Economic vs Accounting Profit
Time Horizons in Decision Making
Production in the Short Run Total Product, Marginal Product, Average Product Law of Diminishing Returns Optimal Use of Resources (Section 13.2)
Costs in the Short Run
In the next 5 chapters, we focus on the sellers’ side of product markets. A key assumption is firms want to maximize profit.
Firms use inputs (also known as factors of production) to produce an output. The amount of a firm’s output depends on the amount of inputs used and on the production function, an equation that describes the technological relationship between the inputs and the output.
Profit (π) is the difference between total revenue (TR) generated from selling the output and total cost (TC) of the inputs used: Π = TR – TC. Profit < TR because of TC.
Economic vs Accounting Profit
Economists measure costs differently from accountants. Accountants generally consider only those costs that involve a direct cash outlay (ie direct costs or explicit costs).
One exception is depreciation, the reduction in the value of physical capital (eg equipment) from age and use. Depreciation is not a market transaction but accountants count it as a cost. For simplicity, we regard depreciation as an explicit cost.
The cost of physical capital is not expensed in its entirety in the year of purchase; it is expensed as depreciation over its useful life.
Economists consider opportunity costs, which consist of explicit costs and implicit costs. Implicit costs do not involve market transactions. Accounting costs differ from economic costs in two instances.
1) Owners’ time and effort – Owners who also manage their firm typically do not pay themselves what they could have earned doing the same job for another firm. When owners underpay themselves, the accounting cost of their time and effort is less than the economic cost.
Implicit cost of owners’ time = forgone earnings = best alternative earnings – salary in own business
Q1: Gameela works at a job that pays $60,000 per year. If she operates her own business, she would pay herself a salary of $15,000 per year. What are the accounting cost and the economic cost of her time and effort if Gameela operates the business?
A: The accounting cost is $15,000. The economic cost is $60,000 (or possibly even more from a different job), which is made up of the $15,000 in explicit cost and $45,000 in implicit cost.
2) Owners’ financial capital – A firm’s owners can finance their business by borrowing funds (ie using debt) or by using their own savings (ie using equity). Some of these savings may be profits retained by the business (ie not paid out to owners).
Debt has an explicit cost; the business must pay interest on borrowed funds.
Equity does not have an explicit cost but it has an implicit cost. When using their own funds in their business, owners give up a return that could have been earned from using the funds in an equally risky alternative (eg buying corporate bonds).
Implicit cost of owners’ financial capital = forgone $ return
= foregone annual % return in equally risky use × $ amount of financial capital
The forgone annual % return from an equally risky use is made up of two parts: 1) the risk-free rate of return, which is the % return if the funds were invested in a riskless investment (eg federal government bonds) and 2) the risk premium, the % return for taking on risk.
Q2: If Gameela starts her own business, she would use $200,000 of her own savings that is currently invested in federal government bonds and earning 3% per year to buy equipment for her business. This amount of money could be earning 10% per year if she invested the money in the bonds of a firm that is equally risky as her intended business. a) What is the accounting cost of using the $200,000 in her business?
b) What is the economic cost?
c) What is the risk premium (as a %)?
A: a) The accounting cost is zero; she