Which store has the lower costs: Wal-Mart or 7-Eleven? Production and Cost 10 When you have completed your study of this chapter, CHAPTER CHECKLIST you will be able to 1 Explain and distinguish between the economic and accounting measures of a firm’s cost of production and profit. 2 Explain the relationship between a firm’s output and labor employed in the short run. 3 Explain the relationship between a firm’s output and costs in the short run. 4 Derive and explain a firm’s long-run average cost curve.
249 250 Part 3 • PRICES, PROFITS, AND INDUSTRY PERFORMANCE 10.1 ECONOMIC COST AND PROFIT The 20 million firms in the United States differ in size and in what they produce, but they all perform the same basic economic function: They hire factors of pro- duction and organize them to produce and sell goods and services. To understand the behavior of a firm, we need to know its goals. The Firm’s Goal If you asked a group of entrepreneurs what they are trying to achieve, you would get many different answers. Some would talk about making a high-quality prod- uct, others about business growth, others about market share, and others about job satisfaction of the work force.
All of these goals might be pursued, but they are not the fundamental goal. They are a means to a deeper goal. The firm’s goal is to maximize profit. A firm that does not seek to maximize profit is either eliminated or bought by firms that do seek to achieve that goal.
To calculate a firm’s profit, we must determine its total revenue and total cost. Economists have a special way of defining and measuring cost and profit, which we’ll explain and illustrate by looking at Sam’s Smoothies, a firm that is owned and operated by Samantha. Accounting Cost and Profit In 2011, Sam’s Smoothies’ total revenue from the sale of smoothies was $150,000. The firm paid $20,000 for fruit, yogurt, and honey; $22,000 in wages for the labor it hired; and $3,000 in interest to the bank.
These expenses totaled $45,000. Sam’s accountant said that the depreciation of the firm’s blenders, refrigera- tors, and shop during 2011 was $10,000. Depreciation is the fall in the value of the firm’s capital, and accountants calculate it by using the Internal Revenue Service’s rules, which are based on standards set by the Financial Accounting Standards Board. So the accountant reported Sam’s Smoothies’ total cost for 2011 as $55,000 and the firm’s profit as $95,000—$150,000 of total revenue minus $55,000 of total costs.
Sam’s accountant measures cost and profit to ensure that the firm pays the correct amount of income tax and to show the bank how Sam’s has used its bank loan. Economists have a different purpose: to predict the decisions that a firm makes to maximize its profit. These decisions respond to opportunity cost and eco- nomic profit. Opportunity Cost To produce its output, a firm employs factors of production: land, labor, capital, and entrepreneurship.
Another firm could have used these same resources to pro- duce other goods or services. In Chapter 3 (pp. 66–67), resources can be used to produce either cell phones or DVDs, so the opportunity cost of producing a cell phone is the number of DVDs forgone. Pilots who fly passengers for Southwest Airlines can’t at the same time fly freight for FedEx.
Construction workers who are building an office high-rise can’t simultaneously build apartments. A commu- nications satellite operating at peak capacity can carry television signals or e-mail messages but not both at the same time. A journalist writing for the New York Times Chapter 10 • Production and Cost 251 can’t at the same time create Web news reports for CNN. And Samantha can’t simultaneously run her smoothies business and a flower shop.
The highest-valued alternative forgone is the opportunity cost of a firm’s pro- duction. From the viewpoint of the firm, this opportunity cost is the amount that the firm must pay the owners of the factors of production it employs to attract them from their best alternative use. So a firm’s opportunity cost of production is the cost of the factors of production it employs. To determine these costs, let’s return to Sam’s and look at the opportunity cost of producing smoothies.
Explicit Costs and Implicit Costs The amount that a firm pays to attract resources from their best alternative use is either an explicit cost or an implicit cost. A cost paid in money is an explicit cost. Explicit cost Because the amount spent could have been spent on something else, an explicit A cost paid in money. cost is an opportunity cost.
The wages that Samantha pays labor, the interest she pays the bank, and her expenditure on fruit, yogurt, and honey are explicit costs. A firm incurs an implicit cost when it uses a factor of production but does not Implicit cost make a direct money payment for its use. The two categories of implicit cost are An opportunity cost incurred by a economic depreciation and the cost of the resources of the firm’s owner. firm when it uses a factor of production for which it does not Economic depreciation is the opportunity cost of the firm using capital that make a direct money payment.
It is measured as the change in the market value of capital—the market price of the capital at the beginning of the period minus its market price at the end Economic depreciation An opportunity cost of a firm using of the period. Suppose that Samantha could have sold her blenders, refrigerators, capital that it owns—measured as the and shop on December 31, 2010, for $250,000. If she can sell the same capital on change in the market value of capital December 31, 2011, for $246,000, her economic depreciation during 2011 is $4,000. over a given period.
This is the opportunity cost of using her capital during 2011, not the $10,000 depreciation calculated by Sam’s accountant. Interest is another cost of capital. When the firm’s owner provides the funds used to buy capital, the opportunity cost of those funds is the interest income for- gone by not using them in the best alternative way. If Sam loaned her firm funds that could have earned her $1,000 in interest, this amount is an implicit cost of pro- ducing smoothies.
When a firm’s owner supplies labor, the opportunity cost of the owner’s time spent working for the firm is the wage income forgone by not working in the best alternative job. For example, instead of working at her next best job that pays $34,000 a year, Sam supplies labor to her smoothies business. This implicit cost of $34,000 is part of the opportunity cost of producing smoothies. Finally, a firm’s owner often supplies entrepreneurship, the factor of produc- tion that organizes the business and bears the risk of running it.
The return to entrepreneurship is normal profit. Normal profit is part of a firm’s opportunity Normal profit cost because it is the cost of a forgone alternative—running another firm. Instead The return to entrepreneurship. of running Sam’s Smoothies, Sam could earn $16,000 a year running a flower Normal profit is part of a firm’s opportunity cost because it is the shop.
This amount is an implicit cost of production at Sam’s Smoothies. cost of not running another firm. Economic Profit A firm’s economic profit equals total revenue minus total cost. Total revenue is Economic profit the amount received from the sale of the product.
It is the price of the output mul- A firm’s total revenue minus total tiplied by the quantity sold. Total cost is the sum of the explicit costs and implicit cost. costs and is the opportunity cost of production. 252 Part 3 • PRICES, PROFITS, AND INDUSTRY PERFORMANCE TABLE 10.1 Economic Accounting Item Total Revenue $150,000 Explicit Costs Cost of fruit, yogurt, and honey $20,000 Wages $22,000 Interest $3,000 Implicit Costs Samantha’s forgone wages $34,000 Samantha’s forgone interest $1,000 Economic depreciation $4,000 Normal profit $16,000 Opportunity Cost $100,000 Economic Profit $50,000 Because one of the firm’s implicit costs is normal profit, the return to the entre- preneur equals normal profit plus economic profit.
If a firm incurs an economic loss, the entrepreneur receives less than normal profit.1 summarizes the economic cost concepts, and Figure 10.1 compares the economic view and the accounting view of cost and profit. Sam’s total revenue (price multiplied by quantity sold) is $150,000; the opportunity cost of the resources that Sam uses is $100,000; and Sam’s economic profit is $50,000.1 Two Views of Cost and Profit MyEconLab Animation Both economists and accountants measure a firm’s total revenue the same way. It equals the price multi- plied by the quantity sold of each Economic Economic Accounting item. Economists measure economic profit profit profit profit as total revenue minus oppor- tunity cost.
Opportunity cost includes explicit costs and implicit costs. Normal profit is an implicit cost. Accountants measure profit as total Implicit costs (including revenue minus explicit costs—costs normal profit) paid in money—and depreciation. Opportunity cost Depreciation Explicit Explicit costs costs The economic view The accounting view Chapter 10 • Production and Cost 253 CHECKPOINT 10.1 MyEconLab You can work these problems in Study Plan 10.1 and get instant Explain and distinguish between the economic and accounting measures of feedback.
a firm’s cost of production and profit. Practice Problems Lee, a programmer, earned $35,000 in 2010, but in 2011, he began to manufacture body boards. After one year, he submitted the following data to his accountant. • He stopped renting out his cottage for $3,500 a year and used it as his fac- tory.
The market value of the cottage increased from $70,000 to $71,000. • He spent $50,000 on materials, phone, utilities, etc. • He leased machines for $10,000 a year. • He paid $15,000 in wages.
• He used $10,000 from his savings account, which pays 5 percent a year interest. • He borrowed $40,000 at 10 percent a year from the bank. • He sold $160,000 worth of body boards. • Normal profit is $25,000 a year.
Calculate Lee’s explicit costs, implicit costs, and economic profit. Lee’s accountant recorded the depreciation on Lee’s cottage during 2011 as $7,000. What did the accountant say Lee’s profit or loss was? In the News What does it cost to make 100 pairs of running shoes? An Asian manufacturer of running shoes pays its workers $275 to make 100 pairs an hour. Workers use company-owned equipment that costs in forgone interest and economic depreciation $300 an hour.com Which costs are explicit costs? Which are implicit costs? With total revenue from the sale of 100 pairs of shoes of $1,650, calculate economic profit.
Solutions to Practice Problems 1. Lee’s explicit costs are costs paid with money: $50,000 on materials, phone, utilities, etc; $10,000 on leased machines; $15,000 in wages; and $4,000 in bank interest. These items total $79,000. Lee’s implicit costs are $35,000 in forgone wages; $3,500 in forgone rent; $1,000 increase in the value of his cottage is economic depreciation of –$1,000; $500 in forgone interest; and $25,000 in normal profit.
These items total $63,000. Economic profit equals total revenue ($160,000) minus total cost ($79,000 ⫹ $63,000), which equals $142,000. So economic profit is $160,000 ⫺ $142,000, or $18,000. The accountant measures Lee’s profit as total revenue minus explicit costs minus depreciation: $160,000 ⫺ $79,000 ⫺ $7,000, or $74,000.
Solution to In the News Explicit costs are wages ($275) and materials ($900). Implicit costs are the for- gone interest and economic depreciation ($300). Economic profit equals total revenue ($1,650) minus total cost ($1,475), which is $175. 254 Part 3 • PRICES, PROFITS, AND INDUSTRY PERFORMANCE SHORT RUN AND LONG RUN The main goal of this chapter is to explore the influences on a firm’s costs.
The key influence on cost is the quantity of output that the firm produces per period. The greater the output rate, the higher is the total cost of production.