Unit #3: Theory of the Firm AP MICROECONOMICS Unit #3: Theory of the Firm Mr. Lindquist TODAY I CAN… Identify the difference between implicit and explicit costs Explain the conflict between accountants and economists Identify how to calculate Normal Profit Apply Concepts in practice examples

AGENDA: Discuss Multiple Choice Part of UNIT #2 TEST FRQ section will be graded no later than Friday Introduce Unit #3: Theory of the Firm Explain concepts from Module 52 Explicit vs. Implicit Costs Accounting vs. Economic Profit Normal Profit Exit Slip - Quiz

What is a firm? The firm is any organization or institution that transforms resources into goods and services SUPPLY SIDE Sellers Producers

Background of U.S. Firms There are many firms (over 17 million) The majority of firms have fewer than 100 workers Most new jobs are in smaller firms Most firms are in services and trade Most firms are sole-proprietorships

3 Types of Business Organizations Sole Proprietorships + Easy to start, Owner has control, Keeps all profits - Unlimited Liability Partnerships General: Hands-on partner (unlimited liability) Limited (silent) Limited Liability Corporations Legal entities (persons) Limited Liability Owners and managers are different (stockholders)

Total Profit = Total Revenue – Total Costs Objective of firms Economists assume that firms try to Maximize Total Profits. Total Profit = Total Revenue – Total Costs

Do you agree with Economists? Do firms really try to maximize total profits? Is Greed Good? Maybe you only want satisfactory profits? CONS? Loyal Employees (fire them?) Pollute (cheaper to pollute)

Two Concepts of Profit Total Profit = Total Revenue – Total Costs “Economists HATE Accountants.” Economic Profit: Total Revenue - Total Explicit Costs and Opportunity Costs 2. Accounting Profit: Total Revenue - Total Explicit Costs

Explicit Costs Dollars spent on resources and inputs. EXAMPLE: Taco Restaurant Building Fryers/Ovens/Sinks/Dish-washer/etc Tables/Chairs Cash Register Labor Inventory: (inputs  Tortillas, Beef, Lettuce, Cheese, Salsa, Sour Cream, Hot Sauce, etc.) Insurance

Implicit Costs Hidden Costs What do you own? Other Income given up. Opportunity Cost What do you own? Your Time and Your Labor What else could you be doing instead of making Tacos? Other Income given up. What else could the money you invested in the fryers/ovens? $5000 in interest in the bank You don’t get because you spent it on your business

Let’s do another Example…

Leonardo DiCaprio In 2014, Leonardo DiCaprio made $39 million dollars acting in movies If he were to leave acting and open a Pizza place… What type of business organization? How would Economists determine his profit? And How would Accountants determine his profits?

Leo’s Pizza Sole Proprietorship Let’s say Leonardo is pretty successful in the Pizza business He makes $2 million dollars in Total Revenue To get his Pizza place running it costs him $1 million dollars Building, Ovens, Labor, Tables/Chairs, Pizza Dough, Sauce, Toppings, etc. These are his “Explicit Costs”

Accountants will say… You brought in $2 million and your total cost of making that was only $1 million: $2 Mill. - $1 Mill. = $1 Million PROFIT!!! You are doing GREAT!!! You’re a millionaire! Way to go! You’re a Pizza Guru! BUT…We know better.

ECONOMISTS will say: ECONOMIC PROFIT = -$38 million He could have made $39 Million acting in movies (“IMPLICIT COSTS”) …Opportunity Cost Economists factor in Explicit Costs and Implicit Costs. Calculate his Economic Profit: TR = Total Revenue – (Explicit Costs + Implicit Costs) $2 million – ($1 million + $39 million) = ECONOMIC PROFIT = -$38 million

Should Leo keep making Pizza???

What if next year Leo made ZERO Economic Profit… Would that be a good thing or bad thing? GOOD! That means he must have brought in at least enough Total Revenue to cover his Implicit (Opp. Cost) and Explicit Cost HE MUST HAVE SOLD A LOT OF PIZZA!!! $40 Million in Revenue Normal Profit = Zero Economic Profit

Normal Profit Break-Even At Zero Economic Profit: Leonardo DiCaprio has earned enough $ to: Pay all his employees, insurance company, utilities, Capital Resources, input costs (pizza dough, toppings, sauce, cheese, etc.) AND compensate himself for all the income he gave up from acting in movies Of course, he’d love to have a positive economic profit. But, Normal Profit is not such a bad deal

From Now On… Costs will always be Economic Profit. PRACTICE ASSIGNMENT Read and Outline Module 54 Page 545-549 DUE WEDNESDAY