Businesses and the Costs of Production

CHAPTER 9: BUSINESSES AND THE COSTS OF PRODUCTION

ACCOUNTING PROFIT

• Definition: Accounting profit (0) is calculated as: \pi = TR - TC

  • Where:

  • TR = Total Revenue

  • TC = Total Costs (Accounting Costs)

• Limitation: Does not consider whether to continue the business or not.

EXPLICIT AND IMPLICIT COSTS

• Economic Costs: Total payments made to obtain and retain services of a resource.

• Key Concepts:

  • Every resource has an opportunity cost.

  • Applies to both purchased and owned resources.

  • Explicit Costs: Cash payments for resources not owned.

  • Implicit Costs: Opportunity cost of using owned resources.

• Example of Costs:

  • A table-making firm invests 5000 in cash (explicit) and owns an oak forest.

  • Hiring workers incurs explicit costs of 5000.

  • Implicit Cost: Foregone sale of the tree valued at 1500.

  • Economic Costs = Explicit Costs + Implicit Costs.

ECONOMIC PROFIT

• Definition: Economic profit generally is less than accounting profit, as it factors implicit costs.

• Calculation:

  • Economic Profit:
    Economic\ Profit = Revenue - Explicit\ Costs - Implicit\ Costs

  • Distinction from Accounting Profit: Accounting profit only deducts explicit costs.

• Normal Profit: When economic profit is zero, indicating earned returns equivalent to next best alternative.

EXAMPLE OF ACCOUNTING AND ECONOMIC PROFIT

• Scenario:

  • Leave a job with a 22,000 salary;

  • Invest 20,000 savings earning 1,000 annually;

  • Rent retail space previously earned 5,000;

  • Foregone Etsy earnings: 5,000.

• After a year, the business earns 57,000 accounting profit but must consider all costs.

ECONOMIC PROFIT & LOSS

• Earnings Above Best Alternative:

  • Economic profit represents earning greater than the best alternative.

  • Economic loss means earning less than the best alternative.

  • Normal profit = 0 economic profit.

• In cases of economic loss, firms might exit the market, freeing up resources.

SHORT RUN AND LONG RUN

• Short Run: Firms can adjust labor and raw materials but can't change factory size.

• Long Run: Firms can adjust all resources, including entering or exiting industries.

PRODUCTIVITY OF LABOR

• Definitions:

  • Total Product (TP): Total output produced.

  • Marginal Product (MP): Extra output from adding one more labor unit.

  • Average Product (AP): Total output per unit of labor input.

• Relationships in labor productivity can show diminishing returns, where adding labor leads to smaller increases in output over time.

LAW OF DIMINISHING RETURNS

• Adding labor to fixed resources leads to smaller output increases due to insufficient space or capital.

• This principle explains why marginal product diminishes.

SHORT-RUN PRODUCTION COSTS

• Fixed Costs: Do not vary with output (e.g. rent, insurance).

• Variable Costs: Fluctuate with production levels (e.g. labor, materials).

• Total Cost (TC) Calculation:
  TC = FC + VC

AVERAGE COSTS

• Average Total Cost (ATC): Total cost divided by output.
  ATC = \frac{TC}{Q}

• Average Variable Cost (AVC): Variable costs per unit of output.
  AVC = \frac{VC}{Q}

• Average Fixed Cost (AFC): Fixed costs spread over output.
  AFC = \frac{FC}{Q}

• Decreasing AFC: As output increases, costs spread over larger quantities.

MARGINAL COST

• Marginal Cost (MC): Additional cost of producing one more unit.

  • Calculated through:
    MC = \frac{\Delta TC}{\Delta Q}

• Relationship between MC and productivity indicates efficiency.

LONG-RUN PRODUCTION COSTS

• Potential for altering plant capacity leads to changes in average costs.

• Economies of Scale: Lower average costs with larger production levels initially, followed by potential diseconomies of scale as production increases further.