Economics Online Tutor
 THIS PAGE DEFINES AND EXPLAINS VARIOUS TERMS USED IN ECONOMICS GRAPHS AND MICROECONOMIC ANALYSIS THAT ARE RELATED TO REVENUE, COSTS AND PROFIT.  THE PURPOSE IS TO DEFINE AND EXPLAIN THE TERMS, SO NO ORGANIZED DISCUSSION IS INVOLVED.
 Revenue, Costs, & Profit

TOTAL PHYSICAL PRODUCT
TPP
TOTAL PRODUCT

THESE ARE INTERCHANGEABLE TERMS.  THEY REFER TO THE TOTAL NUMBER OF UNITS OF OUTPUT FOR A
GIVEN QUANTITY OF A VARIABLE INPUT.

TPP AT FIRST INCREASES RAPIDLY, THEN INCREASES SLOWER, EVENTUALLY WILL DECREASE (FOR
EXAMPLE, WORKERS GET IN EACH OTHERS' WAY).

DIMINISHING MARGINAL RETURNS: WITH ADDITIONAL UNITS OF A VARIABLE INPUT, OUTPUT PER INPUT
WILL INCREASE AT FIRST, BUT EVENTUALLY WILL DECREASE (EVENTUALLY WILL BE NEGATIVE).

MARGINAL PHYSICAL PRODUCT (MPP): AT FIRST INCREASES, THEN A CONSTANT DECREASE UNTIL
NEGATIVE.

AVERAGE PHYSICAL PRODUCT (APP): WILL BE BELOW MPP AS MPP INCREASES, ABOVE MPP WHEN MPP
DECLINES.

MPP WILL CROSS APP AT THE POINT WHERE APP IS MAXIMIZED.

WHAT THIS MEANS:

WHEN MARGINAL IS ABOVE AVERAGE, THE AVERAGE INCREASES.

WHEN MARGINAL IS BELOW AVERAGE, THE AVERAGE DECREASES.

COST CURVES ARE MIRROR IMAGES OF PRODUCT CURVES.

TOTAL COST (TC): INCREASES AS OUTPUT INCREASES: AT FIRST RAPIDLY, THEN MORE SLOWLY, THEN
INCREASINGLY MORE RAPIDLY.

ATC (ALSO CALLED SRATC IN THE SHORT RUN)

ATC = TC / TOTAL OUTPUT

THE ATC CURVE IS U-SHAPED.

MARGINAL COST (MC) = CHANGE IN TOTAL COST / CHANGE IN TOTAL OUTPUT

MC ALSO = CHANGE IN VARIABLE COST / CHANGE IN TOTAL OUTPUT, SINCE VC ARE THE ONLY PORTION
OF TC THAT CHANGES WITH OUTPUT.

MC AT FIRST DECREASES, THEN A STEADY INCREASE.

WHAT THIS MEANS: MC = ATC WHEN ATC IS AT THE MINIMUM POINT OF ITS U-SHAPED CURVE.

TOTAL FIXED COST (TFC): CONSTANT AT ALL OUTPUT LEVELS

AVERAGE FIXED COST (AFC): DECREASES AS OUTPUT DECREASES

AVERAGE VARIABLE COST (AVC) CURVE IS U-SHAPED

MC = AVC WHERE AVC IS AT ITS MINIMUM.

THESE TERMS ALL RELATE TO SHORT RUN SITUATIONS.

LONG RUN:

IN THE LONG RUN, ALL COSTS ARE VARIABLE: ALL POSSIBLE SHORT RUN SITUATIONS ARE AVAILABLE FOR
CONSIDERATION.

THE LRATC CURVE CONNECTS ALL POSSIBLE SRATC CURVES.

THE SHAPE OF THE LRATC CURVE DEPENDS ON:

ECONOMIES OF SCALE: IF LR UNIT COSTS DECREASE AS OUTPUT INCREASES
DISECONOMIES OF SCALE: IF LR UNIT COSTS INCREASE AS OUTPUT INCREASES

WHEN ECONOMIES OF SCALE EXIST, THE LRATC CURVE SLOPES DOWNWARD
WHEN DISECONOMIES OF SCALE EXIST, THE LRATC CURVE SLOPES UPWARD

THE LRATC CURVE CAN BE ANY SHAPE, BUT IS TYPICALLY SHOWN AS U-SHAPED, HAVING A SECTION WITH
ECONOMIES OF SCALE AND A SECTION WITH DISECONOMIES OF SCALE.  THIS U-SHAPE IS NOT
UNIVERSAL BUT IS CONSIDERED TO BE THE MOST TYPICAL SHAPE.

MINIMUM EFFICIENT SCALE (MES): THE LOWEST POINT ON THE LRATC CURVE.

PLANNING HORIZON: ANOTHER NAME FOR THE LONG RUN, SINCE ALL PLANNING OPTIONS (NOTHING
FIXED) ARE OPEN.

PROFIT:

PROFIT IS THE AMOUNT REMAINING FROM TOTAL REVENUE AFTER ALL COSTS HAVE BEEN TAKEN INTO
CONSIDERATION.

PROFIT IS A FLOW CONCEPT.  IT INVOLVES ACTIVITY OVER A PERIOD OF TIME RATHER THAN BALANCES AT
A GIVEN POINT IN TIME (WHICH WOULD BE A STOCK, NOT A FLOW, CONCEPT).  THE PERIOD OF TIME IN
QUESTION IS CALLED THE ACCOUNTING PERIOD.

IN ECONOMICS, TWO KINDS OF PROFIT WILL BE ENCOUNTERED: ACCOUNTING PROFIT AND ECONOMIC
PROFIT.

ACCOUNTING PROFIT INCLUDES THE ITEMS THAT A BUSINESS WILL INCLUDE IN ITS INCOME STATEMENT.
THIS INCLUDES TOTAL REVENUE AND THE COSTS INCURRED FROM FIXED AND VARIABLE COSTS.  SINCE
THESE ARE COSTS THAT THE BUSINESS MUST ACTUALLY PAY OUT, THEY ARE CALLED EXPLICIT COSTS.
ACCOUNTING METHODS THAT A BUSINESS USES TO MATCH COSTS AND REVENUE MAY CREATE A TIMING
DIFFERENCE WITHIN ANY ACCOUNTING PERIOD BETWEEN ACTUAL OUTLAYS AND FIXED COSTS SHOWN
ON THE INCOME STATEMENT.  BUT THESE COSTS ARE PAID AT SOME POINT IN TIME, AND ARE STILL
EXPLICIT COSTS REGARDLESS OF THE ACCOUNTING METHOD USED.

ACCOUNTING PROFIT = TR - TC

TC = TFC + TVC
ECONOMIC PROFIT:

A BUSINESS WILL ONLY REMAIN IN BUSINESS AS LONG AS IT CAN EARN ENOUGH ACCOUNTING PROFIT
TO PREVENT ITS INVESTOR OWNERS FROM INVESTING IN SOMETHING ELSE INSTEAD.  IF INVESTORS CAN
EARN A HIGHER RETURN SOMEWHERE ELSE, THEY WILL SELL THEIR INTEREST IN THE BUSINESS AND
INVEST IN SOMETHING ELSE INSTEAD.  AT THE SAME TIME, IF A BUSINESS CAN EARN MORE MONEY
DOING SOMETHING ELSE, IT WILL CHANGE ITS OVERALL BUSINESS STRATEGY AND MOVE INTO A
DIFFERENT MARKET.

SINCE A CERTAIN AMOUNT OF PROFIT IS REQUIRED TO KEEP THE BUSINESS OPERATING IN ITS CURRENT
FORM, THESE PROFITS REPRESENT A COST OF THE BUSINESS.  IN THE STUDY OF ECONOMICS, THEY ARE
CALLED NORMAL PROFITS.

NORMAL PROFITS ARE COSTS OF THE BUSINESS, BUT NOT EXPLICIT COSTS.  THEY DO NOT REPRESENT
ANY ACTUAL MONEY THAT THE BUSINESS HAS TO PAY FOR EXPENSES.  THEY ARE CALLED IMPLICIT
COSTS.

NORMAL PROFITS, OR IMPLICIT COSTS, ARE OPPORTUNITY COSTS.  THEY REPRESENT THE BENEFIT THAT
WOULD BE RECEIVED FROM INVESTING IN THE NEXT BEST ALTERNATIVE TO THE BUSINESS.  NORMAL
PROFIT IS THE AMOUNT OF PROFIT REQUIRED TO PREVENT RESOURCES FROM BEING DIVERTED TO
ANOTHER USE.

WHEN THESE OPPORTUNITY COSTS ARE DEDUCTED FROM ACCOUNTING PROFIT, THE RESULT IS CALLED
ECONOMIC PROFIT.

ECONOMIC PROFIT = ACCOUNTING PROFIT - OPPORTUNITY COST

THE OPPORTUNITY COST IN THIS EQUATION MAY BE SHOWN WITH A DIFFERENT NAME, SUCH AS NORMAL
PROFIT, IMPLICIT COST, EVEN THE COST OF EQUITY CAPITAL.
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