3.1 Chapter 7 Producers in the Short Run (pg. 151)
Capital – Both an amount of money and a quantity of goods.
Two Types of Financial Capital
1. Equity – A corporation acquires funds from its owners in return for stocks, shares, or equities. The
money goes to the company and the shareholders become owners of the firm, risking the loss of their
money and gaining the right to share in the firm’s profits.
2. Debt – A firm’s creditors (not owners); they have lent money I return for some form of loan agreement. A
firm has to repay the amount borrowed, plus interest.
Dividends – Profits paid out to shareholders of a corporation.
Goals of Firms
2 Key Assumptions:
1. All firms are assumed to be profit-maximizers.
The desire to maximize profits is assumed to motivate all decisions made within a firm, and such
decisions are assumed to be unaffected by the peculiarities of the persons making the decisions and
by the organizational structure in which they work.
2. Each firm is assumed to be a single, consistent decision-making unit.
Intermediate products – All outputs that are used as inputs by other producers in a further stage of
production. For example, one firm mines iron ore and sells it to a steel manufacturer.
R = P – C
Explicit costs – Costs that actually involve a purchase of goods/services by the firm. These include the
hiring of workers, the rental of equipment, interest payments on debt, and the purchase of intermediate
Accountants: P = R – (Explicit Costs)
Economists subtract all explicit and implicit costs.
P = R – (E & I)
Implicit costs – Items for which there is no market transaction but for which there is still an opportunity
cost for the firm that should be included. The two most important implicit costs are the opportunity cost of
the owner’s time (over and above his or her salary) and the o-cost of the owner’s capital (including a
possible risk premium). 3.1 Chapter 7 Producers in the Short Run (pg. 151)
Opportunity Cost of Time
In small and relatively new firms, owners spend a tremendous amount of their time developing the
Pay themselves far less than they could earn if they were instead to offer their labour services to other
If a person can earn $4000/month in their next best alternative job and only pays themselves $1000,
there is a $3000 implicit cost.
Opportunity Cost of Capital
The o-cost of the financial capital that owners have tied up in a firm.
1. What could be earned by learning this amount to someone else in a riskless loan? For example, a risk-
free rate of return on capital is an o-cost, since the firm could close down operations, lend out its money,
and earn a certain percentage of return.
2. What could be earned by lending money to another firm where risk of default was equal to the firm’s own
risk of loss? A risk premium is also a cost.
As a result, a firm could earn say a 6% pure return plus 4% risk premium.
See Table 7-1
Profits and Resource Allocation
When resources are valued by the o-cost principle, their costs show how much these resources would
earn if use in their best alternative uses.
If the R of all the firms in some industry exceed o-cost, the firms in that industry will be earning pure or
Economic profits in an industry are the signal that resources can profitably be moved into that industry.
Economic losses signal that the resources can profitably be moved elsewhere.
If there are zero economic profits there is no incentive for resources to move into or out of an industry.
(Profit when maximized)= TR – TC
Time Horizons for Decision Making
Economists classify the decisions that firms make into three types: 3.1 Chapter 7 Producers in the Short Run (pg. 151)
1. How best to use existing plant and equipment – the short run.
2. What new plant and equipment and production processes to select, given known technical
possibilities – the long run.
3. How to encourage, or adapt to, the development of new techniques – the very long run. All the
firm’s factors of production and its technology can be varied.
Inputs that are not fixed but instead can