Economic Costs and Opportunity Cost in Firms

Theory of the Firm

• Firms exist due to scarcity of resources and their alternative uses.
• When resources are combined to produce a good, alternative uses are forgone.
• Opportunity cost is the value of the best alternative use of a resource.

Economic Costs and Profit

• Economic Costs: Resources are scarce, productive, and have alternative uses. Using resources to produce one good means forgoing using them for other purposes.
• Opportunity Cost: This is the measure of economic cost. It's the value that a resource would have in its best alternative use.
• Explicit Costs: Monetary payments for resources owned by others. Explicit costs are revealed (cash expenditures). Examples: wages, materials, rent.
• Implicit Costs: Opportunity costs of using self-owned or self-employed resources. Implicit costs are the forgone earnings from the best alternative use of these resources (not always obvious). For example, the income a business owner could earn elsewhere could be considered as an implicit cost.

Example of Explicit and Implicit Costs

• A sales representative earning $22,000 per year decides to open a T-shirt retail store.
• Investment of $20,000 savings that were earning $1,000 per year.
• Rented a store (owned) for $5,000 per year.
• Hired a clerk for $18,000 annually.

Calculating Costs and Profit

• Total Sales Revenue: $120,000
• Explicit Costs (Clerk's salary, Cost of T-shirts, Utilities): $63,000
• Accounting Profit: $57,000
• Implicit Costs (Foregone Interest, Foregone Rent, Foregone Wages, Foregone Entrepreneurial Income): $33,000
• Economic Profit: $24,000

Normal Profit as a Cost

• Normal profit is the minimum payment needed to keep an entrepreneur in a business. It is considered an implicit cost.
• If an entrepreneur doesn't receive enough payment (less than normal profit) ,they might shift to a more profitable endeavor.

Economic Profit

• Economic Profit is total revenue less economic costs. This is the return above what's needed to retain entrepreneurial talent.
• Economic profit is zero if total revenue just covers all explicit and implicit costs, including normal profit.

Accounting Profit vs Economic Profit

• Accounting profit considers only explicit costs (payments to outside providers).
• Economic profit takes into account both explicit and implicit costs (including the opportunity cost of resources the firm already owns).

This quiz explores the concepts of economic costs, opportunity costs, and the theory of firms regarding resource allocation. It emphasizes the differences between explicit and implicit costs and the significance of opportunity cost in decision-making. Test your understanding of how firms operate under resource scarcity and the alternatives they forego.