CH 14

Introduction to Microeconomics and Economic Profit

  • Economic Profit is a key concept in understanding firm behavior in microeconomics.

    • It is introduced when discussing the larger framework of production costs.

Chapter 14: The Costs of Production

Key Questions Addressed in the Chapter:

  • What is a production function? What is marginal product? How are they related?

  • What are the various costs of production? How do they relate to each other and to output?

  • How do costs differ in the short run versus the long run?

  • What are economies of scale, diseconomies of scale, and constant returns to scale?

Total Revenue, Total Cost, and Profit

  • Fundamental Assumption: The goal of a firm is to maximize profit.

  • Total Revenue (TR): The total income a firm receives from the sale of its output.

    • Formula: TR=PimesQTR = P imes Q

    • Where:

      • P = Price per unit

      • Q = Quantity of output sold

  • Total Cost (TC): The market value of all inputs used in production.

  • Profit: Difference between total revenue and total costs.

    • Formula: extProfit=TR−TCext{Profit} = TR - TC

Example 1A: Jelani's Gelato Shop

  • Jelani runs a gelato shop and produces 15,000 pints of gelato per year, selling at $5 each.

  • Total costs for the shop are $65,000.

  • Calculating Profit:

    • Total Revenue:

    • TR=PimesQ=5imes15,000=75,000TR = P imes Q = 5 imes 15,000 = 75,000

    • Profit Calculation:

    • extProfit=TR−TC=75,000−65,000=10,000ext{Profit} = TR - TC = 75,000 - 65,000 = 10,000

Opportunity Costs

  • Opportunity cost is crucial in understanding economic decisions.

    • Definition: "The cost of something is what you give up to get it."

  • Types of Costs:

    • Explicit Costs: Direct input costs requiring money outlay by the firm (e.g., wages paid).

    • Implicit Costs: Indirect costs that represent the opportunity cost of a firm's resources (e.g., owner's time).

  • Total Cost Calculation:

    • extTotalCost=extExplicitCosts+extImplicitCostsext{Total Cost} = ext{Explicit Costs} + ext{Implicit Costs}

Example 1B: Costs for Jelani's Gelato Shop

  • Jelani's explicit costs include:

    • Raw materials: $20,000

    • Rent: $12,000

  • Implicit Cost: Opportunity cost if she worked instead at a coffee shop yielding $25,000 per year.

  • Calculations:

    • Explicit Costs:

    • extExplicitCosts=20,000+12,000=32,000ext{Explicit Costs} = 20,000 + 12,000 = 32,000

    • Implicit Cost:

    • extImplicitCost=25,000ext{Implicit Cost} = 25,000

    • Total Costs:

    • extTotalCosts=32,000+25,000=57,000ext{Total Costs} = 32,000 + 25,000 = 57,000

Example 1C: The Cost of Capital

  • Jelani invested $80,000 in setting up her gelato shop.

  • Financing: From savings (withdrawn $30,000) and borrowing ($50,000 at 10% interest).

  • Calculating Costs:

    • Explicit Cost:

    • Interest on borrowing: 0.10imes50,000=5,0000.10 imes 50,000 = 5,000

    • Implicit Cost:

    • Interest on savings: 0.10imes30,000=3,0000.10 imes 30,000 = 3,000

    • Opportunity Cost of Capital: $8,000 per year.

Economic Profit vs Accounting Profit

  • Accounting Profit: Total revenue minus total explicit costs.

    • Definition: extAccountingProfit=TR−extTotalExplicitCostsext{Accounting Profit} = TR - ext{Total Explicit Costs}

  • Economic Profit: Total revenue minus total costs (explicit and implicit).

    • Definition: extEconomicProfit=TR−extTotalCostsext{Economic Profit} = TR - ext{Total Costs}

  • Key Insight: Accounting profit is generally larger as implicit costs are not considered in that measure.

Example 1D: Profit for Jelani's Gelato Shop (Detailed Calculation)

  • Recap of Jelani's outputs and costs:

    • Production: 15,000 pints at $5 each

    • Explicit Costs Breakdown:

    • Raw Materials: $20,000

    • Rent: $12,000

    • Interest Paid: $5,000

    • Calculating Accounting Profit:

    • extAccountingProfit=TR−extExplicitCosts=75,000−37,000=38,000ext{Accounting Profit} = TR - ext{Explicit Costs} = 75,000 - 37,000 = 38,000

    • Calculating Economic Profit:

    • extEconomicProfit=TR−(extExplicit+extImplicitCosts)=75,000−(37,000+28,000)=10,000ext{Economic Profit} = TR - ( ext{Explicit} + ext{Implicit Costs}) = 75,000 - (37,000 + 28,000) = 10,000

Active Learning 2: Economic vs Accounting Profit Changes

  • Scenario: Rent on office space increases by $500/month affecting profits.

  • If you rent office space:

    • Explicit costs increase by $500/month.

    • Accounting and Economic Profits both fall by $500/month.

  • If you own office space:

    • Explicit costs remain unchanged; accounting profit does not change.

    • Implicit costs increase, causing Economic Profit to fall by $500/month.

Understanding Firm Viability with Zero Profit

  • The critical question: Should firms remain operational if they yield zero profit?

    • Profit equation: extProfit=extTotalRevenue−extTotalCostext{Profit} = ext{Total Revenue} - ext{Total Cost}

    • Total Costs include all implicit costs, such as opportunity costs of time and money.

    • Zero Economic Profit suggests the firm covers all costs but does not exceed the owner's next best alternative.

Return on Investment vs Return on Equity

  • Return on Investment (ROI): Measures profitability of an investment based on explicit outlay.

    • Formula: ROI=racextNetProfitextInvestmentROI = rac{ ext{Net Profit}}{ ext{Investment}}

  • Return on Equity (ROE): Measures investment returns considering opportunity costs.

    • Formula for real estate example:

    • Property cost: $100,000

    • Rental Income: $6,000

    • Current market value: $200,000

    • ROI Calculation:

      • ROI=rac6000100,000=0.06ROI = rac{6000}{100,000} = 0.06 or 6%

      • ROE=rac6000200,000=0.03ROE = rac{6000}{200,000} = 0.03 or 3%

Production Function and Costs

  • Production Function: Outlines the relationship between inputs and outputs. Generally entails labor (L) and capital (K).

    • Assumption for analysis: In the short run, capital (e.g., factory size) is fixed, thus increasing output is dependent on labor.

Example 2A: Jon’s Popcorn Truck

  • Jon operates a popcorn truck that can have varying numbers of workers.

  • Production Capacity Based on Workers Hired:

    • 1 Worker: 30 buckets

    • 2 Workers: 55 buckets

    • 3 Workers: 75 buckets

    • 4 Workers: 90 buckets

    • 5 Workers: 100 buckets

Example 2A: Production Function Visualization




  • Tabular representation of output based on labor employed.


    L (Workers)

    Q (Buckets)



    0

    0



    1

    30



    2

    55



    3

    75



    4

    90



    5

    100







    Marginal Product Calculations

    • Marginal Product (MP): The incremental output resulting from an additional unit of labor.

      • Defined formulaically: MPL=racextΔQextΔLMPL = rac{ ext{ΔQ}}{ ext{ΔL}}

    • Marginal Product is indicative of the slope of the production function.

    Diminishing Marginal Product

    • Law of Diminishing Marginal Product: As input quantity increases, the marginal product of an input will eventually decline.

    • Production function becomes flatter as more of a single input is utilized.

      • Implication: The additional output gained from each subsequent labor unit decreases.

      • Conceptual connection: Rational decision-making involves assessing increments, balancing output increases against associated labor costs.

    Converting Production to Costs

    • Fixed costs are incurred irrespective of productivity levels; variable costs change with output.

    • Example of Jon's costs pertaining to the popcorn business:

      • Fixed daily truck cost: $200

      • Each hired worker incurs a wage.

    Total Cost Representation for Different Outputs

    L (Workers)

    Q (Buckets)

    Total Cost

    0

    0

    200

    1

    30

    250

    2

    55

    300

    3

    75

    350

    4

    90

    400

    5

    100

    450

    Various Measures of Cost

    • Total Cost (TC): Sum of fixed costs (FC) and variable costs (VC).

      • Formula: TC=FC+VCTC = FC + VC

    • Fixed Costs (FC): Costs that do not change with production levels.

    • Variable Costs (VC): Costs that vary according to output produced.

    Average Total Cost and Marginal Cost Definitions

    • Average Total Cost (ATC): Reflects the cost per typical unit produced.

      • Formula: ATC=racTCQATC = rac{TC}{Q}

    • Marginal Cost (MC): Measures the increase in total cost when producing an additional unit of product.

      • Formula: MC=racextΔTCextΔQMC = rac{ ext{ΔTC}}{ ext{ΔQ}}

    Analysis of Costs: Example 3

    • Angel produces knitted scarves and must consider fixed and variable costs associated with yarn and labor.

      • Example of costs associated with output levels:
        | Q | FC | VC | TC |
        |---|----|----|----|
        | 0 | 18 | 0 | 18 |
        | 1 | 18 | 15 | 33 |
        | 2 | 18 | 25 | 43 |
        | 3 | 18 | 30 | 48 |
        | 4 | 18 | 32 | 50 |

    Average and Marginal Cost Analysis




    • Average and Marginal Costs from Example 3 Calculation:


      Q

      ATC

      MC



      0

      -

      -



      1

      33.0

      15.0



      2

      21.5

      10.0



      3

      16.0

      5.0



      4

      12.5

      2.0



      5

      10.8

      4.0









      Relationship Between Average Total Cost (ATC) and Marginal Cost (MC) Curves

      • Important relationship illustrated:

        • When: MC < ATC, ATC is declining.

        • When: MC > ATC, ATC is rising.

        • The minimum point of the ATC curve coincides with MC curve intersection.

      Costs in Short Run vs Long Run

      • Short Run (SR):

        • Some inputs are fixed; key costs are fixed costs (FC).

      • Long Run (LR):

        • All inputs are variable; firms can adjust all production factors.

        • ATC at any quantity reflects the most efficient resource mix.

      Long Run Average Total Cost (LRATC) Analysis

      • Different factory sizes result in varying short-run average total cost (SRATC) curves.

        • Firm's capacity planning involves assessing optimal factory size retentively linked to expected output levels.

      Economies of Scale vs Diseconomies of Scale

      • Economies of Scale:

        • LRATC decreases as output quantity increases.

        • Enhanced specialization leads to productive efficiencies.

      • Constant Returns to Scale:

        • LRATC remains constant, signaling an efficient scale of operation.

      • Diseconomies of Scale:

        • LRATC increases with output increments, often due to management challenges in large firms.

      Implications of Scale on Firm Size

      • Industries facing diseconomies tend to have small, competitive firms.

      • Industries benefitting from economies of scale are often characterized by few dominant firms, creating market power.

      Conclusion: Economic vs Accounting Profit

      • The primary goal of firms is profit maximization, necessitating consideration of both explicit and implicit costs.

      • The cost structure related to production must consider marginal behavior; that is a firm’s costs are intertwined with its production techniques.

        • Understanding total costs leads to deeper insights into efficient scale operations, aiding better strategic decisions for firms.