Tags: economic profit, accounting profit, opportunity cost, fixed cost, variable cost, sunk cost, sunk cost fallacy, average total cost, average variable cost, average fixed cost, marginal cost, total cost function, cost curves, ECON 323, Texas A&M, microeconomics
This topic covers how economists measure costs and profits differently from accountants, the distinction between fixed and variable costs, and how the key cost curves (ATC, AVC, MC) relate to each other. Mastering these relationships is essential for understanding firm behaviour in every market structure.
Economic profit
Total revenue minus economic cost. Economic cost includes both explicit (accounting) costs and implicit costs such as opportunity cost.
Accounting profit
Total revenue minus explicit costs only. Always higher than or equal to economic profit because it ignores opportunity cost.
Opportunity cost
The value of the best alternative foregone. If a business owner could earn £80,000 working elsewhere, that salary is an implicit cost of running their own firm.
Fixed cost (FC)
A cost that does not change with the level of output. Examples: rent, insurance, equipment leases. Present in the short run; in the long run, all costs become variable.
Variable cost (VC)
A cost that changes with the level of output. Examples: raw materials, hourly labour, electricity used in production.
Sunk cost
A cost that has already been incurred and cannot be recovered regardless of future decisions. Rational decision-making ignores sunk costs.
Sunk cost fallacy
The error of letting unrecoverable past costs influence current decisions. Classic example: refusing to withdraw troops from a conflict because of lives already lost.
Average total cost (ATC)
Total cost divided by quantity: ATC = TC / Q.
Average variable cost (AVC)
Variable cost divided by quantity: AVC = VC / Q.
Average fixed cost (AFC)
Fixed cost divided by quantity: AFC = FC / Q. Falls continuously as output increases because a fixed numerator is spread over more units.
Marginal cost (MC)
The additional cost of producing one more unit: MC = dTC / dQ.
Economies of scale
When average total cost decreases as output increases. Indicates the firm becomes more efficient at larger volumes.
Accounting profit = Total revenue - Explicit costs
Economic profit = Total revenue - Economic cost (explicit + implicit)
Equivalently: Economic profit = Accounting profit - Opportunity cost
A firm can have positive accounting profit but zero or negative economic profit if its opportunity costs are large enough
Worked example (Lilly's lumberyard):
Revenue: $500,000
Explicit costs: $250,000 (supplies) + $50,000 (rent) + $100,000 (salaries) = $400,000
Accounting profit: $500,000 - $400,000 = $100,000
Opportunity cost: $80,000 (salary she could earn elsewhere)
Economic profit: $100,000 - $80,000 = $20,000
Short run: at least one input is fixed (typically capital). The firm has both fixed and variable costs.
Long run: all inputs are variable. The firm can adjust every factor of production, including capital, plant size, and technology.
A sunk cost cannot be recovered, so it should play no role in forward-looking decisions
The sunk cost fallacy leads people to "throw good money after bad" or continue losing strategies because of past investment
Rational approach: only consider the marginal costs and benefits of the next action, not what has already been spent
MC intersects both ATC and AVC at their minimum points. This is a mathematical property: when the marginal is below the average, it pulls the average down; when above, it pulls it up.
When MC < ATC, average total cost is falling
When MC > ATC, average total cost is rising
The same logic applies to AVC
AFC declines continuously (no intersection with MC)
AFC = FC / Q, where FC = TC - VC.
Worked example:
Output: 50 units, TC = $800, VC = $300
FC = $800 - $300 = $500
AFC = $500 / 50 = $10
Given TC = 100 + 4Q + 2Q²:
FC = 100 (the constant term, independent of Q)
VC = 4Q + 2Q² (the terms that depend on Q)
ATC = TC / Q = (100/Q) + 4 + 2Q
MC = dTC/dQ = 4 + 4Q
To find the output that minimises ATC, set MC = ATC:
4 + 4Q = (100/Q) + 4 + 2Q
Simplify: 2Q = 100/Q, so 2Q² = 100, giving Q² = 50, and Q ≈ 7.07 units.
A technological improvement that increases input productivity shifts the total cost curve downward. For any given level of output, the firm needs fewer or cheaper inputs, reducing cost.
Formula | Expression |
|---|---|
Accounting profit | TR - Explicit costs |
Economic profit | TR - (Explicit + Implicit costs) |
AFC | FC / Q |
AVC | VC / Q |
ATC | TC / Q = AFC + AVC |
MC | dTC / dQ |
ATC-minimising output | Solve MC = ATC for Q |
⚠️ The distinction between economic and accounting profit appears in both multiple choice and short answer. Know the formulas cold and be ready to calculate both from a scenario.
⚠️ MC crosses ATC and AVC at their minimums, not just one of them. This is a common trick in multiple choice.
⚠️ Sunk cost fallacy questions test whether you can identify irrational behaviour driven by unrecoverable past costs, not just define the term.
⚠️ When working with a TC function, remember: the constant term is FC, everything else is VC. Differentiate for MC; divide by Q for ATC.
⚠️ To find the ATC-minimising output, set MC = ATC and solve. Do not set the derivative of MC to zero.
Q: A firm has total revenue of $500,000, explicit costs of $400,000, and the owner's next-best salary is $80,000. What is the economic profit?
A: Economic profit = ($500,000 - $400,000) - $80,000 = $20,000.
Q: A firm produces 50 units with TC = $800 and VC = $300. What is the AFC?
A: FC = $800 - $300 = $500. AFC = $500 / 50 = $10.
Q: Given TC = 100 + 4Q + 2Q², what is the marginal cost function?
A: MC = dTC/dQ = 4 + 4Q.
Q: At what output level is ATC minimised for TC = 100 + 4Q + 2Q²?
A: Set MC = ATC: 4 + 4Q = (100/Q) + 4 + 2Q. Solving gives Q = √50 ≈ 7.07 units.
Q: Why is the sunk cost fallacy irrational?
A: Because sunk costs cannot be recovered, they should not influence future decisions. Rational choice compares only the marginal costs and benefits of the next action.
Q: Where does the MC curve intersect the ATC curve?
A: At the minimum point of the ATC curve. MC also intersects AVC at its minimum.
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