ECON 2030 Chapter : Notes Chapter 12
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Chapter 12 Notes
Production and Cost Analysis I June 16, 2011
Practice Problems (Chapter 12): # 1-3, 7-10, 12, 15
Second exam is one week from today!
Theory of the firm
• Generally a business has two questions to answer:
o What is the quantity we should produce?
o What is the price we should chard?
• Assumption: the goal a business is trying to achieve is to maximize its profits.
o Fair assumption in a fair market economy
Important Definitions
• Profit = benefit - cost
• Total Revenue – total amount of $ taken in
o TR = P x Q
• Marginal Revenue (MR)
o Marginal cost is the change in total revenue from buying one more unit of the
good/service.
o Marginal revenue is the change in total revenue from selling one more unit of
the good or service.
o Example: shoe store has buy two pairs, get one pair free; shoes are $40 each
▪ Marginal revenue of first pair: $40
▪ Marginal revenue of second pair: $40
▪ Marginal revenue of third pair: $0 (free)
o
• Total Cost (TC) = explicit + implicit
o 2 different types of cost – explicit and implicit
o Explicit costs – out of pocket costs; accounting costs
▪ The focus of an accountant is on all the money paid out.
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o Implicit costs – based on the economist’s perspective, there is something that
has been given up when a choice is made
▪ Implicit cost is the accounting benefit of doing the next-best thing
o Example: starting a corn dog stand.
▪ Out of pocket costs (explicit costs) – rent, money to pay for supplies,
money to pay for labor
▪ Implicit Costs – what was given up; example: salary of being an
economics teacher
• Marginal Cost (MC)
o Marginal cost is the change in total cost from producing one more unit of the
good or service.
o
o Crucial in determining the amount that should be produced
Profit
• Accounting Profit = TR – explicit cost
o based on the definitions of accountants
• Economic Profit = TR – explicit cost – implicit cost = Acct profit – implicit cost
o based on the definition of economists
• Maximizing Rule – keep producing until MR = MC
o The is the maximum profit that can be attained
o If profits can increase, they are not maximized
o MR > MC If you give me $20, I will give you $40
o MR < MC If you give me $40, I will give you $20
o MR = MC profit is maximized
• Normal Profit – economic profit that equals zero
o Is this a good or a bad thing? - - this is really a good thing
o This is actually a definition of long-run equilibrium
o Accounting profit of this situation is positive (greater that zero)
▪ Accounting profit will be equal to the implicit cost
▪ Acct profit of what it is doing, is equal to the profit of the next-best thing
▪ There is no incentive to change behavior – equilibrium
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Example
Suppose Danielle is considering opening her own beauty salon. She anticipates the following
costs per year:
Furniture $40,000 explicit cost
Equipment $30,000 explicit cost
Rent $18,000 explicit cost
Coloring Products $12,000 explicit cost
Styling Products $8,000 explicit cost
Total explicit costs per year = $108,000
Danielle is withdrawing $70,000 from her savings account that pays 2% interest (implicit cost)
per year to purchase the furniture and equipment and is quitting her current job that pays
$28,000 (implicit cost). She expects that the total revenues from the new business in the first
year will be $125,000.
Calculate the following:
Explicit Costs = $108,000
Implicit Costs = $28,000 + 0.02*$70,000 = $29,400
Accounting Profit = TR – explicit cost = $125,000 - $108,000 = $17,000
Economic Profit = Acct profit – implicit cost = $17,000 - $29,400 = -$12,400 (negative profit)
