Cost, Revenue, and Profit Glen Whitman Dept. of Economics CSUN

Types of Cost Reminder: All costs are opportunity costs! Reminder: All costs are opportunity costs! Fixed costs: costs that do not change with the level of production (or activity) Fixed costs: costs that do not change with the level of production (or activity) Variable costs: costs that do change with the level of production (or activity) Variable costs: costs that do change with the level of production (or activity)

Fixed v. Variable Costs: a philosophical look Not always the same as accountants’ use of these same terms. Not always the same as accountants’ use of these same terms. Accountants need to classify certain expenditures as fixed or variable for recording and administration. Accountants need to classify certain expenditures as fixed or variable for recording and administration. Difference depends on period of time in question. Difference depends on period of time in question. Difference also depends on the decision being made. Difference also depends on the decision being made.

Marginal Decision-Making Marginal means next, additional, or incremental. Marginal means next, additional, or incremental. Refers to the change in something that results from doing a little more of some activity. Refers to the change in something that results from doing a little more of some activity. Examples: Examples: Marginal cost Marginal cost Marginal revenue Marginal revenue Marginal utility Marginal utility

Why Think Marginally? Most decisions are made at the margin. Most decisions are made at the margin. Will your firm increase or decrease production? Will your firm increase or decrease production? Will you study an additional hour for your exam? Will you study an additional hour for your exam? Marginal analysis is crucial for maximization of net benefits (profits). 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 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. 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. If MR > MC, do more. If MR < MC, do less. If MR < MC, do less. In short, get as close to MR = MC as possible. In short, get as close to MR = MC as possible.

Production Example QuantityPriceTotalRevenueMarginalRevenueMarginalCost

The Case of Continental Airlines Other airlines would run an additional flight only if they could fill 65% of the seats, which was the breakeven point. 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. In the early 1960s, Continental began running flights with 50% or fewer seats filled. Continental outperformed its competitors. How is this possible? Continental outperformed its competitors. How is this possible? Source: Hall & Lieberman, Microeconomics: Principles and Applications, South-Western College Publishing, 1998, p. 199.

Continental, continued Continental was basing decision on marginal cost; others were using average cost. 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. Fixed costs of flights: reservation system, fees for landing rights, interest on debt, etc. Marginal costs of running flights: jet fuel, in- flight meals, pilot hours, flight attendant hours. Marginal costs of running flights: jet fuel, in- flight meals, pilot hours, flight attendant hours. Only the latter are relevant for the decision of how many flights to run! 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? Once you’ve decided to run a flight, what price should you charge? Jet fuel and pilot hours are all irrelevant now. Jet fuel and pilot hours are all irrelevant now. What is relevant? Meals, maybe flight attendants (if more are needed for more customers). 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. Could make sense to charge very low prices to fill up seats. Costs may be “fixed” for some decisions and “variable” for others. Costs may be “fixed” for some decisions and “variable” for others.

Other Applications Television commercials Television commercials How many times should you run a commercial? How many times should you run a commercial? How many different commercials should you make? How many different commercials should you make? Hiring decisions Hiring decisions How many labor hours should you hire? How many labor hours should you hire? How many different workers should you hire? How many different workers should you hire? Number of store locations Number of store locations Hours of operation Hours of operation

Typical Behavior of MC May be constant if you buy in a competitive market. May be constant if you buy in a competitive market. But usually it’s increasing, for two reasons: But usually it’s increasing, for two reasons: Workers have diminishing marginal productivity. Workers have diminishing marginal productivity. You may have to pay higher prices to attract more labor and other resources from alternative uses. You may have to pay higher prices to attract more labor and other resources from alternative uses.

Typical Behavior of MR May be constant if you sell in certain types of highly competitive market. May be constant if you sell in certain types of highly competitive market. But it’s usually decreasing for two reasons: But it’s usually decreasing for two reasons: You have to lower price to sell more. You have to lower price to sell more. You face diminishing returns to your efforts. You face diminishing returns to your efforts. duplication of effort duplication of effort diversion of previous revenues diversion of previous revenues reaching most likely targets first reaching most likely targets first

What If Your Costs and Benefits Don’t Arrive at the Same Time? The time value of money: a given quantity of money is worth more now than later, because money now can earn money later. 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. 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. 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: If you have an amount PV and invest it at interest rate r for i periods, then its future value FV is: If you will receive an amount FV i periods in the future, then its present value PV is: If you will receive an amount FV i periods in the future, then its present value PV is: FV = PV(1 + r) i PV = FV/(1 + r) i

Using Present & Future Values Use an appropriate interest rate. Use an appropriate interest rate. What if you’re borrowing money for a present cost, in expectation of future benefits? 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? What if you’re using your own money for a present cost, in expectation of future benefits? Interest rate depends on degree of risk. Interest rate depends on degree of risk. If there is a stream of costs or benefits, discount each year separately (or use a table). If there is a stream of costs or benefits, discount each year separately (or use a table).