1. Verbal Bellringer with your partner
This is a financial statement for Facebook
A.How much revenue did they make last year?
B.How much profit did they keep last year?
C.How have they been doing the last four years?
D.Is this a good stock to buy?
3. THE COSTS OF
PRODUCTION
3
Total Revenue, Total Cost,
Profit
• We assume that the firm’s goal is to
maximize profit.
Profit = Total revenue – Total cost
the amount a
firm receives
from the sale
of its output
the market
value of the
inputs a firm
uses in
production
4. THE COSTS OF
PRODUCTION
4
Costs: Explicit vs. Implicit
• Explicit costs require an outlay of money,
e.g., paying wages to workers.
• Implicit costs do not require a cash outlay,
e.g., the opportunity cost of the owner’s time.
• Remember one of the Ten Principles:
The cost of something is
what you give up to get it.
• This is true whether the costs are implicit or
explicit. Both matter for firms’ decisions.
5. THE COSTS OF
PRODUCTION
5
Explicit vs. Implicit Costs: An Example
You need $100,000 to start your business.
The interest rate is 5%.
• Case 1: borrow $100,000
– explicit cost = $5000 interest on loan
• Case 2: use $40,000 of your savings,
borrow the other $60,000
– explicit cost = $3000 (5%) interest on the loan
– implicit cost = $2000 (5%) foregone interest
you could have earned on your $40,000.
In both cases, total (exp + imp) costs are $5000.
6. THE COSTS OF
PRODUCTION
6
Economic Profit vs. Accounting Profit
• Accounting profit
= total revenue minus total explicit costs
• Economic profit
= total revenue minus total costs (including
explicit and implicit costs)
• Accounting profit ignores implicit costs,
so it’s higher than economic profit.
7. The equilibrium rent on office space has just
increased by $500/month.
Compare the effects on accounting profit
and economic profit if
a. you rent your office space
b. you own your office space
A C T I V E L E A R N I N GA C T I V E L E A R N I N G 22
Economic profit vs. accounting profitEconomic profit vs. accounting profit
7
8. The rent on office space increases $500/month.
a. You rent your office space.
Explicit costs increase $500/month.
Accounting profit & economic profit each fall
$500/month.
b.You own your office space.
Explicit costs do not change,
so accounting profit does not change.
Implicit costs increase $500/month (opp. cost
of using your space instead of renting it),
so economic profit falls by $500/month.
A C T I V E L E A R N I N GA C T I V E L E A R N I N G 22
AnswersAnswers
8
9. With your partner
• 2 items at your house that the more you
use them, the more you will pay
• 2 items you can use 24/7 and you don’t
have to pay more
11. Let’s think more specifically about costs
• Fixed Costs = costs that do not change based
on production and don’t change in SR
• Examples: capital goods, tools, buildings, menus
Nokia factory in Finland
Coke factory in Atlanta, Georgia
12. Special fixed costs
• “Entry costs” – costs to start up the
business
Business with low
Entry costs
Business with
very high
Entry costs
13. Costs we can change in the short run
Variable costs = costs
that change based on
production
The more I produce, the
more cost I will incur.
If I don’t produce at all,
my variable costs will
be 0
For example: labor,
electricity, raw
materials
Nike factory in China
15. Marginal Costs
• Marginal costs =
the cost of
producing 1
additional unit
• For example:
• Why helpful?
• Diminishing
marginal product!
Widgets
0
1
2
3
4
FC
1
1
1
1
1
VC
0
6
11
16
22
MC
X
16. Total Costs
• Total Costs = fixed + variable costs
For example:
Widgets
0
1
2
3
4
FC
1
1
1
1
1
VC
0
1
2
3
5
TC
1
2
3
4
6
MC
X
1
1
1
2
Revenue
0
2
4
6
8
Assume Widgets
price
$2/each
Profit
-1
0
1
2
2
17. Averages
• Do you guys bring up or down the GPA of all
of Flowing Wells high school?
• Does the cross country team bring up or
down the average weight of Flowing Wells
High School?
• Does a high average cost of living mean that
everyone spends a lot to live in California?
19. In your notes
1. Write 3 examples of FC for this firm
2. Write 3 examples of VC for this firm
3. How could this firm increase its TR?
4. Give an example of diminishing marginal
returns from your life
In Case 2, the foregone interest is the interest you could have earned on your savings. It is an opportunity cost.
This example shows that an important implicit cost is the cost of capital, the foregone returns you could have earned had you used your savings to buy bonds or other assets instead of investing them in your business.
The hope is that students will see that what really matters to them is not just the explicit costs, but total (implicit + explicit) costs.
Accountants keep track of how much money flows into and out of the firm, so they ignore implicit costs.
Economists study the pricing and production decisions of firm, which are affected by implicit as well as explicit costs.
