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Understanding Explicit and Implicit Costs in Production Economics

This presentation delves into the concepts of explicit and implicit costs, essential for evaluating the total cost of production. Explicit costs refer to the direct cash expenditures by a firm, such as wages and materials. In contrast, implicit costs represent the opportunity costs associated with self-owned resources, like forgone wages or rent. The presentation illustrates these concepts through examples, showing how to calculate accounting profit and economic profit. This understanding is crucial for entrepreneurs to assess the true profitability of their ventures and make informed business decisions.

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Understanding Explicit and Implicit Costs in Production Economics

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  1. Micro Chapter 20 Presentation 3- Cost of Production

  2. Explicit Costs • Cash expenditures a firm makes to those who supply labor services, materials, fuel, transportation etc. • Cash payments for the use of resources owned by others ($$ value)

  3. Implicit Costs • Opportunity cost of using self-owned, self-employed resources • Amount of $$ that self-employed resources could have earned in their best alternative use • Ex- using a building rather than renting it…the amount of rent you could have made

  4. Economic Cost (opportunity cost) • The value or worth the resources used to produce a good would have in its best alternative use • Ex- steel in a building could be used for cars • Ex- for an assembly line worker making computers, the contribution he could have produced for another good

  5. Economic Costs- Firm’s Standpoint • The payments a firm must make, or the incomes it must provide, to attract the resources away from alternative production opportunities. • These payments can be explicit or implicit.

  6. Normal Profit • The minimum payment you must receive for performing entrepreneurial functions for a firm rather than for yourself • Included in implicit costs

  7. Accounting Profit • Profit = Total Revenue- Explicit Costs

  8. Economic Profit (Pure Profit) • Profit = Total Revenue – Economic Costs (Implicit and Explicit Costs)

  9. Example Problem • You have been earning $22,000/yr. You decide to open your own T-Shirt company. You invest $20,000 of savings that have earning you $1000/year in interest. Your firm will be in a small store that you own and have been renting out for $5000/year. You also hire a clerk for $18000/year. Calculate Accounting and economic profit

  10. Example Results • Total Sales Revenue………………..120,000 • Cost of t-shirts…………40000 • Clerk’s salary…………...18000 • Utilities…………………...5000 TOTAL COSTS (Explicit)………………………(63,000) ACCOUNTING PROFIT…………………………$57,000

  11. Analysis • $57,000 accounting profit looks good but doesn’t include implicit costs and overstates the economic success of the company.

  12. Analysis Cont’d • By providing your own financial capital, building and labor you incur implicit costs (forgone income): • Accounting Profit………………………57000 • Forgone interest……………………….1000 • Forgone rent…………………………...5000 • Forgone wages………………………..22000 • Forgone entrepreneurial income….5000 TOTAL Implicit Costs…………………………….(33000) Economic Profit……………………………………$24000

  13. ECONOMIC Profit = TR-ECONOMIC COSTS = 120000 – 63000-33000 • = $24000

  14. Key Question 2 Gomez runs a small pottery firm. He hires one helper at $12,000 per year, pays annual rent of $5,000 for his shop, and spends $20,000 per year on materials. He has $40,000 of his own funds invested in equipment (pottery wheels, kilns, and so forth) that could earn him $4,000 per year if alternatively invested. He has been offered $15,000 per year to work as a potter for a competitor. He estimates his entrepreneurial talents are worth $3,000 per year. Total annual revenue from pottery sales is $72,000. Calculate accounting profits and economic profits for Gomez’s pottery.

  15. Key Question 2 Solution • Explicit costs: $37,000 (= $12,000 for the helper + $5,000 of rent + $20,000 of materials). Implicit costs: $22,000 (= $4,000 of forgone interest + $15,000 of forgone salary + $3,000 of entrepreneurship). • Accounting profit = $35,000 (= $72,000 of revenue - $37,000 of explicit costs); Economic profit = $13,000 (= $72,000 - $37,000 of explicit costs - $22,000 of implicit costs).

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