🛒principles of microeconomics review
7.1 Explicit and Implicit Costs, and Accounting and Economic Profit
Last Updated on June 25, 2024
Costs and profits are crucial concepts in microeconomics. Firms must consider both explicit costs, which involve direct payments, and implicit costs, which represent opportunity costs. Understanding these distinctions is key to making informed business decisions.
Profit calculations differ between accounting and economic perspectives. While accounting profit only considers explicit costs, economic profit factors in both explicit and implicit costs. This difference impacts how firms evaluate their financial performance and make strategic choices.
Costs and Profit in Microeconomics
Explicit vs implicit costs
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1.2 Opportunity Costs & Sunk Costs – Principles of Microeconomics View original
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1.2 Opportunity Costs & Sunk Costs – Principles of Microeconomics View original
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1.2 Opportunity Costs & Sunk Costs – Principles of Microeconomics View original
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1.2 Opportunity Costs & Sunk Costs – Principles of Microeconomics View original
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1.2 Opportunity Costs & Sunk Costs – Principles of Microeconomics View original
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1.2 Opportunity Costs & Sunk Costs – Principles of Microeconomics View original
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1.2 Opportunity Costs & Sunk Costs – Principles of Microeconomics View original
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- Explicit costs require direct monetary payment (wages, rent, materials, utilities)
- Implicit costs do not involve direct monetary payment but still represent a cost to the firm
- Opportunity costs of using resources owned by the firm (foregone interest, rental income, wages)
- Sunk costs, which are past expenses that cannot be recovered, are not considered in decision-making
Calculation of profit types
- Accounting profit calculated as total revenue minus explicit costs
- Does not consider implicit costs
- Economic profit calculated as total revenue minus both explicit and implicit costs
- Considers all costs, including opportunity costs
- Relationship between accounting and economic profit
- Economic profit always less than or equal to accounting profit
- Positive economic profit implies positive accounting profit
- Zero economic profit means accounting profit equals implicit costs (normal profit)
- Negative economic profit can still result in positive accounting profit
Cost structure impact on decisions
- Short run has at least one fixed input (capital), only variable inputs (labor, materials) can be adjusted to change output
- Decisions focus on minimizing short-run costs and maximizing short-run profits (adjusting production levels, changing variable input quantities)
- Long run has all inputs variable, including capital
- Decisions focus on minimizing long-run costs and maximizing long-run profits (investing in technology, expanding/contracting facilities, entering/exiting markets)
- Impact of cost structure
- Higher fixed costs emphasize long-run decisions, higher variable costs emphasize short-run decisions
- Economies of scale (decreasing long-run average costs) may encourage expanding production
- Diseconomies of scale (increasing long-run average costs) may lead to finding optimal production level
Cost Analysis and Efficiency
- Marginal cost: The additional cost of producing one more unit of output
- Average cost: The total cost divided by the quantity produced
- Break-even point: Where total revenue equals total cost, resulting in zero economic profit
- Allocative efficiency: Achieved when the price of a good equals its marginal cost of production
- Productive efficiency: Occurs when a firm produces at the lowest possible average total cost
Key Terms to Review (26)
Economies of Scale: Economies of scale refer to the cost advantages that businesses can exploit by expanding their scale of production. As a company increases its output, its average costs per unit typically decrease due to more efficient utilization of resources, specialized equipment, and division of labor.
Allocative Efficiency: Allocative efficiency refers to the optimal distribution of resources and production of goods and services in an economy to best meet the needs and preferences of consumers. It is achieved when the mix of goods and services produced aligns with what consumers most value, as reflected in their willingness to pay.
Productive Efficiency: Productive efficiency refers to the optimal use of resources to produce goods and services at the lowest possible cost, without waste or inefficiency. It is a central concept in microeconomics that is closely tied to the production possibilities frontier and the behavior of firms in perfectly competitive markets.
Total Revenue: Total revenue is the total amount of money a firm receives from the sale of its products or services. It is the product of the quantity sold and the price per unit, and is a crucial factor in a firm's profitability and decision-making processes.
Fixed Inputs: Fixed inputs are factors of production that cannot be easily changed or adjusted in the short-term. They represent resources that a firm must commit to in order to operate, and their quantities remain constant regardless of the level of output produced.
Explicit Costs: Explicit costs refer to the direct, out-of-pocket expenses incurred by a business in the production of goods or services. These are the easily identifiable and measurable costs that must be paid to external parties for resources used in the production process.
Variable Inputs: Variable inputs are production inputs that can be adjusted in the short-run to change the quantity of output produced. They are resources that a firm can increase or decrease as needed to meet changes in demand, in contrast to fixed inputs which remain constant.
Implicit Costs: Implicit costs are the opportunity costs associated with using a firm's own resources, such as the owner's time or a building the firm owns, rather than purchasing those resources from the market. They represent the value of resources that a firm forgoes when using them for production instead of selling them or using them for another purpose.
Short Run: The short run is a period of time in which at least one factor of production, typically capital, is fixed while other factors, such as labor, can be varied. This concept is central to understanding production and costs in the context of microeconomic analysis.
Labor: Labor refers to the human effort, both physical and mental, that is used in the production of goods and services. It is one of the primary factors of production, along with land, capital, and entrepreneurship, that contribute to the creation of economic value.
Long Run: The long run is a period of time in which all factors of production, including capital equipment and facilities, can be varied. It is a time frame in which a firm can make any changes it desires to its production process, allowing it to adjust its scale of operations to the most efficient level.
Economic Profit: Economic profit is the difference between a firm's total revenue and its total economic costs, which include both explicit costs (such as wages, rent, and raw materials) and implicit costs (such as the opportunity cost of the owner's time and the cost of using the firm's own capital). Economic profit is a more comprehensive measure of a firm's profitability compared to accounting profit, which only considers explicit costs.
Short-Run Costs: Short-run costs refer to the costs incurred by a firm in the short-term, where at least one factor of production is fixed. These costs include both variable costs, which change with output, and fixed costs, which remain constant regardless of output level. Understanding short-run costs is crucial for firms to make optimal production decisions and determine profitability.
Accounting Profit: Accounting profit is the difference between a company's total revenue and its explicit or out-of-pocket costs. It represents the financial gain or surplus generated by a business's operations, as calculated according to generally accepted accounting principles (GAAP).
Diseconomies of Scale: Diseconomies of scale refer to the increase in average cost per unit that can occur when a company or industry expands its scale of production beyond an optimal level. This phenomenon is the opposite of economies of scale, where average costs decrease as output increases.
Opportunity Cost: Opportunity cost is the value of the next best alternative that must be foregone when making a choice. It represents the tradeoffs involved in deciding how to allocate scarce resources between competing alternatives.
Capital: Capital refers to the resources, both physical and financial, that are used in the production of goods and services. It is a key factor of production, along with land, labor, and entrepreneurship, that enables economic activity and the generation of wealth.
Short-Run Profits: Short-run profits refer to the positive difference between a firm's total revenue and its total explicit costs during a relatively short period of time, typically less than a year. This concept is crucial in understanding the decision-making process of firms as they seek to maximize their financial performance in the short-term, while also considering their long-term strategies and goals.
Long-Run Costs: Long-run costs refer to the total costs a firm incurs when all factors of production, including capital equipment and facilities, can be varied. In the long run, a firm can adjust all of its inputs, including the size of its plant and equipment, to find the most efficient combination of inputs to produce a given level of output.
Normal Profit: Normal profit is the minimum level of profit a firm must earn to remain in business in the long run. It represents the opportunity cost of the firm's resources, or the returns the firm's owners could earn by employing their resources elsewhere in the economy.
Marginal Cost: Marginal cost is the additional cost incurred by a firm when producing one more unit of a good or service. It represents the change in total cost that results from a small increase in output. Marginal cost is a crucial concept in understanding a firm's production decisions and profitability across various market structures.
Break-Even Point: The break-even point is the level of output or sales at which a company's total revenue exactly matches its total costs, resulting in neither a profit nor a loss. It represents the point where a business transitions from operating at a loss to generating a profit.
Sunk Costs: Sunk costs refer to costs that have already been incurred and cannot be recovered, regardless of future actions taken. These costs are considered irrelevant for decision-making purposes as they do not affect the future outcome of a situation.
Average Cost: Average cost is the total cost of production divided by the total quantity of output produced. It represents the per-unit cost of producing a good or service and is a crucial metric in understanding a firm's profitability and decision-making.
Long-Run Profits: Long-run profits refer to the potential for a firm to earn profits over an extended period of time, where the firm has the flexibility to adjust all of its inputs, including capital investments. This concept is closely tied to the ideas of explicit and implicit costs, as well as accounting and economic profit.
Long-Run Average Costs: Long-run average costs refer to the average cost per unit of output when a firm can vary all of its inputs, including its capital equipment and facilities. It represents the lowest possible average cost a firm can achieve in the long run as it adjusts its production scale to the most efficient level.