| Cost and Revenue of Doing Business |
| Steven M. Reff Economics Lecturer University of Arizona (2007 - 2016) The 2015 University of Arizona Five-Star Faculty Award |
In this unit on the Cost and Revenue of Doing Business, you will learn about the following:
*The Two Main Types of Costs (Fixed Costs and Variable Costs)
*The Difference between Explicit and Implicit Costs
*Formulas for Total Revenue, Total Cost, and Profit/Loss
*Price Taker and Its Total Revenue, Total Cost, and Profit/Loss
*Price Searcher and Its Total Revenue, Total Cost, and Profit/Loss
*The Difference between Total Revenue and Profit
*How a Firm Determines Profit Maximization
*The Difference between Explicit and Implicit Costs
*Formulas for Total Revenue, Total Cost, and Profit/Loss
*Price Taker and Its Total Revenue, Total Cost, and Profit/Loss
*Price Searcher and Its Total Revenue, Total Cost, and Profit/Loss
*The Difference between Total Revenue and Profit
*How a Firm Determines Profit Maximization
It's funny how people who have never studied economics think if a firm is
bring in money (revenue), then the firm is earning a profit. All because a firm is
bringing in money (revenue) doesn't mean it is earning a profit.
Total Revenue = Price x Quantity
TR = P x Q
The total revenue formula is that simple -- Price times Quantity. Total revenue is the
amount of money that is brought into the firm through the sale of its goods or services.
Total expenditures by the consumer is equal to the total revenue brought in by the firm.
Total Revenue = Total Expenditures
bring in money (revenue), then the firm is earning a profit. All because a firm is
bringing in money (revenue) doesn't mean it is earning a profit.
Total Revenue = Price x Quantity
TR = P x Q
The total revenue formula is that simple -- Price times Quantity. Total revenue is the
amount of money that is brought into the firm through the sale of its goods or services.
Total expenditures by the consumer is equal to the total revenue brought in by the firm.
Total Revenue = Total Expenditures
The Formula for Total Revenue
The Formula for Profit
The Two Main Types of Costs
Profit is the difference between the total revenue brought in by the firm minus the
total cost of production of the goods or services.
Profit = Total Revenue - Total Cost
Profit = TR - TC
So, here is an easy question. Is a firm in business to make a profit? The answer is
NO. The firm is in business to MAXIMIZE PROFITS. If you are a firm, do you want to
make $1 in profit or $1 million in profit? You would prefer to make a $1 million in profit.
total cost of production of the goods or services.
Profit = Total Revenue - Total Cost
Profit = TR - TC
So, here is an easy question. Is a firm in business to make a profit? The answer is
NO. The firm is in business to MAXIMIZE PROFITS. If you are a firm, do you want to
make $1 in profit or $1 million in profit? You would prefer to make a $1 million in profit.
You will learn in a future lesson that firms
compete with each other in different market
structures. In this section, you will learn there
are firms that are price takers and firms that
are price searchers.
The graph to the far left is an individual firm
that is a price taker. It must take the market or
industry price shown in the second graph
because no one firm has a price advantage
over another firm. The market is so large with
many, many buyers and many, many sellers of
the product. An example of a price taker is an
individual farmer in the agricultural industry.
Because there are so many farmers who sell
an identical crop, no individual farmer sets
the price in the market, but rather the market
determines the price that the farmer must
take.
compete with each other in different market
structures. In this section, you will learn there
are firms that are price takers and firms that
are price searchers.
The graph to the far left is an individual firm
that is a price taker. It must take the market or
industry price shown in the second graph
because no one firm has a price advantage
over another firm. The market is so large with
many, many buyers and many, many sellers of
the product. An example of a price taker is an
individual farmer in the agricultural industry.
Because there are so many farmers who sell
an identical crop, no individual farmer sets
the price in the market, but rather the market
determines the price that the farmer must
take.
Take your cursor and move the demand and supply curve in the industry or
market graph above and see how each individual farmer's (firm) price matches that of
the industry or market. Notice how the price line for the individual firm is horizontal
or what is called infinitely elastic demand.
market graph above and see how each individual farmer's (firm) price matches that of
the industry or market. Notice how the price line for the individual firm is horizontal
or what is called infinitely elastic demand.
The graph to the left represent the
individual firm being a price taker at
$5 per unit. Take your cursor and
drag it along the yellow dots along
the price line.
individual firm being a price taker at
$5 per unit. Take your cursor and
drag it along the yellow dots along
the price line.
Notice on the total revenue graph that the
individual firm's total revenue keeps
increasing as more units are sold in the
market. For every 10 units sold in the
market the total revenue rises by the
same amount ($50).
Knowing this, then you know that
total revenue is maximized at
infinity. You will learn later that the firm's
goal is not to maximize revenue, but
instead, to maximize profits.
individual firm's total revenue keeps
increasing as more units are sold in the
market. For every 10 units sold in the
market the total revenue rises by the
same amount ($50).
Knowing this, then you know that
total revenue is maximized at
infinity. You will learn later that the firm's
goal is not to maximize revenue, but
instead, to maximize profits.
Price Taker and Its Total Revenue, Total Cost, and Profit/Loss
A firm that is a price taker is described above
showing a perfectly horizontal or perfectly
elastic demand or price line.
A firm that is a price searcher, though, has a
demand curve that is downward sloping as
shown to the left.
Take your cursor and drag it along the price
searcher demand curve starting at $10 and
working your way to $0.
Notice from $10 to $5 the total revenue
increases and as you continue from $5 to $0
the total revenue decreases. Does this mean
the firm should charge $5? The obvious answer
is NO. Remember you already learned that the
firm isn't in business to maximize revenue, but
instead is in business to MAXIMIZE PROFITS.
Please don't forget this if you get into business.
showing a perfectly horizontal or perfectly
elastic demand or price line.
A firm that is a price searcher, though, has a
demand curve that is downward sloping as
shown to the left.
Take your cursor and drag it along the price
searcher demand curve starting at $10 and
working your way to $0.
Notice from $10 to $5 the total revenue
increases and as you continue from $5 to $0
the total revenue decreases. Does this mean
the firm should charge $5? The obvious answer
is NO. Remember you already learned that the
firm isn't in business to maximize revenue, but
instead is in business to MAXIMIZE PROFITS.
Please don't forget this if you get into business.
To show you how total revenue changes
for a price searcher drag your cursor
along the yellow dots on the demand
curve.
Notice that TR is maximized at $5, but
this doesn't mean the firm should charge
$5.
Again, the firm is in business to
MAXIMIZE PROFITS, not total revenue.
for a price searcher drag your cursor
along the yellow dots on the demand
curve.
Notice that TR is maximized at $5, but
this doesn't mean the firm should charge
$5.
Again, the firm is in business to
MAXIMIZE PROFITS, not total revenue.
The Difference between Explicit and Implicit Costs
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How a Price Taker Firm Determines Profit Maximization
A firm is in business to maximize profits. To maximize profits a firm produces where TR > TC by the greatest amount
or where MR = MC (marginal revenue = marginal cost).
or where MR = MC (marginal revenue = marginal cost).
Number 1:
Take your
cursor and
drag down
column to
figure MR
and graph
TR
Take your
cursor and
drag down
column to
figure MR
and graph
TR
Number 2:
Take your
cursor and
drag down
column to
figure MC
and graph
TC
Take your
cursor and
drag down
column to
figure MC
and graph
TC
Number 3:
Take your
cursor and
drag down
column to
figure and
graph the
Profit/Loss
Take your
cursor and
drag down
column to
figure and
graph the
Profit/Loss
Column 1: Notice the MR = P at $15. For a price taker the TR goes up for each unit by the price of the product.
Column 2: Notice the MC falls at first and then begins to rise. When MC begins to rise, this is where the
Law of Diminishing Marginal Return sets in. (You will learn more about this in the unit on Labor Costs.)
Column 3: Notice when a firm begins selling output it loses money (Quantities 1 and 2) because it hasn't covered its fixed costs.
Notice, also, that profit increases until profit maximization and then profit begins to diminish.
Profit-Maximization happens at a Q = 7 units and P = $15. Notice that this is where TR > TC by the greatest amount ($78)
and where MR = MC at $15. Remember that decisions are made at the margin where MR = MC.
Column 2: Notice the MC falls at first and then begins to rise. When MC begins to rise, this is where the
Law of Diminishing Marginal Return sets in. (You will learn more about this in the unit on Labor Costs.)
Column 3: Notice when a firm begins selling output it loses money (Quantities 1 and 2) because it hasn't covered its fixed costs.
Notice, also, that profit increases until profit maximization and then profit begins to diminish.
Profit-Maximization happens at a Q = 7 units and P = $15. Notice that this is where TR > TC by the greatest amount ($78)
and where MR = MC at $15. Remember that decisions are made at the margin where MR = MC.
Total Cost = Fixed Costs + Variable Costs
TC = FC + VC
Total cost is the amount money that the firm spends to produce the goods or services.
The Formula for Total Costs
Price Searcher and its Total Revenue, Total Cost, and Profit/Loss
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How a Price Searcher Firm Determines Profit Maximization
A firm is in business to maximize profits. To maximize profits a firm produces where TR > TC by the greatest amount
or where MR = MC (marginal revenue = marginal cost).
or where MR = MC (marginal revenue = marginal cost).
Number 1:
Take your
cursor and
drag down
column to
figure MR
and graph
TR
Take your
cursor and
drag down
column to
figure MR
and graph
TR
Number 2:
Take your
cursor and
drag down
column to
figure MC
and graph
TC
Take your
cursor and
drag down
column to
figure MC
and graph
TC
Column 1: Notice the MR goes down at a decreasing rate and beyond zero begins to go down at an increasing rate.
Column 2: Notice the MC falls at first and then begins to rise. The TC and MC are identical to those shown earlier in the
Price Taker graph.
Column 3: Notice even though TR is the greatest at 5 units, the firm produces 4 units because that is where profit
is the greatest.
Profit-Maximization happens at Q = 4 units and P = $30 . Notice that this is where TR > TC by the greatest amount
and where MR = $15 and MC = $3. Notice at Q = 5 at a P = $25 the MR = $5 is less than MC = $11.
This means profit goes down by $6 ($78 to $72) at Q = 5, even though TR is the greatest at Q = 5.
Column 2: Notice the MC falls at first and then begins to rise. The TC and MC are identical to those shown earlier in the
Price Taker graph.
Column 3: Notice even though TR is the greatest at 5 units, the firm produces 4 units because that is where profit
is the greatest.
Profit-Maximization happens at Q = 4 units and P = $30 . Notice that this is where TR > TC by the greatest amount
and where MR = $15 and MC = $3. Notice at Q = 5 at a P = $25 the MR = $5 is less than MC = $11.
This means profit goes down by $6 ($78 to $72) at Q = 5, even though TR is the greatest at Q = 5.
Number 3:
Take your
cursor and
drag down
column to
figure and
graph the
Profit/Loss
Take your
cursor and
drag down
column to
figure and
graph the
Profit/Loss
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Take your cursor
and click and move
the cost term inside
the yellow rectangle
to the appropriate
column--
Fixed Cost or
Variable Cost.
and click and move
the cost term inside
the yellow rectangle
to the appropriate
column--
Fixed Cost or
Variable Cost.
Test Your Knowledge on Explicit and Implicit Costs
Let's say I left the
teaching profession and
invested my time and
money into starting a
business. My first-year
costs are listed in blue.
Click and drag each cost
into the correct column --
Explicit Costs or Implicit
Costs.
teaching profession and
invested my time and
money into starting a
business. My first-year
costs are listed in blue.
Click and drag each cost
into the correct column --
Explicit Costs or Implicit
Costs.
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Here is What You Have Learned in this Lesson on Cost and Revenue of Doing Business:
*The Two Main Types of Costs (Fixed Costs and Variable Costs)
*The Difference between Explicit and Implicit Costs
*Formulas for Total Revenue, Total Cost, and Profit/Loss
*Price Taker and Its Total Revenue, Total Cost, and Profit/Loss
*Price Searcher and Its Total Revenue, Total Cost, and Profit/Loss
*The Difference between Total Revenue and Profit
*How a Firm Determines Profit Maximization
*The Difference between Explicit and Implicit Costs
*Formulas for Total Revenue, Total Cost, and Profit/Loss
*Price Taker and Its Total Revenue, Total Cost, and Profit/Loss
*Price Searcher and Its Total Revenue, Total Cost, and Profit/Loss
*The Difference between Total Revenue and Profit
*How a Firm Determines Profit Maximization