pcecon.com Class Notes
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Short Run Choices Review
So far, we have learned that a producer can decide whether to operate (produce, open up) by comparing the price to average variable cost at its lowest level.
So, the question...
"Should the seller produce ANY output?"
is answered by asking
"is P greater than AVC at the minimum AVC?"
If so, operate; otherwise, shut down.
Also, a producer will find it adds to its profit by making and selling only those units of output that will sell for a price at least as great as the marginal cost of making or selling them.
The question...
"How much output should the seller make or sell?"
is answered by asking the question
"is P greater than MC for this amount of output?"
The producer then produces every unit of output for which the price is at least as great as the marginal cost.

Short Run Profit

So far, we have not discussed profit much. In the short run, if a seller makes the decisions we outlined above, it will be making as much money as it can given its costs. Since we have discussed all the decisions that the firm can make in the short run, calculating how big profit is will simply enable us to see, after the decisions are made, how well the firm is doing. In this sense, it is like the score of a game; you play the best you can, but if in the end you lose, there really isn't much else you could have done differently.

Profit is calculated by finding the revenues of the firm minus its costs.

If profit is calculated by taking the firm’s total revenue and subtracting only the explicit costs, we find what is called
accounting profit.

When all costs (including the implicit) are deducted from revenue, the result is called
economic profit, which is generally less than accounting profit.

All costs (even variable ones) that we consider in this class will include the implicit as well as explicit. So, when we talk of profit, we will mean economic profit, unless we specify accounting profit.

All of the costs of the firm added together are called
total cost. Total cost is thus the sum of fixed costs (FC) and variable costs (VC).

Total Cost (TC) = VC + FC

Profit is Revenue minus Total Cost, or

Profit= Revenue - Total Cost

But, remember that revenues are the price (P) of the product times the amount of the product that is made and sold (Q), so

Profit = PxQ - TC

On a per unit basis, dividing by output (Q), profit per unit of output would be


or

is average total cost (ATC), which is total cost divided by the amount of output.

so, profit per unit of output is simply P - ATC.

So, the question
"is profit being made by the seller, at the output selected?"
is answered by asking
"is P greater than ATC for this amount of output?"

To find profit, we can then multiply this by the amount of output actually being produced (designated as Q*).

Profit = Q* x (P-ATC)

ATC will vary depending on how much output we produce.

How does ATC change as output is increased?

Remember that Total Cost (TC) = VC + FC, so



But, we already know that is average variable cost (AVC).

is also a kind of average cost, which we call
average fixed cost (AFC).

What does average fixed cost look like? Well, the fixed cost part won't change, but at bigger values of output (Q) we will be dividing by a bigger number, so AFC will get smaller as Q gets bigger:



If we add AVC to AFC, we get
average total cost (ATC), which is also total cost divided by the amount of output.



Knowing this will help us understand what ATC is like, since it will look like AVC with AFC added on. This means that ATC will be far above the AVC for small amounts of output, and will get closer to AVC as output is increased:




In Summary...

1. When deciding whether to produce anything in the short run:
"Should the seller produce ANY output?"

is really asking
"is PAVC at the minimum AVC?"

2. When deciding how much to produce in the short run:
"How much output should the seller make or sell?"
is really asking asking
"is P MC for this amount of output?"
The amount of output for which every unit has a marginal cost no greater than the price will be the right amount to produce and sell. This amount can be called Q*.

3. When trying to learn whether the seller is making any profit:
"is profit being made by the seller, at the output (Q*) selected?"
is really asking
"is P ATC for this amount of output?"
If it is, then the amount of profit is Q* times P-ATC, where the ATC is the average total cost of producing exactly Q* units.

Copyright 2006 by Ray Bromley. For economics information, and other information about Ray Bromley, visit www.raybromley.com. Permission to copy for educational use is granted, provided this notice is retained. All other rights reserved.
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