Chapter 4 – Costs of Production Part II Chapter 4 – Costs of Production

Activity Money.. Incentive => Implicit Cost

Explicit vs Implicit Cost Explicit costs are expenses for which one must pay with cash or equivalent. Because a cash transaction is involved, they are relatively easily accounted for in analysis. These costs are never hidden, one has to pay separately. (Follow the money!) Example- Electricity Bill, wages to workers etc. Implicit costs do not involve a cash transaction, and so we use the opportunity cost concept to measure them. Implicit costs are related to forgone benefits of any single transaction. These are intangible costs that are not easily accounted for. (Opportunity Cost) Example, the time and effort that an owner puts into the maintenance of the company rather than working on expansion.

1. The sole proprietor of the "Books and More" bookstore receives all accounting profits earned by her firm and a $28,000-a-year salary she pays herself. She has a standing salary offer of $35,000 a year if she agrees to work for a large corporation. If she had invested her capital outside her own company, she estimates that would have returned $22,000 a year. Last year, her accounting profit was $50,000. What was her economic profit?

What are her Implicit Costs? She says that she currently makes $28,000 / yr She COULD be making $35,000 if she works for a large corporation We can deduce that she is “losing” $7,000 by not taking the other job that pays more.. Therefore her opportunity cost for her time is $7,000 If she had invested her capital ($$) into something, she would have made $22,000 Total Implicit cost = $7,000 + 22,000 = $29,000

EP = AP + EC – IC – EC = AP – IC EP = AP - IC EP = TR – (Total Costs) EP = TR – (IC + EC) EP = TR – IC – EC AP = TR – EC AP + EC = TR TR= AP + EC Sub TR into EP’s TR EP = AP + EC – IC – EC = AP – IC EP = AP - IC

Economic Profit = Accounting Profit – Implicit Cost EP = 50,000 – 29,000 = $21,000

Learning Objectives Know how to calculate total, average and marginal product values

Economic Costs Economic costs include: explicit costs, which are payments to resource supplies outside a business implicit costs, which are what owners give up by being involved in a business Economic profit is found by subtracting economic costs (both explicit and implicit) from total revenue.

Accounting versus Economic Profit Accounting profit is total revenue minus explicit costs. Because accountants consider only explicit costs, accounting profit always exceeds economic profit by the amount of the business’s implicit costs.

Production in the Short Run (a) some inputs (such as capital) are fixed (cannot be adjusted in SH) other inputs (such as labour) are variable (can be adjusted) Examples: Labour, Materials DrLaiManufacturer produces 10 lambos a day. Mr. Lai is thinking of increasing current production to 20! In the short run, I cannot acquire more machines right away, so the machines I have represent a fixed input. I can, however, hire more workers and have them work longer which represent my variable input

Inputs are combined to make total product. The overall quantity of output produced with a given workforce Includes all variable inputs Other product measures include: average product, which is total product divided by the number of workers marginal product, which is the extra total product associated with an additional worker

Average Product The quantity of output produced per worker Average Product = Total Product (q) # of workers (L)

Marginal Product The extra output produced by an additional worker Marginal Product = Change in total product Change in workforce

Total, Marginal, and Average Products 1 2 3 4 5 6 Number of Workers Employed per Day T-Shirts Produced per Day 50 100 150 200 250 300 Labour (L) (workers per day) Total Product (q) (T-shirts Marginal (Δq/ΔL) Average (q/L) 1 2 3 4 5 6 TP 80 200 250 270 280 -- 80 100 83.3 67.5 56 45 80 120 50 20 10 -10 1 2 3 4 5 6 Number of Workers Employed per Day T-Shirts Produced per Day 40 60 80 100 120 -20 20 Diminishing returns set in AP MP

When employing 3 workers, the workforce average product is 83.3 (250 shirts /3 workers) If a Fourth worker is added?, what is the marginal product? Change in Total Product / Change in Workforce (270-250) / 3 = 20 shirts Therefore by adding an extra worker (from 3 to 4), we are able to output 20 extra shirts (from 250 to 270) Labour (L) (workers per day) Total Product (q) (T-shirts Marginal (Δq/ΔL) Average (q/L) 1 2 3 4 5 6 80 200 250 270 280 -- 80 100 83.3 67.5 56 45 80 120 50 20 10 -10

What is the Average Product when employed 5 workers? Total Product / Labour 280 / 5 = 56 Product/ Labour What is the Marginal Product if we go from 5 workers to 6? Change in Total Product / Change in Workforce (270-280)/(6-5) = -10 shirts Whoa! What just happened?

The Law of Diminishing Marginal Returns Short-run production is determined by the law of diminishing marginal returns. According to this law: the addition of more variable input causes marginal product to fall after some point average product also falls after some point Copyright © 2009 by McGraw-Hill Ryerson Limited. All rights reserved.

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