To figure out how firms calculate profit, it’s probably easiest to use the dreaded cost curves. So you need to understand the underlying cost concepts behind the shape of the curve. Also, there’s a discussion of market types which is also beneficial for companies to understand so they can judge their market power
Before we look at the cost curves in detail, we need to start with a few definitions.
Although we will be looking at the costs of a firm in terms of wages, raw materials, etc., economists like to start with a more abstract term. What does an economist mean by the economic cost of production? This is the opportunity cost of production. As you have probably read in more textbooks than you care to remember, this is the value that could have been generated had the resources been employed in their next best use. Remember that this concept of opportunity cost is useful when dealing with production possibility frontiers.
It is also important that you understand the difference between fixed cost and variable costs. Fixed costs are those that do not vary as output increases. Examples include rent, office costs and, certainly in the short run, machinery.
Variable costs, surprise surprise, are costs that do vary as output increases. The best example is raw materials. If a firm wants to make more chocolate, for example, it will need more cocoa beans and sugar.
Labour is also a variable cost, but some textbooks refer to it as semi-variable. Many firms have a fairly permanent staff. If they need to increase output, the workers will be asked to do overtime. In a sense, this is still variable, because the number of man-hours worked will still rise, but the actual number of workers may not. Of course, if a firm is planning some serious expansion, the actual number of workers employed will eventually rise, but employers are nervous about employing someone permanently who may not be required in the long term. The cost of letting a permanent member of staff go can be much higher than sacking a part-time or contract worker.
Total, marginal and average costs
As with total, marginal and average product in the last Learn-It, we first need to define total, average and marginal cost.
Total cost (TC). This is the total cost to the firm of producing a given number of units. This can be sub-divided. Total cost = total fixed costs + total variable costs (or TC = TFC + TVC). A cost is either fixed or variable. There is no third group. If a cost is not fixed, then, by definition, it must vary with output.
Average cost (AC). This is the cost, on average, per unit of output produced. If a firm made 100 bars of chocolate at a total cost of £10, then the cost, on average, per bar of chocolate produced, is 10p. So, algebraically:
It also follows that average cost = average fixed cost + average variable cost (AC = AFC + AVC). This is derived by simply dividing both sides of the total cost equation by Q. Average cost is often called average total cost so as to distinguish it from AFC and AVC.
Marginal cost (MC). This is the additional cost incurred by a firm as a result of producing one more unit of output. It is the extra cost at the margin (i.e. by producing the marginal unit of output).
Why the marginal curve cuts the average curves where they are momentarily flat
Imagine you are with a group of friends, waiting at the bus stop in anticipation of a great Friday night out. You all decide to check that you have enough money for the frivolities that lie ahead.
There are nine of you and, coincidentally, you all have exactly £20 each. This means that the average amount of money that each of you holds is also £20.
Your tenth friend is late, but finally arrives. He only has £10 on him. This means that between you the total amount of money is £190, and the new average is £190 divided by 10, which is £19. The arrival of your tenth friend has reduced the average because the amount he added to the total, the marginal, was less than the…