Production, Costs and Market Structures
Senior 4 · Economics
Production, Costs and Market Structures
Lesson 2 of 3
24 min
In the last lesson output was measured in kilograms and litres. Now we attach prices to the inputs and to the output, and the firm’s central question finally gets a money answer: what level of output makes the most profit? Get the cost concepts right here and much of the rest of microeconomics — supply curves, market structures, why firms enter and leave industries — follows almost for free. Get them muddled and none of it works.
Byiringiro runs a small carpentry workshop making dining tables. Some of his costs do not change no matter how many tables he makes this week; others rise with every table.
Here is his full cost schedule for one week, in Frw. Study how each column is built from the ones before it (the AFC, ATC and MC figures are rounded to the nearest franc).
| Tables (Q) | TFC | TVC | TC | AFC | AVC | ATC | MC |
|---|---|---|---|---|---|---|---|
| 0 | 100,000 | 0 | 100,000 | — | — | — | — |
| 1 | 100,000 | 60,000 | 160,000 | 100,000 | 60,000 | 160,000 | 60,000 |
| 2 | 100,000 | 100,000 | 200,000 | 50,000 | 50,000 | 100,000 | 40,000 |
| 3 | 100,000 | 132,000 | 232,000 | 33,333 | 44,000 | 77,333 | 32,000 |
| 4 | 100,000 | 172,000 | 272,000 | 25,000 | 43,000 | 68,000 | 40,000 |
| 5 | 100,000 | 225,000 | 325,000 | 20,000 | 45,000 | 65,000 | 53,000 |
| 6 | 100,000 | 300,000 | 400,000 | 16,667 | 50,000 | 66,667 | 75,000 |
Here is how every column was calculated, using the row for 5 tables as the example:
Look down the ATC column: 160,000, 100,000, 77,333, 68,000, 65,000, 66,667. It falls to a lowest point of 65,000 Frw at 5 tables, then rises. Average total cost is U-shaped, and two forces explain it. At low output, AFC is large and falling quickly, which pulls ATC down. At high output, diminishing returns from the last lesson push variable cost per unit up, and that eventually drags ATC back up. The bottom of the U is the firm’s most efficient output — the cheapest possible cost per table.
Now compare MC with ATC step by step. From 1 to 5 tables, MC is below ATC, and ATC falls. From 5 to 6 tables, MC (75,000) is above ATC, and ATC rises. This is the same marginal-pulls-average rule from the last lesson: marginal cost cuts average total cost at its lowest point. When the cost of the next unit is below your average, it drags the average down; when it is above, it pushes the average up.
Revenue is the money coming in, before any costs are taken off. Suppose Byiringiro can sell as many tables as he makes at the going market price of 75,000 Frw each.
Because Byiringiro can sell any quantity at the same 75,000 Frw, his price does not change with output, so here AR = MR = price. A firm in this position is called a price taker — it accepts the market price and only chooses how much to make. We meet the opposite case, where selling more forces the price down, in the next lesson.
Profit = total revenue − total cost. Let us find the output that makes profit largest, at a price of 75,000 Frw. Put revenue and cost side by side:
| Tables (Q) | TR (Frw) | TC (Frw) | Profit (Frw) |
|---|---|---|---|
| 1 | 75,000 | 160,000 | −85,000 |
| 2 | 150,000 | 200,000 | −50,000 |
| 3 | 225,000 | 232,000 | −7,000 |
| 4 | 300,000 | 272,000 | 28,000 |
| 5 | 375,000 | 325,000 | 50,000 |
| 6 | 450,000 | 400,000 | 50,000 |
Profit is largest — 50,000 Frw — at 5 or 6 tables. But there is a faster way to find that output than building the whole table, and it is the rule you must know: a firm maximises profit where marginal cost equals marginal revenue (MC = MR).
Here is why the rule works, which matters far more than the rule itself. As long as one more table adds more to revenue than to cost (MR is greater than MC), making it increases profit, so keep going. Once a table would add more to cost than to revenue (MC is greater than MR), it shrinks profit, so stop. The best output is the last one for which MR is still at least MC. MR here is 75,000 Frw. From the cost table, MC reaches 75,000 Frw at the 6th table — so he produces 6 tables, and profit is 450,000 − 400,000 = 50,000 Frw.
Break-even is the output where the firm makes neither profit nor loss: TR = TC, so profit is zero. That happens where price equals average total cost. The lowest ATC in the table is 65,000 Frw (at 5 tables). So if the market price were exactly 65,000 Frw, the best the firm could do is break even. At any price below 65,000 Frw it cannot avoid a loss; above it, it makes a profit. Keep that fact — price against lowest average cost — in mind, because it drives everything in the next lesson.
A word about ‘profit’. Economists include in cost the opportunity cost of the owner’s own time and money — what he could have earned elsewhere. Covering that opportunity cost is called earning normal profit, and economists treat it as a cost of staying in business. Anything above it is supernormal (abnormal) profit. So ‘breaking even’ in economics means the owner is still earning normal profit — enough to keep him in the trade — not that he is earning nothing at all.
Tip
MC = MR is the profit-maximising rule for every firm in this course, whatever the market. Learn the reasoning, not just the letters: while the next unit earns more than it costs, make it; stop at the unit where the two are equal.
And never confuse marginal cost with average cost. MC is the cost of the next unit (a change in total cost); AC is total cost shared out over all units. In a table, MC comes from subtracting neighbouring TC rows; AC comes from dividing one TC by its own Q.
A firm’s total fixed cost is 60,000 Frw. At 10 units its total variable cost is 90,000 Frw. Find TC, AFC, AVC and ATC at 10 units.
Solution. TC = TFC + TVC = 60,000 + 90,000 = 150,000 Frw. AFC = 60,000 ÷ 10 = 6,000 Frw. AVC = 90,000 ÷ 10 = 9,000 Frw. ATC = 150,000 ÷ 10 = 15,000 Frw (check: AFC + AVC = 6,000 + 9,000 = 15,000 Frw).
Total cost is 272,000 Frw at 4 units and 325,000 Frw at 5 units. Find the marginal cost of the 5th unit, and explain why answering 65,000 Frw would be wrong.
Solution. MC = change in TC = 325,000 − 272,000 = 53,000 Frw. 65,000 Frw is the average total cost at 5 units (325,000 ÷ 5), not the cost of the one extra unit. Marginal cost comes from the difference between neighbouring totals, never from dividing.
A trader sells 40 kg of beans at 500 Frw per kg. Her total cost is 16,000 Frw. Find her total revenue and her profit.
Solution. TR = 500 × 40 = 20,000 Frw. Profit = TR − TC = 20,000 − 16,000 = 4,000 Frw.
A firm is producing where MR = 6,000 Frw and MC = 4,000 Frw. Should it produce more or less to raise profit? Explain.
Solution. More. The next unit would add 6,000 Frw to revenue but only 4,000 Frw to cost, a net gain of 2,000 Frw. It should keep expanding until MC has risen to meet MR at 6,000 Frw, and stop there.
A workshop’s lowest average total cost is 65,000 Frw per table. If the market price of a table falls to 60,000 Frw, can the workshop make a profit at any level of output? What is happening at exactly 65,000 Frw?
Solution. No. If the very lowest average cost per table is 65,000 Frw, then at a price of 60,000 Frw every table sells for less than it costs on average, so the firm makes a loss at every output. At a price of exactly 65,000 Frw the firm breaks even — price equals lowest ATC, so it earns normal profit and no more.
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What to remember
