Economics notes: Costs and Profits

•       In economics, costs are divided into short-run costs and long-run costs.

•       In the short-run, at least one factor of production is fixed.

•       How long is the short run?

–      As long as it takes to sell your ships and retire to the sun

–      As long as it takes to charter in more ships

Cost Characteristics

•       Short run average costs

–      At least one fixed factor of production

•       Long run average costs

–      All factors of production are variable

This is an envelope curve. It is drawn at the tangency points of a series of short-run curves, NOT at their lowest points. That is because the lowest point of one short-run curve at quantity Q is not as low as the costs of producing quantity Q on another short-run curve, so in the long-run, you move on to the next level of production.

Fixed and Variable Costs

•       Total cost is made up of total fixed costs and total variable costs:

TC=TF + TV

•       Fixed costs are incurred even if there is no output

•       Variable costs are only incurred when goods or services are produced

•       Average cost is also made up of average fixed costs and average variable costs

Average and Marginal Costs

•       The average cost of a good or service is the total cost divided by the total quantity

AC = TC/Q

•       The marginal cost is the cost of the last unit of a good or service that is produced.

MC = Change in total cost/change in output

Average Cost Curves

The Law of Diminishing Marginal Returns

When increasing amounts of a variable factor are used with a given amount of a fixed factor, there will come a point when each extra unit of the variable factor will produce less extra output than the previous unit

•       To start with, as more of the variable factor are used,  extra units of output cost less and MC falls

•       After point x (next slide), diminishing returns set in

•       The point of lowest cost per unit is

MC=AC

•       This derives from the mathematical connection between the marginal and the average

Ship Costs

•       Fixed costs - these are incurred whether or not the ship trades

–      operating costs

–       capital costs

•       Variable costs - these are only incurred when the ship trades

–      voyage costs

–      cargo costs

•       The different classifications of ship cost can be related to different types of charter

•       For a bareboat or demise charter the owner only pays the capital costs

•       For a time charter the owner pays all fixed costs

•       For a voyage charter the owner pays fixed costs and voyage costs and possibly cargo costs

Profit

•       Normal profit is the equivalent to the return on capital if it were invested in a risk free investment

•       This is a cost

•       It is difficult to make a normal profit in shipping as Return On Capital Employed (ROCE) is historically low

•       Supernormal profit also known as pure profit occurs in a freight rate boom

Pure Profit

•       Pure profit = revenue – cost (including normal profit)

•       This will now be referred to as ‘profit’.

•       The rational firm aims to maximise profit.

•       It will produce that quantity of goods which produce the greatest profit or the least cost

•       How is this determined?

Profit Maximisation

For all firms in all market condition, the maximum profit will be made when marginal revenue MR ( the sale price of the last unit sold) is the same as marginal cost MC (the cost of the last unit to be made)

MR = MC

Profit Maximisation

•       At output Q1,if more units are produced the extra revenue MR will be greater than the extra cost, MC. Total profit is increased by increasing output.

•       At output Q2, the extra cost MC is greater than the extra revenue MR and profits can be reduced. Total profit is increased by reducing output.

•       At Q3, profits are at their maximum.

Scale Economies

A ship’s carrying power varies as the cube of her dimensions, while the resistance offered by the water increases only a little faster than the square of the dimensions.

A large ship requires less fuel in proportion to its tonnage than a small one.

The steel enclosing a tank increases with the square of the tank width, while the volume enclosed increases with the cube.

A large ship needs less steel per tonne carried and less paint to maintain it, than a small ship

A large ship needs the same number of crew, managers and voyage fixtures as a small ship.

Large ships will always have lower costs per tonne of cargo carried than small ships.

Maximum Ship Size

•       Ship size faces internal constraints in the short term from:

–      Ports that cannot take their draft, length or width

–      Ports cannot handle any more goods/passengers at one time

–      Technical limits of construction, operation or propulsion are reached

•       Ship size faces external and longer term constraints when:

–      The potential costs of an accident to a very large ship outweigh the benefits of scale economies

–      Demand conditions change so that a smaller parcel size is needed