Verbal Bellringer with your partner

This is a financial statement for FacebookA.How much revenue did they make last year?

B.How much profit did they keep last year?C.How have they been doing the last four years?

D.Is this a good stock to buy?

• Costs!

• Chapter 14

• Theory of the firm

THE COSTS OF PRODUCTION

3

Total Revenue, Total Cost, Profit

• We assume that the firm’s goal is to maximize profit.

Profit = Total revenue – Total cost

the amount a firm receives from the sale of its output

the market value of the inputs a firm uses in production

THE COSTS OF PRODUCTION

4

Costs: Explicit vs. Implicit• Explicit costs require an outlay of money,e.g., paying wages to workers.

• Implicit costs do not require a cash outlay,e.g., the opportunity cost of the owner’s time.

• Remember one of the Ten Principles: The cost of something is what you give up to get it.

• This is true whether the costs are implicit or explicit. Both matter for firms’ decisions.

THE COSTS OF PRODUCTION

5

Explicit vs. Implicit Costs: An ExampleYou need $100,000 to start your business.

The interest rate is 5%. • Case 1: borrow $100,000

– explicit cost = $5000 interest on loan

• Case 2: use $40,000 of your savings, borrow the other $60,000– explicit cost = $3000 (5%) interest on the loan– implicit cost = $2000 (5%) foregone interest you

could have earned on your $40,000.

In both cases, total (exp + imp) costs are $5000.

THE COSTS OF PRODUCTION

6

Economic Profit vs. Accounting Profit

• Accounting profit = total revenue minus total explicit costs

• Economic profit= total revenue minus total costs (including

explicit and implicit costs)• Accounting profit ignores implicit costs,

so it’s higher than economic profit.

The equilibrium rent on office space has just increased by $500/month. Compare the effects on accounting profit and economic profit if

a. you rent your office spaceb. you own your office space

A C T I V E L E A R N I N G A C T I V E L E A R N I N G 22 Economic profit vs. accounting profitEconomic profit vs. accounting profit

7

The rent on office space increases $500/month. a. You rent your office space.

Explicit costs increase $500/month. Accounting profit & economic profit each fall $500/month.

b.You own your office space.Explicit costs do not change, so accounting profit does not change. Implicit costs increase $500/month (opp. cost of using your space instead of renting it), so economic profit falls by $500/month.

A C T I V E L E A R N I N G A C T I V E L E A R N I N G 22 AnswersAnswers

8

With your partner

• 2 items at your house that the more you use them, the more you will pay

• 2 items you can use 24/7 and you don’t have to pay more

An unsuccessful business

• Costs that they can change tomorrow

• Costs that they can’t change

Let’s think more specifically about costs

• Fixed Costs = costs that do not change based on production and don’t change in SR

• Examples: capital goods, tools, buildings, menus

Nokia factory in Finland

Coke factory in Atlanta, Georgia

Special fixed costs

• “Entry costs” – costs to start up the business

Business with lowEntry costs

Business with very highEntry costs

Costs we can change in the short run

Variable costs = costs that change based on production

The more I produce, the more cost I will incur.

If I don’t produce at all, my variable costs will be 0

For example: labor, electricity, raw materials

Nike factory in China

Michael Jordan visiting Nike Factory in 1999 Why produce in China?

Marginal Costs

• Marginal costs = the cost of producing 1 additional unit

• For example:

• Why helpful?• Diminishing

marginal product!

Widgets

01234

FC

11111

VC

06

111622

MC

X

Total Costs• Total Costs = fixed + variable costsFor example:

Widgets

01234

FC

11111

VC

01235

TC

12346

MC

X1112

Revenue

02468

Assume Widgets price

$2/eachProfit

-10122

Averages

• Do you guys bring up or down the GPA of all of Flowing Wells high school?

• Does the cross country team bring up or down the average weight of Flowing Wells High School?

• Does a high average cost of living mean that everyone spends a lot to live in California?

Average Costs• Average Fixed Costs = FC/Q• Average Variable Costs = VC/Q• ATC = TC/Q

In your notes1. Write 3 examples of FC for this firm2. Write 3 examples of VC for this firm3. How could this firm increase its TR?4. Give an example of diminishing marginal

returns from your life

Group assignment1

2