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Deviations from profit maximizationExplicit and implicit costsEconomic profits

Chapter 20

Production and Cost in the Firm

Profit Maximization

Firms are assumed to maximize profits (no such thing as enough).

Real-world deviations from profit-max: max. sales max. growth max. prestige, CEO salary, equity, or

lifestyle of managers.

Checks on Deviations from Profit Maximization

Stockholders can vote managers out.Threat of take-oversBankruptcyCEOs get stock as partial

compensationBottom Line: Modeling firms as profit-

maximizers works well as a predictor of behavior.

Economic Costs

The cost of producing a particular quantity of a good includes the value of all inputs used (even if the firm did not have to pay for them).

Economists use opportunity cost to help value inputs.

One Month at Mom & Pop’s Grocery Store

An example of how to calculate economic costs.

Purchased or Hired Factors

Cost of groceries sold $13,200 Use amounts paid to wholesalers. Includes waste in produce, meats, etc.

Labor, 2 part-time employees 600 Use wages paid, include SS taxes,

unemployment taxes, cost of benefits if applicable.

Purchased or Hired Factors, Cont’d.

As long as the price paid reflects the market value, the opportunity cost is the price paid. Examples include: Payroll cost, plus benefits Interest paid on borrowed funds Cost of materials Rental cost of any rented land or

equipment Utilities bills

Mom & Pop’s Time

Mom & Pop don’t pay themselves regular salaries. They keep the money “leftover” at the end of the month for themselves.

How does an economist value their time?

Use of Entrepreneur’s Time, Other’s time

Mom works 55 hours/week $1,100 Her next best opportunity is to work for

“Super-Grocery”. Use foregone wages & benefits.

Pop works 55 hours/week $2,200 His next best opportunity is to work as a

bookkeeper. Use foregone wages & benefits.

Use of building, land

Mom & Pop own the building and the land used for the store. They don’t have a mortgage.

Rent $800 Estimate the rental value of the

property. If they didn’t use it themselves, they could be renting it out.

Use of Equipment Owned by the Firm

They own all of the coolers, meat slicers, scanners, cash registers, etc. used in the store.

Use of Equipment $200 Equipment can be thought of as being

“used up” as it is used. The cost of this is called “depreciation”.

Depreciation

Economists care about physical depreciation, and measure it by the change in the re-sale price of the equipment. This is the opportunity cost of using the equipment for, say, one year versus selling it now.

Accounting versus Economic depreciation

Accountants uses “depreciation” on tax returns, but that value comes from tax laws, not from physical depreciation.

Most items will be fully depreciated in an accounting sense long before they are in a physical sense.

Special Case: Sunk costs

If a machine has no alternative use within or outside of the firm then there is zero opportunity cost to using the machine.

The cost of the machine is said to be sunk.

If there are costs that could not be recovered if the firm were to shut down (ex: advertising costs) then these costs are also sunk.

Sunk costs, Cont’d

Sunk costs can be ignored when planning for the future.

They still affect the bottom line, however.

Use of the firm’s own funds

Mom & Pop do not have loans, but they have a lot of money tied up in the business.

Value of inventory = $300,000.Inventory Carrying Cost $1,500

Opportunity cost is 6% interest foregone on long-term gov’t bonds.

$300,000@6% interest/12 months.

Risk-Taking

Insurance premiums $300 Some of the risks of being in this business

can be insured against. property, liability insurance premiums

Being in business is riskier than buying a gov’t bond. The owners ought to be compensated for assuming extra risk.

Risk premium $250 Extra 1% opp. cost of using funds.

Total Economic Costs

Explicit Costs (13,200 + 600 + 300) = $14,100.

Implicit Costs (1,100 + 2,200 + 800 + 200 + 1,500 +300 + 250) = $6,350.

Total Economic Cost = $14,100 + $6,350 =$20,450.

Profits

Suppose revenues for the month were $20,200.

Accounting profits = Revenue - Explicit costs = $20,200 - $14,100 = $6,100.

Economic profits = Revenue - Economic costs = $20,200 - $20,450 = -$250.

How well are Mom & Pop doing?

Interpreting Economic Profits

What does it mean if a firm makes zero economic profits?

Negative Economic Profits

(Economic Losses)The firm would do better if its

resources were used elsewhere.If Mom & Pop made economic losses,

they would want to quit the business, work at next best jobs, rent out building, invest the money in bonds, etc.

Positive Economic Profits

The firm is earning over-and-above that necessary to attract the resources to the firm.

The firm is earning an above-normal rate-of-return on its investment, even after compensating for the riskiness of the investment.

Economic Profits and Resource Allocation

Economic profits direct resources into this industry. Mom & Pop can expect to face more competitors in the future. This will likely reduce their own profits.

Economic losses direct resources out of this industry. With fewer firms in the market, remaining firms may break even.

We will study this more later.

Coming Up

Production Costs in the SR and LR.Cost curves of the firm

Group Work

Exercises in Opportunity Costs

Using Your Car

How much does it cost you to own and use your car for a year? Make a list of all of the economic costs. Just list the types of costs you would need to calculate--do not attempt to actually fill in numbers (unless you want to).

Buying versus Renting a Building

Suppose you are opening a retail shop. Should you buy or rent a business location? Make a list of the economic costs associated with each option for 10 years.