Types of Cost, Revenue and Profit

Introduction

Understanding the different types of costs, revenues, and profits is fundamental to analyzing firm behavior in economics. Firms aim to maximize profit, and this involves managing their costs and generating sufficient revenue.

Types of Costs

Costs can be categorized in several ways:

• Fixed Costs (FC): Costs that do not change with the level of output in the short run. Examples include rent, insurance, and salaries of permanent staff.
• Variable Costs (VC): Costs that change with the level of output. Examples include raw materials, wages of temporary staff, and energy.
• Total Costs (TC): The sum of fixed costs and variable costs. $$TC = FC + VC$$
• Average Fixed Cost (AFC): Fixed costs divided by the quantity of output. $$AFC = \frac{FC}{Q}$$
• Average Variable Cost (AVC): Variable costs divided by the quantity of output. $$AVC = \frac{VC}{Q}$$
• Average Total Cost (ATC): Total costs divided by the quantity of output. $$ATC = \frac{TC}{Q}$$

Types of Revenue

Revenue represents the income a firm receives from selling its goods or services.

• Total Revenue (TR): The total income from selling a certain quantity of goods or services. $$TR = P \times Q$$ where P is price and Q is quantity.
• Average Revenue (AR): Total revenue divided by the quantity of goods or services sold. $$AR = \frac{TR}{Q} = P$$

Types of Profit

Profit is the difference between total revenue and total cost.

• Profit (π): Total revenue minus total cost. $$π = TR - TC$$
• Economic Profit: Profit minus the opportunity cost of using resources. This includes both explicit costs and implicit costs (e.g., the forgone salary of the owner). $$Economic Profit = π - Opportunity Cost$$
• Accounting Profit: Profit shown on a firm's financial statements, which only considers explicit costs. $$Accounting Profit = π$$

Short-Run and Long-Run Production

Firms operate within different time horizons, which affect their production decisions.

Short Run

The short run is a period where at least one factor of production is fixed. This often means that the firm's plant and equipment are fixed.

Key concepts in the short run include:

• Marginal Cost (MC): The additional cost incurred by producing one more unit of output. Firms aim to produce where MC equals marginal revenue (MR) to maximize profit.
• Marginal Revenue (MR): The additional revenue gained by selling one more unit of output.

Long Run

The long run is a period where all factors of production are variable. This allows the firm to adjust all inputs, including plant and equipment.

Key concepts in the long run include:

• Cost Curves: In the long run, firms can choose the optimal combination of inputs to minimize their costs. This leads to the development of various cost curves (e.g., MC, AVC, ATC).
• Perfect Competition: In the long run, firms in a perfectly competitive market will produce at the point where their MC equals the minimum of their average total cost (ATC). This ensures that economic profit is zero.

Profit Maximisation as the Main Objective

Firms are generally assumed to be profit maximizers. This means they will produce the level of output where the difference between total revenue and total cost is greatest.

The profit-maximizing rule for a firm is:

Produce where $$MR = MC$$

This rule applies in both the short run and the long run.

Cost Type	Description
Fixed Costs	Do not change with the level of output.
Variable Costs	Change with the level of output.
Total Costs	Sum of fixed and variable costs.
Average Fixed Cost	Fixed costs divided by quantity.
Average Variable Cost	Variable costs divided by quantity.
Average Total Cost	Total costs divided by quantity.
Total Revenue	Income from selling goods or services.
Average Revenue	Total revenue divided by quantity.
Profit	Total revenue minus total costs.