Total Revenue, Total Cost, Profit
We assume that the firm’s goal is to maximize profit.
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.
Explicit vs. Implicit Costs: An Example
You 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.
Economic Profit vs. Accounting Profit
= total revenue minus total explicit costs
= total revenue minus total costs (including explicit and implicit costs)
Accounting profit ignores implicit costs,
so it’s higher than economic profit.
Note: most accountants know this and take it into account
Economic profit vs. accounting 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 space
b. you own your office space
The Production Function
A production function shows the relationship between the quantity of inputs used to produce a
good, and the quantity of output of that good.
It can be represented by a table, equation, or graph.
Farmer Jack grows wheat.
He has 5 acres of land.
He can hire as many workers as he wants.
The marginal product of any input is the increase in output arising from an additional unit of
that input, holding all other inputs constant. E.g., if Farmer Jack hires one more worker,
his output rises by the marginal product of labour.
∆ (delta) = “change in…”
∆Q = change in output, ∆L = change in labour
Marginal product of labour (MPL) =
Why MPL Is Important
Recall one of the Ten Principles:
Rational people think at the margin.
When Farmer Jack hires an extra worker,
his costs rise by the wage he pays the worker
his output rises by MPL
Comparing them helps Jack decide whether he would benefit from hiring the worker.
Why MPL Diminishes
Diminishing marginal product:
the marginal product of an input declines as the quantity of the input increases (other things
E.g., Farmer Jack’s output rises by a smaller and smaller amount for each additional
If Jack increases workers but not land,
the average worker has less land to work with,
so will be less productive.
In general, MPL diminishes as L rises
whether the fixed input is land or capital (equipment, machines, etc.).
Farmer Jack must pay $1000 per month for the land, regardless of how much wheat he grows.
The market wage for a farm worker is $2000 per month.
So Farmer Jack’s costs are related to how much wheat he produces….
Marginal Cost (MC)
is the increase in Total Cost from
producing one more unit:
Why MC Is Important
Farmer Jack is rational and wants to maximize
his profit. To increase profit, should he produce more whea