Act removed government control over fares, routes, and market entry (of new airlines) from commercial aviation. The goal was to allow market forces to encourage entry into air transportation by new carriers, entry into new markets by current carriers, and generally reduce the rigid practices previously enacted by the Civil Aeronau- tics Board. The first observable result of this deregulation was increased competition in the industry. Price competition was observed for the first time. Other effects of competition were greater route frequency, better on-time performance, more baggage efficiency, and expanded frequent flyer programs.

Although the average fare per passenger mile did fall from 33.3 cents in 1974 to 13.6 cents in 2016 (in real terms), deregulation also brought about a wave of bankruptcy filings, union disputes, and a sky-high number of passenger complaints (Breyer, 2011; Burtless & Haveman, 1987). After the deregulation, most airlines simply went out of business; a few were taken over by the major airlines.

By 2015 the number of domestic airlines was down to just four primary carriers. Although United Airlines (2018) generated $9.4 billion in passenger revenue in 2017, its net income in that same year was just $580 million. Why is United Airlines not more profitable? What is so costly about operating an airline? Will there be another merger? The discussion of costs and profits in this chapter will shed more light on this issue.

As explained in the preceding chapter, entrepreneurs attempt to minimize costs in order to increase profit. But we need to be careful to define costs of inputs in terms of opportunity cost. Measuring costs of inputs in this way can be a problem if you are not used to thinking in terms of opportunity cost and are more used to thinking in terms of explicit cost. Explicit costs are accounting costs or money outlays. Implicit costs are those additional costs implied by the alternatives given up. When economists talk of costs, they mean all opportunity costs— explicit and implicit.

Some examples can make this clearer. Suppose you have the option of working 2 hours of overtime at $18 an hour or going to a movie that costs $12. The cost of attending the movie is the $12 ticket charge plus the $36 you could have earned working overtime. Attending the movie will cost you $48. The explicit cost is $12. The implicit cost is $36. Or suppose your rich aunt in Arizona sends you her “old” Tesla that is worth $50,000. She doesn’t care what you do with it. You are excited because now you can own an electric self-driving car at very low cost. You need only pay for electricity, oil, insurance, and repairs. Right? No! You have forgotten to include a calculation of the implicit cost. If you sold the car, you could invest the $50,000. You could put the money in an investment fund that earns 3% per year. In other words, you are giving up $1,500 per year if you choose to drive the Tesla. The total cost is the implicit cost of that $1,500 plus the explicit costs of electricity, oil, insurance, and repairs. Do you still want to drive the Tesla?

173

Section 8.1 Accounting Profit and Economic Profit

8.1 Accounting Profit and Economic Profit In Chapter 3 Maya’s lemonade stand was used as an example of a firm as a supplier. Now sup- pose we can obtain Maya’s account books in order to calculate her profits. Let’s say she had total revenue of $15,000 for the summer. Her books say that she had accounting (explicit) costs of $11,500. Her accounting profit is $3,500, determined by subtracting her explicit costs from her total revenue. These are the profits she reported for tax purposes. Economists think that profits figured in this way are misleading because implicit costs are ignored. If Maya’s skills and talents are worth $2,000, this is an opportunity cost. The total of her implicit costs plus her explicit costs is $13,500. She will be earning an economic profit of $1,500. Economic profit is the difference between total revenue and the total of explicit and implicit costs of production. An entrepreneur who does not earn a profit that is at least equal to his or her opportunity cost will quit the endeavor.

Economics in Action: How to Look at Years With Economic Lenses

Perhaps you have opened a restaurant and want to look at what you have made over the year, which is also known as your accounting profit. But you’re also thinking about your old job and wondering how much you could have made if you had not changed your job. This implicit cost, added to your explicit (accounting) costs, would show you the total costs to be subtracted from your total revenues in order to find your economic profit. Follow the link to The Khan Academy (http://www.khanacademy.org) and search for the video “Economic Profit vs Accounting Profit” to find out how the two compare to each other.

Opportunity Cost and Normal Profit The opportunity cost of capital and enterprise is referred to as normal profit. A normal profit represents the rate of return that is necessary to keep capital and enterprise in an industry. Say, for example, the normal profit is 8%. Then a firm earning an 8% rate of return is earning zero economic profit because its capital and enterprise could earn 8% elsewhere. The con- cept of normal profit is used by regulators in setting prices for public utilities such as electric and telephone companies. If an electric utility is not granted a price increase and the rate of return on its capital falls below the normal profit, capital will leave that industry to try to earn its opportunity cost elsewhere.

In other words, normal profit is part of the implicit cost structure of firms. Just like the “free” Tesla, a firm’s capital, even if it is paid for, represents wealth that could be sold and invested elsewhere. The calculation is, in principle, exactly the same as in the Tesla example.

http://www.khanacademy.org

174

Section 8.1 Accounting Profit and Economic Profit

Figure 8.1 shows the relationships of the concepts of accounting profit, economic profit, and normal profit. Total revenue is the same in both bars, but the difference between economic profit and accounting profit is the implicit costs, including normal profit.

Figure 8.1: Economic profit and accounting profit

Economic profit differs from accounting profit by the amount of implicit costs.

Accounting profit

Accounting costs = explicit costs

Implicit costs (including normal

profit)

Economic profit

Economic costs = implicit costs + accounting costs

Total revenue

Accounting costs = explicit costs

A correct definition of costs is important because economists use costs and profits to predict behavior. When economic profits are positive, economists predict that new firms will enter an industry. When economic profits are negative, firms will leave the industry. When economic profits are zero, existing firms will remain and earn normal profits, but no new ones will enter. Economic profit serves as a signal, calling forth entry into or exit out of an industry. If a firm is not earning a normal profit in its present industry, its resources will flow to an indus- try where a higher rate of return can be earned. If more than a normal profit is being earned in an industry, resources will be attracted to it.

The Use of Accounting Profits in Economic Analysis Economic theory is based on the concepts of economic costs and economic profit, but these data aren’t usually available for real-world analyses. Economists are suspicious of accounting costs and accounting profits for at least two reasons. The first has to do with the way in which accounting costs are gathered. The second has to do with the discrepancy between account- ing costs and economic costs.

175

Section 8.2 Cost in the Short Run

Firms may have incentives to maximize or minimize the calculation of their accounting profits depending on the purpose for which the information will be used. Since federal income tax is paid on accounting profits, firms have incentives to make profits look as small as possible for the Internal Revenue Service. On the other hand, a firm seeking to raise capital would want to make the profits appear as large as possible for potential investors. There are techniques that can be used to manipulate accounting profits. Some flexibility in measuring profits comes from the very different ways in which firms can account for items whose value is estimated subjectively. These techniques fall into three categories: altering approved accounting meth- ods, manipulating managers’ estimates of costs, and changing the time periods in which costs are paid and revenues are received. Even though accounting profits may not reflect the eco- nomic reality, these data are all that are available.

8.2 Cost in the Short Run The production function relates inputs, such as raw materials and labor, to outputs, or quantity of goods and services produced. The inputs in the production function have prices and rep- resent production costs to the firm, making it possible for the firm to develop cost schedules.

Defining Costs An example of a cost schedule for a firm is given in Table 8.1. Total cost (TC) is simply the sum of all the costs of production for a given level of output. Total cost is made up of two compo- nents: total fixed costs (TFC), like rent and insurance, and total variable costs (TVC), such as wages and utilities. Total fixed costs are the costs of the fixed inputs; they can’t be avoided or changed in the short run. These costs will be the same regardless of how many units of out- put the firm produces. Total variable costs vary directly with output. Variable costs increase as more output is produced because more of the variable inputs have to be purchased if more output is to be produced. Thus, TFC + TVC = TC.

Total fixed costs and total variable costs are shown in the second and third columns in Table 8.1. In this cost schedule, we assume that the firm has already identified the combination of inputs that minimizes the total variable costs for each level of output. These figures represent the cost of the economically efficient input combinations.

Consider this example using the information from the first four columns in Table 8.1: Suppose a firm hires one additional worker, and output increases from 20 to 30 units. The variable cost increases by the wage of that worker (for a given time period), which is $32, bringing the total variable cost to $108. The total fixed cost stays constant at $60, since fixed costs are not related to output. The total cost of 30 units is therefore $108 + $60 = $168. If the firm would like to increase its output to 40 units, the variable cost would increase another $32, bringing total variable cost to $140. The total cost of 40 units is $140 + $60 = $200.

176

Section 8.2 Cost in the Short Run

Given the information in the first four columns of Table 8.1, the rest of the columns are com- puted as follows. Average fixed cost (AFC) is total fixed costs of production divided by the quantity of output. Average variable cost (AVC) is total variable costs divided by the number of units of output. That is,

AFC = TFC

and

AVC = TVC

Average total cost (ATC) is equal to the total costs of producing a quantity of output divided by that level of output. That is,

AC = TC Q

Recall from Chapter 6 that marginal cost (MC) is the change in total cost as a result of produc- ing one more (or one less) unit of output. That is,

AC = change in TC change in Q =

change in TVC change in Q

Marginal costs are really marginal variable costs because there are no marginal fixed costs. When output changes, the change in fixed costs is zero.

Table 8.1: Cost schedule for a firm

Output per week

(Q)

Total fixed costs

(TFC) ($)

Total variable

costs (TVC) ($)

Total cost (TC)

($)

Average fixed cost

(AFC) ($)

Average variable

cost (AVC) ($)

Average total cost (ATC) ($)

Marginal cost

(MC) ($)

0 60 0 60 — 0 — 0

10 60 40 100 6 4 10 4

20 60 76 136 3 3.8 6.8 3.6

30 60 108 168 2 3.6 5.6 3.2

40 60 140 200 1.5 3.5 5 3.2

50 60 175 235 1.2 3.5 4.7 3.5

60 60 216 276 1 3.6 4.6 4.1

70 60 262 322 0.86 3.74 4.6 4.6

80 60 312 372 0.75 3.9 4.65 5.0

90 60 369 429 0.67 4.1 4.77 5.7

100 60 460 490 0.6 4.3 4.9 6.1

177

Section 8.2 Cost in the Short Run

Let’s return to the example above using the information in Table 8.1: Suppose a firm hires one additional worker and output increases from 20 to 30 units. The average variable cost (AVC) of 20 units is TVC/Q = $76/20 = $3.8 per unit. The average variable cost of 30 units is $108/30 = $3.6 per unit. Although total fixed cost stays constant at $60 across all levels of out- put, average fixed cost (AFC) does change, since the calculation for average fixed cost involves the quantity of output produced. For example, the average fixed cost of 20 units is $60/20 = $3 per unit. However, the average fixed cost of 30 units is $60/30 = $2 per unit. Average fixed cost decreases as output increases because the total fixed cost is spread out across a greater amount of output.

As shown in the formulas, the average total cost of 20 units can be calculated two different ways:

When Q = 20, average total cost can either be TC/Q = $136/20 = $6.8 per unit, or we can also calculate ATC = AVC + AFC, where ATC = $3.8 + $3 = $6.8 per unit.

For Q = 30, ATC = TC/Q = $168/30 = $5.6 per unit, or ATC = AVC + AFC = $3.6 + $2 = $5.6. Mar- ginal cost (MC) is the change in total cost per unit for a given change in quantity. When Q = 20, TC = $136. When Q = 30, TC = $168; thus, MC = ($168 – $136)/10 = $3.2.

Economics in Action: The Costs of Selling Puppies

There are multiple costs to consider when running a business, and understanding the difference between fixed costs and variable costs is the best place to start. Watch an example of a puppy business to learn more here: https://www.youtube.com/watch?v=nQ5APwtB-ig.

Cost Curves We can draw a series of cost curves from the data given in Table 8.1. The total fixed costs, total variable costs, and total cost curves are shown in Figure 8.2. The shape of the produc- tion function determines the shape of the total variable cost curve and also the shape of the total cost curve, because it is the summation of the fixed cost and the variable cost curve. As the amount of the variable input increases, both output and variable costs increase. If output increases more rapidly than input cost, variable cost increases at a decreasing rate. In Figure 8.2 decreasing costs are shown as output increases from zero to Q1. From Q1 to higher levels of output, output increases less rapidly than the input cost increases. Then variable costs increase at an increasing rate.

Now let’s look at average and marginal costs. Figure 8.3 shows the average fixed costs (AFC), average variable costs (AVC), average total cost (ATC), and marginal cost (MC) curves for a firm. The AFC curve declines continuously, getting closer and closer to the horizontal axis of the graph. This decline occurs because fixed costs are constant. Since average fixed costs are calculated by dividing that constant amount by an ever-increasing quantity (levels of output), the average fixed costs become smaller and smaller as output increases.

https://www.youtube.com/watch?v=nQ5APwtB-ig

178

Section 8.2 Cost in the Short Run

Figure 8.2: Total cost curves

The shapes of the total cost (TC) curve and total variable costs (TVC) curve are a reflection of the production function. From zero output to an output level of Q1, total cost and variable cost increase at a decreasing rate. Beyond output level Q1, costs increase at an increasing rate.

Cost

Output/time periodQ 1

TFC

TVC

Figure 8.3: Marginal and average total cost curves

Average fixed costs (AFC) decline continuously, while average variable costs (AVC) decline, reach a minimum, and then increase, resulting in a U-shaped average total cost (ATC) curve. The marginal cost (MC) curve intersects the ATC curve at the minimum ATC.

Cost

Output/time periodQ 1

ATC

AFC

179

Section 8.2 Cost in the Short Run

The U-shaped AVC curve represents returns to the variable inputs that at first increase and then diminish. The variable inputs are being added to a given quantity of fixed input, such as fixed-size physical operations. Increasing returns occur for output levels up to Q1 in Figure 8.3.

At output levels above Q1, returns to the variable inputs decline. That is, returns are diminish- ing. The AVC and ATC curves are U-shaped because of decreasing costs (increasing average product) for small levels of output and then increasing costs (decreasing average product) for higher levels of output. Average cost declines sharply at first because average fixed costs drop rapidly and then more slowly.

Note that the MC curve intersects the ATC—point A in Figure 8.3. These points illustrate the relationship between average and marginal values, discussed in the preceding chapter. For the AC and AVC to be declining, marginal cost must be below average cost. For the AC and AVC to be rising, marginal cost must be above the average cost. Thus, marginal cost and average cost must be equal where the AC curve is at its minimum point. Think about how your grade point average goes up or down depending on your grade in an additional (marginal) course. Also, note that when the MC curve starts to rise as output is increased, it is still below the AVC curve. Thus, average variable costs are still falling. An average value falls as long as the mar- ginal value is below it, regardless of whether the marginal value is falling or rising.

The Relationship Between Product Curves and Cost Curves We have said that cost curves could be derived from production functions, because both show a relationship between inputs and outputs. Figure 8.4 shows the relationship between a pro- duction function (represented by product curves) and costs.

Figure 8.4: Relationships between product curves and cost curves

The cost curves are closely related to the respective product curves. When the product curve is increasing, the cost curve is decreasing, and vice versa.

0 Labor/ time

period

Output/ time period

Q 2

Q 1

L 1

L 2

TP L

AP L

MP L

180

Section 8.3 Cost in the Long Run

Figure 8.4 shows the marginal product (MP) and average product (AP) curves discussed in Chapter 7. In this case the variable input is labor. These curves are directly related to the cost curves presented in Figure 8.3. For example, the marginal cost (MC) curve is closely related to the marginal product of labor (MPL) curve introduced in Chapter 7. At those output levels where marginal product is increasing, reflecting increasing returns, marginal cost is decreas- ing. When the MPL curve is at its maximum, the MC curve is at its minimum point. When mar- ginal product is declining, reflecting diminishing returns, marginal cost is rising.

This relationship is based on simple logic. The cost curves simply measure the dollar value of inputs needed to produce a given output, and the production function measures outputs for a given amount of inputs. Given prices of resources, increasing returns have to mean decreasing marginal costs, and diminishing returns have to mean increasing marginal costs.

8.3 Cost in the Long Run In the long run, all productive resources are variable. Therefore, there are no fixed inputs in the long run. That means that there are also no fixed costs in the long run. All costs are vari- able in the long run. In fact, the long run is defined as the period long enough so that all inputs can vary.

Usually, the most important long-run decision is what size to construct the physical opera- tions. For a manufacturer of a good, such as Hershey’s, this could be the number of chocolate factories. For a service-based business, like Amazon, it could be the number of fulfillment cen- ters. Each possible size of a firm’s physical operations is represented by a short-run average cost (AC) curve. The long-run decision is based on the selection of the desired short-run aver- age cost curve. That choice will be based on the output the firm expects to produce, such as in chocolate (for Hershey’s) or quantity of packages shipped (for Amazon). Figure 8.5 illustrates this decision. Taking the example of Hershey’s, suppose the technological factors (given by the production function) are such that only three chocolate factories are feasible. These facto- ries are represented by curves AC1, AC2, and AC3 in Figure 8.5. The long-run decision of which short-run curve to operate on will depend on the planned output of the firm. If output is less than Q1, then the firm should operate using one factory plant represented by AC1, because its size will produce any output level between zero and Q1 at a per-unit cost that is lower than it would be for any other size. If an output level between Q1 and Q2 is planned, the firm should build two factories, AC2. If output is greater than Q2, the third factory (represented by AC3) should be built.

All these possible short-run curves shown in Figure 8.5 can be combined to determine the best option for the firm in the long run. The long-run average cost (LRAC) curve repre- sents the lowest attainable average cost of producing any given output. It is a curve tangent to all the possible short-run average cost curves. For example, if you knew you were going to produce exactly Q2 units of output, the plant size represented by AC2 would have the lowest average cost.

In Figure 8.6, point A indicates the optimal-size plant. The optimal-size plant is represented by the short-run average cost curve with the lowest attainable per-unit costs.

181

Section 8.3 Cost in the Long Run

Figure 8.5: Alternative number of chocolate factories

The determination of how many factories to build is a long-run decision of a firm. This decision is based on selection of the short-run cost curve that is optimal for the expected output level.

Cost

Output/time periodQ 1

AC 1

AC 2

Q 2

AC 3

Figure 8.6: Long-run average cost curve

The long-run average cost (LRAC) curve represents the lowest attainable average cost of producing any level of output. Q1 and Q2 correspond to the Q1 and Q2 in Figure 8.5. The optimal size of physical operations for producing Q2 is represented by point A, where the minimum point on a short-run average cost curve is tangent to the long-run average cost curve at its minimum point.

Cost

Output/time periodQ 1

LRAC

Q 2

182

Section 8.3 Cost in the Long Run

Economies and Diseconomies of Scale The LRAC curve in Figure 8.6 is U-shaped. This shape means that, at first, as physical opera- tions and firm output increase, long-run average costs fall. After a certain point (point A on Figure 8.6), however, producing more becomes more costly. As the firm’s size continues to increase, average cost begins to rise. Economists refer to these changes in long-run average cost due to increased plant size as economies and diseconomies of scale. Economies of scale are declines in long-run average cost that are due to increased plant size. Diseconomies of scale are increases in long-run average cost that are due to increased plant size. As scale (firm size) increases, economies (cost savings) result. After a while, further growth results in disec- onomies (higher average costs).

Global Outlook: Protecting New Domestic Industries

For many products, economies of scale are an important factor in being able to compete in a global market. If the world market is not large, there may be room for only a few suppliers who take advantage of cost savings in large-scale production or service output. The first producer may enjoy a lasting advantage for that reason. Scale economies are especially important for large durable goods, such as aircraft and heavy machinery, or for first movers into new service industries, such as Airbnb. Consumers also benefit from economies of scale because lower costs often mean lower prices.

As a result of these large-scale economies, policy makers have often argued that manufacturing needs to be protected from foreign competition in order to get a toehold in domestic markets and someday be able to compete in global markets. This position, often referred to as the infant industry argument, was strongly advocated by Alexander Hamilton (1755–1804), who served as the first secretary of the U.S. Treasury in Washington’s cabinet. Hamilton was a promoter of economic growth and a strong federal government.

Many advocates of protection point to the success of China, which experienced rapid economic growth over several decades with restrictive trade barriers. Regardless of the arguments, it’s difficult to make a convincing case for protecting industries in places like the United States. How can policy makers recognize promising industries in advance? Are they better equipped to discover these industries than private investors? Also, unless new industries can attain economies of scale to help them be cost competitive on world markets, the government may have to protect the industries into old age.

Economics in Action: Why Do Countries Restrict Trade?

It may make sense to protect an industry temporarily so that it can grow to successfully compete in world markets, but what are the other reasons that a country might want to restrict trade? Learn more here: https://www.youtube.com/watch?v=Y2X3KPilAt0.

https://www.youtube.com/watch?v=Y2X3KPilAt0

183

Section 8.3 Cost in the Long Run

As a firm increases its scale of operations, it usually can employ more specialized machinery. Also, large firms are often able to obtain quantity discounts on intermediate products from other firms, such as discounts or cost breaks for purchasing a certain quantity.

Diseconomies of scale are slightly harder to grasp. However, they are familiar to anyone who has dealt with bureaucracies, public or private. Diseconomies result from the fact that as an organization becomes very large, communication and coordination become more difficult and time consuming, and control from the top diminishes. After a firm has taken advantage of the gains to be achieved by growing larger, it becomes more difficult for upper management to monitor production activity and easier for some workers to shirk. With further growth, the LRAC curve turns upward.

Optimal-Size Plants in the Real World If you look at real-world industries, you see many different-sized firms operating side by side in the same industry. Steel, for example, is produced by both very large and very small firms. If there is a single, optimal size plant for each industry, why do firms of so many different sizes exist? Economists have spent much time investigating real economies of scale. One common type of LRAC curve is shown in Figure 8.7, which shows economies of scale over a large range of output. This situation occurs in the auto industry, where there are a few very large firms. The optimal-size firm in Figure 8.7 produces at output level Q1, which conceivably might rep- resent the normal sales of the entire industry. In such industries, a natural monopoly can occur. A natural monopoly is a monopoly that emerges because of economies of scale. The size of the market is such that there is room for only one optimal-size firm. Many public utili- ties (such as gas and electric companies) need to have all the sales in a market in order to become large enough to be of optimal size.

Figure 8.7: Economies of scale and a natural monopoly

When economies of scale exist over large ranges of output, one large firm may be most efficient.

Cost

Output/time periodQ 1

LRAC

184

Section 8.4 Profit Maximization

The benefit of economies of scale may not be passed along to consumers. Economies of scale mean that it is efficient to have production carried out by large firms. However, these large- scale firms may exert monopoly pricing power so that lower costs are not passed on to con- sumers in the form of lower prices. We will return to this problem in the chapter on monopoly.

8.4 Profit Maximization The choice of total output in goods or services is one of several decisions that determine a firm’s profits. The firms examined here and in the next three chapters are all profit-maximizing firms (excluding, for example, nonprofit companies). What does profit maximization mean in terms of production decisions? It means that, in the short run, the firm will attempt to choose the output that maximizes the difference between total revenue and total cost. Total revenue (TR) is the price an item sells for multiplied by the number of units sold. Marginal revenue (MR) is the change in total revenue from selling one more (or one less) unit.

Profit will be maximized at the level of output at which marginal revenue equals marginal cost, or MR = MC. For any output level where marginal revenue is greater than marginal cost (MR > MC), the firm adds to its total profit with each unit sold. For example, if the market- clearing price is $10, and at output Q1 = 5,500 the marginal cost is $8, an additional unit sold will raise total revenue by $2 more than it will increase marginal costs. At this level of output, with total revenue increasing faster than total cost, it is in the firm’s interest to pro- duce and sell additional output. As long as MR continues to be greater than MC, total revenue will increase faster than total cost, and each additional unit sold will add to the firm’s profit. Therefore, whenever MR is greater than MC, the firm should increase its output and sales to increase profits.

If marginal cost is greater than marginal revenue (MC > MR), an increase in output will cause total costs to increase faster than total revenue. If at output level Q2 = 7,500 marginal rev- enue (the price) is $10 but marginal costs have risen to $1100, an additional unit produced would cause the firm’s total costs to rise by more than its total revenue, and profits would be reduced. Whenever marginal cost is greater than marginal revenue, the firm should reduce production to maximize profits.

To recap, if marginal revenue is greater than marginal cost, the firm should expand produc- tion and sales. If marginal cost is greater than marginal revenue, the firm should decrease production and sales. At the point at which marginal revenue and marginal cost are equal, it would be unprofitable to either increase or decrease production. The decision rule for profit maximization, then, is to produce that level of output at which marginal revenue equals mar- ginal cost (MR = MC). This rule is just another way of saying, “Produce where total profit is at its maximum,” or “Produce where total revenue exceeds total cost by the largest amount.” Generally, the MR = MC rule is the most convenient to work with.

It’s easy to see this relationship on a graph. In Figure 8.8 the price is fixed by the market; the firm is able to sell all of its output at this price. Thus, the total revenue (TR) curve in

185

Section 8.4 Profit Maximization

Figure 8.8(a) is a straight line from the origin. The marginal revenue (MR) curve in panel (b) is a horizontal line at the level of the price of the product. The total cost (TC) curve is consis- tent with the law of diminishing returns beyond output level Q1 = 5,500. The vertical distance between TR and TC is greatest at output level Q2 = 7,000. Note that if output were decreased below Q2, MC would fall below MR, and TR would fall by more than TC. Thus, profit would fall. If output were increased above Q2, TC would increase more than TR, and MC would be above MR. Again, profit would fall. Profit is at a maximum at Q2 = 7,000.

Figure 8.8: Profit maximization

Profit is maximized where marginal cost is equal to marginal revenue. The vertical distance between total revenue (TR) and total cost (TC) is greatest in panel (a) at Q2 = 7,000, the same level of output where marginal cost (MC) equals marginal revenue (MR) in panel (b).

Cost

(a)

Output and sales/ time period

TRTC

MR = Price

Cost

(b)

Output and sales/ time period

5,500 7,000 7,500

7,5007,0005,500

The decision to produce that output where marginal revenue equals marginal cost will come up again and again, so it is important to make sure you understand it. It will always be true that maximum profit will be obtained by operating at the point where MR = MC, as long as the firm stays in business.

186

Section 8.4 Profit Maximization

Check Point: Rules for Profit Maximization

• MR > MC Expand output. • MR = MC Profits maximized, leave output unchanged. • MR < MC Reduce output.

Policy Focus: State Gambling

For many years the only state in the United States that legalized gambling to generate tax revenue was Nevada. However, in recent years most states have legalized or at least discussed the legalization of certain forms of gambling. When the idea is to generate revenue for public projects, the most common form of sanctioned gambling is a state-run lottery. It has even been suggested that the federal government run a lottery and use the profits to retire the federal debt! State governments usually earmark the proceeds from a lottery for some special purpose—most commonly, education.

In 2017, 44 states plus the District of Columbia had state-run lottery operations. The lottery generated net revenue of over $80 billion for the states. This rapidly growing source of revenue takes some pressure off taxes as a source of funds for state projects. In the 1980s alone, state revenue from lotteries grew almost 1,000%. Some of this growth came from the expansion of lottery activity. In 1980 only 14 states had lotteries; by 1990 the number had grown to 33, and 10 more states joined by 2010 (National Conference of State Legislatures, 2010). In 2016 six states—Alabama, Alaska, Hawaii, Mississippi, Nevada, and Utah—did not have state-run lotteries. Nevada and Mississippi still take in substantial revenue from taxes on other types of gambling.

Some people feel that lotteries are a very regressive form of tax because the poor spend a higher percentage of their income in buying lottery tickets. Others, who support the lottery concept, argue that a lottery ticket is a voluntary purchase. Thus, a lottery cannot be viewed as a tax because people purchase the tickets of their own free will. Some advocates point out that people are going to gamble anyway, so the state might as well get involved and make some profit to do “good things,” such as spending more on education. However, the odds in state lotteries are much poorer than in other games of chance. Although states spend roughly 5% of the revenues in administrative costs to run the lottery, the states still keep an average of 33% of lottery bets (Gandel, 2016). That percentage is much higher than the “house share” in casino gambling or off-track betting. In addition, large winnings are usually paid in installments over 10 to 26 years and not all at once, unless winners are willing to take a “cash option” of 45% to 55% of the jackpot.

(continued)

Photos.com/Thinkstock In recent years most states have legal- ized or discussed legalization of cer- tain forms of gambling. But for many years the only state with legalized gambling was Nevada, which used gam- bling to generate tax revenue.

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Conclusion

Conclusion We may find a partial answer to the exit of over one hundred firms from the airline industry in the concept of economies and diseconomies of scale. Smaller airlines could not reach the size economies that are needed to spread some costly expenditures over large numbers of passengers. The first cost that can be spread is the cost of flight frequency. Most business passengers prefer frequent flights in order to accommodate schedule changes. If you are a business traveler, you prefer an airline that flies 10 flights a day between two cities over an airline that has only two flights per day. The convenience of the more frequent flights is a cost to the airline. A second cost is the expense of maintaining sophisticated reservation sys- tems and customer service phone lines that are well staffed. Travelers want easy access to flight information and prices and do not want to be put on hold or face other types of incon- venience when they need assistance. Finally, smaller airlines could not offer enough service to establish “hub-and-spoke” service systems. In fact, most of the small carriers that were taken over by the major airlines were the “spoke” airlines, flying into “hubs.” When these air- lines were purchased, the service that they provided was available at lower cost because the larger carrier was able to take advantage of economies of scale.

Policy Focus: State Gambling (continued)

In many states the Sunday morning newspapers still carry a headline about the latest millionaire created by the lucky lottery drawing on Saturday night. The scene usually goes something like this: The newspaper reports that a local teacher, Maria, was the winner of a $6 million jackpot. “It hasn’t hit me yet,” she says, smiling broadly under the brim of a new lottery baseball cap. “But I wouldn’t know what to do if I quit my job. I like to work.”

Let’s consider the real value of Maria’s winnings, pretending that she won the MEGA Millions jackpot in the California State Lottery. First, if Maria chose the default option, she would not receive her $6 million all at once. Instead, she would receive 26 equal annual installments. If she chose the cash option, she would be paid now, but not $6 million. She would receive the cash that would have been invested by the state in order to provide 26 annual payments, which is around 50% of the total jackpot (California State Lottery, 2017).

Assuming that Maria opts for the cash option of $3 million, she still has to settle up with her tax obligations. Lucky for Maria, lottery prizes are exempt from California state and local personal income taxes! However, the Internal Revenue Service still expects the federal government to receive its share of the winnings. Based on Maria’s resident status, the California State Lottery must withhold from 25% to 30% in federal income taxes. She may even have additional tax liability, depending on her financial situation.

At this point, Maria is now down to roughly $2.25 million, or 37.5% of what the headlines reported. This is still a very nice prize, and most of us would be thrilled to be in her boots. But Maria is only 40 years old and plans to live to the ripe old age of 80, so perhaps it is a good thing that Maria “likes to work.”

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Conclusion

7. How can you discern from the table in Question 6 that the total fixed cost (TFC) is equal to $12?

8. Calculate the marginal cost for each widget in Question 6. How does the marginal cost compare to the average total cost for each quantity?

9. Graph the values of AFC, AVC, ATC, and MC using the completed table in Question 6.

Key Ideas

1. Economists calculate both implicit and explicit costs of production. Implicit costs are those costs implied by alternatives given up. Explicit costs are money expenditures, or accounting costs. When total cost (both implicit and explicit costs) is equal to total revenue, economists say there is zero economic profit. This means the firm is covering all economic costs, including a normal profit. When costs exceed revenues, firms and resources will leave an industry in order to earn the opportunity cost associated with those resources.

2. In the short run, as variable inputs are added to the fixed inputs, the firm may experience increasing returns at low levels of output. Eventually, the firm will incur diminishing returns at some higher levels of output.

3. The U shape of the long-run average cost (LRAC) curve is due to economies and dis- economies of large-scale production.

4. Profit maximization means that an entrepreneur will produce that level of output that equates marginal cost and marginal revenue. Profits are the greatest when total revenue exceeds total cost by the largest possible amount.

Critical-Thinking Questions

1. Why are cost curves normally U-shaped in the long run? Are they U-shaped in the short run for the same reason?

2. How does accounting profit differ from economic profit? 3. What is normal profit? Why is it important for a firm to earn at least normal profit in

the long run? 4. What is the difference between diminishing returns and diseconomies of scale? 5. What occurs when marginal cost equals marginal revenue? Why is this important? 6. ECON CORP produces widgets for everyday use. The total cost schedule is given in

the table below. In the table, TFC is total fixed cost, TVC is total variable cost, AFC is average fixed cost, AVC is average variable cost, and ATC is average total cost. Com- plete the table.

Widgets (per day)

Total cost (dollars) TFC TVC AFC AVC ATC

0 12

1 20

2 26

3 30

4 32

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Conclusion

Key Terms accounting profit The difference between total revenue and explicit costs.

average fixed cost (AFC) Total fixed costs of production divided by number of units of output.

average total cost (ATC) Total costs of producing a level of output divided by the number of units of output.

average variable cost (AVC) Total variable costs of production divided by the number of units of output.

diseconomies of scale Increases in long- run average cost that are due to increased plant size.

economic profit The difference between total revenue and the total of explicit and implicit costs of producing.

economies of scale Declines in long-run average cost that are due to increased plant size.

long-run average cost (LRAC) curve A curve tangent to all the possible short-run cost curves and representing the lowest attainable average cost of producing any given output.

marginal revenue (MR) The change in total revenue from selling one more (or one less) unit.

natural monopoly A monopoly that emerges because economies of scale mean that there is room for only one firm in that market.

normal profit The opportunity cost of capital and enterprise, or the rate of return that is necessary for a firm to remain in a competitive industry.

optimal-size plant The plant represented by the short-run average cost curve with the lowest attainable per-unit costs.

total cost (TC) The sum of all the costs of production for a given level of output.

total fixed costs (TFC) The costs of the fixed inputs of production, which can’t be avoided in the short run.

total variable costs (TVC) The total of costs that vary directly with the level of out- put, increasing as more output is produced.

10. Why does marginal cost intersect average variable cost and average total cost at their minimum?

11. There is a famous statement that claims, “There is no such thing as a free lunch.” Based on the concepts in this chapter, what does this mean in terms of opportunity cost?

12. At what size do universities start experiencing diseconomies of scale? What does the existence of many different sizes of universities indicate about the optimal size?

13. What is the length of time that distinguishes between short- and long-run costs? Can it be different for different firms? Provide an example.

14. What is the infant industry argument? How has it been used by the United States in the past?

15. There are many issues that governments face when determining whether to regulate a natural monopoly. Provide an example of a natural monopoly and describe how it could be regulated.