Micro Chapter 20

1. Micro Chapter 20 Presentation 3- Cost of Production

2. Explicit Costs • Cash expenditures a firm makes to those who supply labor services, materials, fuel, transportation etc. • Cash payments for the use of resources owned by others ($$ value)

3. Implicit Costs • Opportunity cost of using self-owned, self-employed resources • Amount of $$ that self-employed resources could have earned in their best alternative use • Ex- using a building rather than renting it…the amount of rent you could have made

4. Economic Cost (opportunity cost) • The value or worth the resources used to produce a good would have in its best alternative use • Ex- steel in a building could be used for cars • Ex- for an assembly line worker making computers, the contribution he could have produced for another good

5. Economic Costs- Firm’s Standpoint • The payments a firm must make, or the incomes it must provide, to attract the resources away from alternative production opportunities. • These payments can be explicit or implicit.

6. Normal Profit • The minimum payment you must receive for performing entrepreneurial functions for a firm rather than for yourself • Included in implicit costs

7. Accounting Profit • Profit = Total Revenue- Explicit Costs

8. Economic Profit (Pure Profit) • Profit = Total Revenue – Economic Costs (Implicit and Explicit Costs)

9. Example Problem • You have been earning $22,000/yr. You decide to open your own T-Shirt company. You invest $20,000 of savings that have earning you $1000/year in interest. Your firm will be in a small store that you own and have been renting out for $5000/year. You also hire a clerk for $18000/year. Calculate Accounting and economic profit

10. Example Results • Total Sales Revenue………………..120,000 • Cost of t-shirts…………40000 • Clerk’s salary…………...18000 • Utilities…………………...5000 TOTAL COSTS (Explicit)………………………(63,000) ACCOUNTING PROFIT…………………………$57,000

11. Analysis • $57,000 accounting profit looks good but doesn’t include implicit costs and overstates the economic success of the company.

12. Analysis Cont’d • By providing your own financial capital, building and labor you incur implicit costs (forgone income): • Accounting Profit………………………57000 • Forgone interest……………………….1000 • Forgone rent…………………………...5000 • Forgone wages………………………..22000 • Forgone entrepreneurial income….5000 TOTAL Implicit Costs…………………………….(33000) Economic Profit……………………………………$24000

13. ECONOMIC Profit = TR-ECONOMIC COSTS = 120000 – 63000-33000 • = $24000

14. Key Question 2 Gomez runs a small pottery firm. He hires one helper at $12,000 per year, pays annual rent of $5,000 for his shop, and spends $20,000 per year on materials. He has $40,000 of his own funds invested in equipment (pottery wheels, kilns, and so forth) that could earn him $4,000 per year if alternatively invested. He has been offered $15,000 per year to work as a potter for a competitor. He estimates his entrepreneurial talents are worth $3,000 per year. Total annual revenue from pottery sales is $72,000. Calculate accounting profits and economic profits for Gomez’s pottery.

15. Key Question 2 Solution • Explicit costs: $37,000 (= $12,000 for the helper + $5,000 of rent + $20,000 of materials). Implicit costs: $22,000 (= $4,000 of forgone interest + $15,000 of forgone salary + $3,000 of entrepreneurship). • Accounting profit = $35,000 (= $72,000 of revenue - $37,000 of explicit costs); Economic profit = $13,000 (= $72,000 - $37,000 of explicit costs - $22,000 of implicit costs).