Theory Of The Firm PDF

1 THEORY OF THE FIRM 2 ECONOMICS COSTS AND PROFIT ECONOMIC COSTS  Costs exist because resources are scarce, are productive, and have alternative uses.  When society uses a combination of resources to produce a particular product, it for-goes all alternative o...

1 THEORY OF THE FIRM 2 ECONOMICS COSTS AND PROFIT ECONOMIC COSTS  Costs exist because resources are scarce, are productive, and have alternative uses.  When society uses a combination of resources to produce a particular product, it for-goes all alternative opportunities to use those resources for other purposes.  The measure of the economic cost, or opportunity cost, of any resource used to produce a good is the value or worth the resource would have in its best alternative use. 3 ECONOMICS COSTS AND PROFIT 1. A firm’s explicit costs (revealed and expressed) are the monetary payments (or cash expenditures) it makes to those who supply labor services, materials, fuel, transportation services, and the like. Such money payments are for the use of resources owned by others. 2. A firm’s implicit costs (present but not obvious) are the opportunity costs of using its self-owned, self- employed resources. To the firm, implicit costs are the money payments that self-employed resources could have earned in their best alternative use. 4 ECONOMICS COSTS AND PROFIT  Suppose you are earning $22,000 a year as a sales representative for a T-shirt manufacturer. At some point you decide to open a retail store of your own to sell T-shirts. You invest $20,000 of savings that have been earning you $1000 per year. And you decide that your new firm will occupy a small store that you own and have been renting out for $5000 per year. You hire one clerk to help you in the store, paying her $18,000 annually. A year after you opened the store, you total up your accounts and find the following: 5 ECONOMICS COSTS AND PROFIT Total Sales Revenue $120,000 Cost of T-shirts $40,000 Clerk’s Salary 18,000 Utilities 5,000 Total (explicit) Costs 63,000 Accounting Profit $ 57,000 Foregone Interest $ 1,000 Foregone rent 5,000 Foregone wages 22,000 Foregone entrepreneurial income 5,000 Total Implicit Costs 33,000 Economic Profit $ 24,000 6 ECONOMICS COSTS AND PROFIT Normal Profit as a Cost  Your entrepreneurial talent in the above example is a normal profit. The payment you could otherwise receive for performing entrepreneurial functions is indeed an implicit cost. If you did not realize at least this minimum, or normal, payment for your effort, you could withdraw from this line of business and shift to a more attractive endeavor. So a normal profit is a cost of doing business. 7 ECONOMICS COSTS AND PROFIT Economic Profit (or Pure Profit)  To the economist, economic profit is total revenue less economic costs (explicit and implicit costs, the latter including a normal profit to the entrepreneur). So when an economist says a certain firm is earning only enough revenue to cover its costs, this means it is meeting all explicit and implicit costs and the entrepreneur is receiving a payment just large enough to retain his or her talents in the present line of production. 8 ECONOMICS COSTS AND PROFIT  If a firm’s total revenue exceeds all its economic costs (explicit implicit), any residual goes to the entrepreneur. That residual is called an economic, or pure, profit. In short: Economic Profit = Total Revenue – Economic Cost  In our example, economic profit is $24,000. An economic profit is not a cost because it is a return in excess of the normal profit that is required to retain the entrepreneur in this particular line of production. Even if the economic profit is zero, the entrepreneur is still covering all explicit and implicit costs, including a normal profit. 9 ECONOMICS COSTS AND PROFIT