Today

1. Today • Deviations from profit maximization • Explicit and implicit costs • Economic profits

2. Chapter 20 Production and Cost in the Firm

3. Profit Maximization • Firms are assumed to maximize profits (no such thing as enough). • Real-world deviations from profit-max: • max. sales • max. growth • max. prestige, CEO salary, equity, or lifestyle of managers.

4. Checks on Deviations from Profit Maximization • Stockholders can vote managers out. • Threat of take-overs • Bankruptcy • CEOs get stock as partial compensation • Bottom Line: Modeling firms as profit-maximizers works well as a predictor of behavior.

5. Economic Costs • The cost of producing a particular quantity of a good includes the value of all inputs used (even if the firm did not have to pay for them). • Economists use opportunity cost to help value inputs.

6. One Month at Mom & Pop’s Grocery Store An example of how to calculate economic costs.

7. Purchased or Hired Factors • Cost of groceries sold $13,200 • Use amounts paid to wholesalers. • Includes waste in produce, meats, etc. • Labor, 2 part-time employees 600 • Use wages paid, include SS taxes, unemployment taxes, cost of benefits if applicable.

8. Purchased or Hired Factors, Cont’d. • As long as the price paid reflects the market value, the opportunity cost is the price paid. Examples include: • Payroll cost, plus benefits • Interest paid on borrowed funds • Cost of materials • Rental cost of any rented land or equipment • Utilities bills

9. Mom & Pop’s Time • Mom & Pop don’t pay themselves regular salaries. They keep the money “leftover” at the end of the month for themselves. • How does an economist value their time?

10. Use of Entrepreneur’s Time, Other’s time • Mom works 55 hours/week $1,100 • Her next best opportunity is to work for “Super-Grocery”. Use foregone wages & benefits. • Pop works 55 hours/week $2,200 • His next best opportunity is to work as a bookkeeper. Use foregone wages & benefits.

11. Use of building, land • Mom & Pop own the building and the land used for the store. They don’t have a mortgage. • Rent $800 • Estimate the rental value of the property. If they didn’t use it themselves, they could be renting it out.

12. Use of Equipment Owned by the Firm • They own all of the coolers, meat slicers, scanners, cash registers, etc. used in the store. • Use of Equipment $200 • Equipment can be thought of as being “used up” as it is used. The cost of this is called “depreciation”.

13. Depreciation • Economists care about physical depreciation, and measure it by the change in the re-sale price of the equipment. This is the opportunity cost of using the equipment for, say, one year versus selling it now.

14. Accounting versus Economic depreciation • Accountants uses “depreciation” on tax returns, but that value comes from tax laws, not from physical depreciation. • Most items will be fully depreciated in an accounting sense long before they are in a physical sense.

15. Special Case: Sunk costs • If a machine has no alternative use within or outside of the firm then there is zero opportunity cost to using the machine. • The cost of the machine is said to be sunk. • If there are costs that could not be recovered if the firm were to shut down (ex: advertising costs) then these costs are also sunk.

16. Sunk costs, Cont’d • Sunk costs can be ignored when planning for the future. • They still affect the bottom line, however.

17. Use of the firm’s own funds • Mom & Pop do not have loans, but they have a lot of money tied up in the business. • Value of inventory = $300,000. • Inventory Carrying Cost $1,500 • Opportunity cost is 6% interest foregone on long-term gov’t bonds. • $300,000@6% interest/12 months.

18. Risk-Taking • Insurance premiums $300 • Some of the risks of being in this business can be insured against. • property, liability insurance premiums • Being in business is riskier than buying a gov’t bond. The owners ought to be compensated for assuming extra risk. • Risk premium $250 • Extra 1% opp. cost of using funds.

19. Total Economic Costs • Explicit Costs (13,200 + 600 + 300) = $14,100. • Implicit Costs (1,100 + 2,200 + 800 + 200 + 1,500 +300 + 250) = $6,350. • Total Economic Cost = $14,100 + $6,350 =$20,450.

20. Profits • Suppose revenues for the month were $20,200. • Accounting profits = Revenue - Explicit costs = $20,200 - $14,100 = $6,100. • Economic profits = Revenue - Economic costs = $20,200 - $20,450 = -$250. • How well are Mom & Pop doing?

21. Interpreting Economic Profits • What does it mean if a firm makes zero economic profits?

22. Negative Economic Profits • (Economic Losses) • The firm would do better if its resources were used elsewhere. • If Mom & Pop made economic losses, they would want to quit the business, work at next best jobs, rent out building, invest the money in bonds, etc.

23. Positive Economic Profits • The firm is earning over-and-above that necessary to attract the resources to the firm. • The firm is earning an above-normal rate-of-return on its investment, even after compensating for the riskiness of the investment.

24. Economic Profits and Resource Allocation • Economic profits direct resources into this industry. Mom & Pop can expect to face more competitors in the future. This will likely reduce their own profits. • Economic losses direct resources out of this industry. With fewer firms in the market, remaining firms may break even. • We will study this more later.

25. Coming Up • Production Costs in the SR and LR. • Cost curves of the firm

26. Group Work • Exercises in Opportunity Costs

27. Using Your Car • How much does it cost you to own and use your car for a year? Make a list of all of the economic costs. Just list the types of costs you would need to calculate--do not attempt to actually fill in numbers (unless you want to).

28. Buying versus Renting a Building • Suppose you are opening a retail shop. Should you buy or rent a business location? Make a list of the economic costs associated with each option for 10 years.