Production, Cost and Profit

1. Production, Cost and Profit

2. Economic Costs • Costs are accounting for the fact that when one thing is produced alternative goods and services are forgone. • This is the idea of opportunity cost. When one thing is chosen, the opportunity to do the next best thing is forgone.

3. When production occurs inside an organization costs are incurred. This is obvious. In economics we like to conceptualize these costs a couple of different ways. When it is all said and done no matter way you conceptualize cost the total would be the same. And, in fact, all costs are opportunity costs. One way to breakup up costs are between what are called explicit and implicit costs. Another way to breakup costs are between what are called fixed and variable costs. Let’s turn to each of these next.

4. Say there is a company that makes golf clubs and the explicit costs of production include • Explicit costs • 12,000 hired labor • 5,000 rent • 20,000 materials • 37,000 total Explicit costs are costs where money has to be paid out of the pocket of the owner of the company.

5. Explicit cost • In the example, the labor hired to make, say, golf clubs, would then not be used to make something else, say, aluminum baseball bats - an opportunity cost. • These explicit costs represent payments to non-owners of the firm.

6. Implicit cost • Costs of using owner supplied resources. • The implicit costs represent money payments owner supplied resources could have earned in their next best use. • As an example of this, say the owner of the company put in a bunch of money that used to earn interest in a bank account. The interest forgone is a cost of doing business.

7. Implicit costs • 15,000 owner’s labor sacrifice if working elsewhere • 3,000 entrepre. cost • 4,000 interest forgone • 22,000 total

8. Profit • Accounting profit = Revenue - explicit cost. • Economic profit = Revenue - explicit cost - implicit cost. • Profit will be used in general and this will mean economic profit. Implicit costs are incorporated into an economic analysis.

9. Explicit costs 12,000 hired labor 5,000 rent 20,000 materials 37,000 total Implicit costs 15,000 owner’s labor 3,000 entrepre. cost 4,000 inter. forgone 22,000 total Example where revenue is 72,000 • Accounting profit = 72,000-37,000 = 35,000 • Economic profit = 72,000-37,000-22,000 = 13,000

10. If the example on the previous screen only had revenue of 55,000 then Accounting profit = 55,000 – 37,000 = 18,000 Economic Profit = 55,000 – 37,000 – 22,000 = -4,000 So, here the economic profit is negative. This means that the individual would have more profit by doing what he was doing before. The accounting profit is 18,000 but what he was doing before gave him 22,000 so he is 4,000 worse off.

11. Production cost • We will consider cost over two different time frames: • short run and • long run. • We will distinguish between two types of inputs: • variable and • fixed.

12. The input called capital • The main capital good of a firm is typically the plant or production facility. • It takes time to physically alter the plant so that the level of output can be changed.

13. Examples of plant adjustment • How long would it take to alter a restaurant facility? • 6 months? • ... to alter an automobile factory? • 2 years? • Each production setting is likely to have a different time frame to alter the production facility.

14. The short run • The short run is that time period in which at least one input can not be changed or altered as output changes. • So, at least one input is fixed in the short run and the rest are variable inputs and costs are divided up accordingly. • We typically think of the plant as the fixed input. The short run is that time frame right up to the time it takes to alter the plant.

15. The long run • The long run is the time frame longer or just as long as it takes to alter the plant. • Thus the long run is that time period in which all inputs are variable and thus all costs are variable.