Economic Profit, Production and Economies of Scale

By the end of this Section you should be able to: Calculate and define:

2 kinds of Profit 2 kinds of associated costs

Production Total Product (TP) Marginal Product (MP)

Increasing, decreasing and negative marginal returns Discuss and apply the Law of Diminishing Marginal Product

Average Product (AP)

Profit

Firm’s main goal is to maximize profit. Profit is defined as Total Revenue (TR)

minus Total Cost (TC).TR=price*quantity=PQTC – we will talk about this in the next section

Costs

There exists two types of costs:Explicit Cost: A Cost paid in Money. Implicit Cost: Expenses an owner does not

have to pay out of pocket, such as Opportunity Cost, Owner Provided Capital (K), and Owner Provided Labor (L).

These two types of costs yield 2 types of Profits.

Types of Profit

Accounting Profit: looks at revenue as money taken in and costs as the money it takes to produce things.Defines Total Costs as explicit costs.

Economic Profit: looks at revenue as money taken in and costs as the money it takes to produce things and expenses an owner does not payout of pocket.Defines Total Costs as explicit and implicit

costs.

Example of Types of Profit

Suppose Sam owns a smoothie shop: TR: $150,000 Explicit Costs:

Cost of fruit and yogurt: $20,000 Cost of wages: $22,000

Implicit Costs: Sam’s forgone wages (owning a smoothie shop and not

working somewhere else): $34,000

Accounting Profit: TR – EC = 150,000-20,000-22,000 = 108,000

Economic Profit: TR – EC – IC = 150,000-42,000-34,000 = 74,000

Production

The relationship between output and quantity of labor is described by total product, marginal product and average product.

Total Product

Total Product is the total quantity of a good provided in a given period. It defines the total amount that can be

produced in a period of time given the number of workers.

So we look at production possibilities with a set number of workers.

Marginal Product

Marginal Product is the change in total product due to a one unit increase in the amount of labor employed.

MP= TP Labor

Quantity of Labor

Gallons per Additional Worker

0

Increasing Marginal Returns

Decreasing Marginal Returns

Negative Marginal Returns

So we look at how the total product changes while the amount of labor changes.

Increasing Marginal Returns

Increasing Marginal Returns is when the marginal product of an additional worker exceeds the marginal product of the previous worker. When there are few workers, they can’t get everything

done. As you hire more workers, the work gets done (there is an increase in quantity produced).

As the number of workers increases, the total amount produced increases and the production per worker increases too.

Decreasing Marginal Returns

Decreasing Marginal Returns is when the marginal product of an additional worker is less than the marginal product (MP) of the previous worker. Each additional worker is not helping as much as the

previous worker, but they do help and positively increase output.

As the number of workers increases, the total amount produced increases but the amount produced per worker decreases.

Negative Marginal Returns

Negative Marginal Returns is when an additional person decreases the amount of quantity produced. Too many cooks in the Kitchen, New Workers

Distract, etc. As the number of workers increases, both the

amount of production decreases and the amount of production per worker decreases.

The type of return (Increasing, Decreasing or Negative) is determined by the slope of the total product line.

Law of Diminishing Returns

• The law of diminishing returns: as successive units of a variable resource are added to a fixed resource, the marginal product of the variable resource will eventually decline.

• Because there are fixed things (plant size) in the short run, increasing variable inputs such as labor will lead to diminishing returns.

Average Product

Average Product (AP) is the general productivity of each worker.

AP = TP

Q of Labor