Production, Costs & Profits

Business & Firms Firm: is a enterprise or organization that transforms inputs (factors of production such as natural resources, capital resources and human resources) into outputs (goods and services) Production: is the process of transforming inputs into outputs Input Production Process Outputs Example; Firms Inputs Outputs McDonald’s Beef, bun, cooking equipment, workers, etc. Burgers Honda Auto parts, machines, equipment, workers, etc. Cars

Productive Efficiency Example; Imagine that you were Chief Executive Officer (C.E.O.) of Honda. Now, Honda has decided to produce one million cars this year. Your job is to choose the production process from the following two options. Question: As the C.E.O. of Honda, which production process (a labour- intensive process or capital intensive process) would you choose? Economists assume that the objective of a firm is to maximize profits and consequently minimize costs Thus, with this objective, the firm would maximize productive efficiency (i.e. making a given quantity of output at the lowest cost). Hence, Honda should choose the least costly mix of inputs (Process B) Production Plants (Capital) Workers (Labour) Process A 2 ($2 million/year) 2000 ($2 million/year) Process B 3 ($2.4 million/year) 1500 ($1.5 million/year)

Revenue Total Revenue (TR): is equal to price times quantity TR = Price × Quantity Total revenue can be represented by the area under the demand curve

Economic Costs & Economic Profits Economic costs: are the payments the firm needs to make or provide to attract needed resources to produce From a firm’s point of view, there are two types of costs that it incurs, explicit and implicit costs Economic Costs = Explicit Costs + Implicit Costs Explicit costs (Accounting costs): are the monetary payments. These are the costs actually paid out in money. Example; The costs of hiring workers (labour costs) or the costs of using equipment (capital costs)

Implicit Costs: are the opportunity costs of using the firm’s self-owned, self-employed resources These are costs which do not require an actual expenditure of money Example; Owner’s opportunity cost of being involved with a business (e.g. the income that the owner can earn in the labour market)

Objectives of the Firm The primary objective of the firm is profit maximization, but alternative objectives may exist such as: Increasing market share Revenue maximization Shareholder wealth maximization Accounting Profit: is income as reported on the income statement Accounting Profit = Total Revenue – Explicit Costs Economic Profit: is accounting profit less the implicit opportunity costs not included in the explicit costs. Economic Profit = Total Revenue – Economic Costs

Sources of Economic Profit The economic profit for a firm can originate from sources such as: Competitive advantage Exceptional managerial efficiency or skill Difficult to copy technology or innovation (patents, copyrights) Exclusive access to less-expensive inputs Preferential treatment under government policy Exertion of monopoly power (price control) in the market Market barriers to entry that limit competition

Example; Economic Costs & Profit Example; Imagine that you were a software designer. Last year, you left your job which paid $70,000 a year and then you started your own software company. This year your company sold 1,000 software at $100 each. You hired a programmer and paid her $30,000 annually. The capital cost (costs of computers, equipment etc.) is $10,000 Questions: 1) What is the firms total revenue? Total Revenue = Price × Quantity = $100 × 1,000 = $100, 000 2) What are the firms explicit costs? Explicit costs = Labour costs + Capital costs = $40, 000

3) What is the firm’s accounting profit? Accounting profit = Total Revenue – Explicit costs = $60, 000 4) What are the firm’s economic costs? Economic Costs = Explicit Costs + Implicit Costs = $110,000 5) What is the economic profit? Economic Profit = Total Revenue – Economic Cost = -$10,000

Determining Accounting Profit

Determining Economic Profit

Economic Versus Accounting Profit

Economic Profit The concept of economic profit tells the firm whether it should remain in business, or instead shut down Economic Profit > 0 , the firm has a positive economic profit and the owner should remain in business. Economic Profit =0 , when the total revenue just equals to the economic costs, we say the firm is making normal profit. In this case the firm is indifferent between remaining in business and shutting down. Thus, zero economic profit is the minimum amount of profit necessary to key the firm in business Economic Profit < 0, if the firm has negative economic profit or economic loss, the owner should consider shutting down.