Economic Costs and Profits 1st Semester Notes PDF

 Theory of Production and Costs 1. We move from behaviour of consumers to behavior of producers 2. Firms use economic resources to produce goods & services and incur costs 2  Theory of Production and Costs We will look at: 1. Econ...

 Theory of Production and Costs 1. We move from behaviour of consumers to behavior of producers 2. Firms use economic resources to produce goods & services and incur costs 2  Theory of Production and Costs We will look at: 1. Economic Costs and profits 2. Short-run Production Costs and Relationships 3. Long-runProduction Costs and Relationships 2  Some Basic Notions of Production and Cost  In simple terms, production involves converting an input (factor of production) into output.  An input is anything that a firm uses in the production process to manufacture goods and services. Examples of inputs include labour, capital, technology, land and entrepreneurial ability.  An output is the end product of the production process. In other words, outputs are finished products and services. Examples include cars, computers and robots.  Some Basic Notions of Production and Cost Most firms require a wide variety of inputs for their production processes.  For example, the list of inputs for Pula Steel in Botswana include iron ore, coal, oxygen, skilled labour, blast furnaces and the services of the people managing the company.  Some Basic Notions of Production and Cost Although many inputs are used in most production processes, we usually abstract from that complexity and talk about just two: capital and labor. We sometimes represent the relationship between inputs and output with a production function, like so: 𝑸 = 𝒇(𝑲, 𝑳) This is a mathematical representation that tells how much output (q) you’ll get from any combination of inputs (K and L).  Some Basic Notions of Production and Cost To understand the decisions of a firm, we must understand what is it that it is trying to do or to achieve (goal or objective) The economic goal of the firm is to maximize profits  Some Basic Notions of Production and Cost 𝑷𝒓𝒐𝒇𝒊𝒕 𝒐𝒇 𝒕𝒉𝒆 𝒇𝒊𝒓𝒎=𝑻𝒐𝒕𝒂𝒍 𝑹𝒆𝒗𝒆𝒏𝒖𝒆 –𝑻𝒐𝒕𝒂𝒍 𝑪𝒐𝒔𝒕𝒔 𝝅 = 𝑻𝑹 − 𝑻𝑪 Total Revenue (TR): the amount a firm receives for the sale of output. 𝑻𝑹 = 𝑸𝒖𝒂𝒏𝒕𝒊𝒕𝒚 (𝑸) ∗ 𝑷𝒓𝒊𝒄𝒆 (𝑷) 𝑻𝑹 = 𝑷𝑸 Total cost (TC): the market value of the inputs a firm uses in production (The amount that a firm pays to buy inputs) TC is more difficult to measure.  Explicit vs. Implicit Costs Explicit (involving actual payments) Money actually paid out for the use of inputs i.e. monetary payment or the “out of pocket” or cash expenditures a firm makes to those who supply labour services, materials, fuel, transportation, etc. Examples of explicit costs include: salaries the firm pays to workers, cost of raw materials, cost of transport, cost of fuel etc. 7  Explicit vs. Implicit Costs Implicit (no money changes hands) The opportunity cost of using self owned, self employed resources. i.e. to the firm implicit costs are the money payments the self employed resources could have earned in their best alternative use, e.g forgone income, forgone interest, forgone rent etc.  Explicit vs. Implicit Costs Implicit cost also include entrepreneurial income/ talent– it is the payment that you could otherwise receive for performing entrepreneurial functions in other business endeavors that are similar to yours Entrepreneurial income is also referred to as normal profit required to attract and retain resources in a specific line of production.  Explicit vs. Implicit Costs In other words normal profit is the profit level required to cover both implicit and explicit costs ensuring that the entrepreneur earns enough to justify staying in the business instead of switching to an alternative or another business similar to his  ECONOMIC COSTS VS. ACCOUNTING COST  Economic cost is a payment that must be made to obtain and retain the services of a resource. Mathematically it refers the sum of explicit and implicit costs. These costs must be distinguished from:  Accounting costs, which refer only to the firm’s actual expenditures, or explicit cost, incurred for purchased or hired inputs.  Accounting & Economic profit Profit of the firm = Total Revenue – Total Costs When calculating accounting profit, TC= Explicit Costs Accounting Profit = TR- TC (Explicit Costs)  Accounting & Economic profit And when calculating Economic profit TC= (Explicit Costs + Implicit Costs) Economic Profit = TR- TC (Explicit Costs + Implicit costs)  Example 1 Suppose Mpho earns P20 000/ year as a sales representative for a shoe firm. She decides to open a store to sell shoes at the retail level. She invests P20 000 of her savings which has been earning interest of P1000/year. She decides her new firm will occupy a small store which she owns and been renting out for P5000/year. She hires a clerk to help in the firm and earns P20 000/ year. The costs of utilities are estimated to be P5000 / year. The costs of ready made shoes is estimated at P40 000/ year. Her entrepreneurial talent is worth P5000 per annum in business opportunities of similar scope. The total revenue expected from the sale of shoes is estimated to be P 120 000. Calculate accounting profit and economic profit.  Solution Cost of Shoes P40 000 Clerk’s Salary P20 000 Utilities P5 000 Total Explicit Costs P 65 000 Accounting Profit= TR- TC (EXPLICIT COST) P120 000- P65 000= P 55 000 Alternatively: Accounting Profit= TR- Accounting costs P120 000- P65 000= P 55 000 N.B. The accounting profit does not accurately reveal Mpho’s economi status because it ignores her implicit costs.  Solution Accounting profit is always higher than the economic profit because accounting profit only subtracts explicit costs while with economic profit both explicit and implicit are subtracted. By providing her own financial capital, building and labour she incurs inclusive or implicit costs ( forgone income P1000 interest, P5000 rent and P20 000 wages). We have also been told that her entrepreneurial talent is worth P5000 annually in other business endeavors of similar scope, so with this information we can calculate economic profit  Solution Forgone interest rate (on savings) P 1 000 Forgone Rent P 5 000 Forgone wages P 20 000 entrepreneurial income P 5 000 Total Implicit Costs P 31 000 Economic Profit =TR-TC (Explicit+implicit) = P120000- (P65000+P31000) =P 24 000  Solution Alternatively: Economic Profit =TR-Economic cost = P120000- (P65000+P31000) =P 24 000  Conclusion The economic costs include as cost of production both explicit and implicit costs, including a normal profit required to attract and retain resources in a specific line of production. The accountants only includes explicit costs. Accounting Profit = firms TR – Explicit Costs Economic Profit = firms TR – (Explicit Costs + Implicit Costs).  Example 2 Being an entrepreneur, Ms Juliet is running a production firm and paying P200, 000 in wages, P50, 000 in interest on borrowed money capital and P 70, 000 for the yearly rental of its factory building. If the entrepreneur worked for somebody else as Manager she would earn P40 000 per year. She owns no land or building. Calculate the entrepreneur’s economic profit, if she receives total revenue of P400, 000 from selling the year’s output. What is the accounting profit to the entrepreneur?  Example 3 John runs a bakery firm. He hires one helper at P20, 000 per year, pays annual rent of P5000 for his bakery, and spends P50, 000 for materials. He has P75, 000 of his own funds invested in equipment (baking machine, ovens etc.) that could earn him P7500 per year if alternatively invested. He has been offered P35, 000 per annum to work as a baker for a competitor. He estimates his entrepreneurial talents are worth P25, 000. Total annual revenue from bread sales is P190, 000. Calculate the accounting profit and economic profit for John’s bakery firm.