PRODUCTION AND COSTS: PROFIT AP Economics Mr. Bordelon

Profit Profit. Total revenue minus total cost. π means “profit.” π = TR – TC Total revenue. Price of output times the quantity sold. TR = PQ Total cost. Cost of all inputs used to produce output. TC = $Input + $Input … What qualifies as a cost?

Explicit and Implicit Costs Explicit cost. Cost that requires a specific payment (outlay) of money. “Accounting Costs” Implicit cost. Measured by value in dollars of benefits forgone. “Economic Costs” Implicit cost should sound very familiar…begins with an o…and ends with a…

Explicit and Implicit Costs Why do we care about this? More often than not people when looking at their business or even setting up a business focus on explicit costs only. The problem is that the implicit costs—that is, opportunity costs—can exceed the explicit costs, and that can affect how people’s decisions about business, production, etc.

Explicit and Implicit Costs Example: In the early planning stages of setting up my firm, I focused primarily on what I would need to run my office. Rent, hiring a paralegal, ordering legal research software, paper, computers, equipment, etc. (explicit) What I didn’t think about it initially was the salary that I was then earning, losing out on any interest when I used my savings to build the business, and the like. (implicit) AP examples for explicit costs: rent, wages, interest on debt, raw materials, depreciation on equipment, utility bills. AP examples for implicit costs: forgone salary, interest lost on liquidated savings accounts, not renting out existing capital but using it for business.

Explicit and Implicit Costs Let’s say that Travis wants go to the Sorbonne in Paris for a year before becoming a professional twerker. How would we figure out his costs? Well, we need to look at it in terms of what he actually chooses (his explicit costs) and he’s giving up (his implicit costs):

Explicit and Implicit Costs In this case, Travis would have to pay $19,500 in explicit costs to spend a year in Paris. But that’s not his total cost. Remember, for Travis to go to Paris, he has to give up starting his career as a professional twerker for a year. Given Travis’s twerking talents, we assume that he would have had $35,000 starting. That $35,000 represents his implicit costs.

Explicit and Implicit Costs So to find what it ultimately costs Travis to spend a year in Paris, we have to combine his explicit and implicit costs--$19, ,000 = $54,500. $54,500 represents the true cost to Travis to forgo his twerking and spend time in Paris.

Explicit and Implicit Costs Why do we have to consider his salary even though he hasn’t got the job yet? It’s not about the salary per se, as much as it is using his own resources. In this case, another way to look at it is that Travis has to use his time for education. That is time he could have spent twerking his way to $35,000/y.

Explicit and Implicit Costs Reminder about opportunity cost: When you consider the cost of an activity, you need to include the cost of using your own resources. You can come up with a specific value of those resources by determining what those resources would have earned in their next best alternative use.

Accounting Profit vs. Economic Profit Accounting profit. Business’s total revenue minus explicit cost and depreciation (reduction in value, usually annually). Economic profit. Business’s total revenue minus the opportunity cost of its resources. Usually less than the accounting profit.

Babette’s Cajun Café For 2012, Babette made $100,000 in revenue. From the revenue, she paid her expenses: food, wages, rent (what kind of costs are these?). Her expenses total $60,000. Is Babette’s restaurant profitable? Not necessarily…

Babette’s Cajun Café—Depreciation Like most people who have never taken AP Economics or were lucky enough to have Mr. Bordelon as their teacher, you may have assumed that she had $40,000 as profit. First things first—depreciation. Depreciation occurs because equipment wears out over time. For example, this year, Babette had to replace a stove and some pipes in her kitchen. Every year, Babette’s got to replace appliances and furnishings. It’s just the cost of doing business, wear and tear. Yearly depreciation reflects what an accountant would estimate to be the reduction in value. Let’s say he takes off $5,000 for depreciation, leaving $35,000.

Babette’s Cajun Café—Accounting Profit Now that we’ve taken into account depreciation, we can find Babette’s accounting profit. Accounting profit = TR – (Explicit Cost + Depreciation) Accounting profit = $100,000 – ($60,000 + $5,000) Accounting profit = $100,000 – $65,000 Accounting profit = $35,000 $35,000 is what Babette has to report on her income tax forms and what she would have to report to potential investors. But does that help her make decisions about her business?

Babette’s Cajun Café—Economic Profit Let’s say Babette is trying to decide whether to keep her restaurant open or become a professional twerker. For her to make this decision, accounting profit won’t do it. She needs to know her economic profit. Remember, this focuses on her opportunity cost which includes explicit and implicit costs.

Babette’s Cajun Café—Economic Profit Economic profit will typically be different from the accounting profit because of the implicit costs. Businesses can face implicit costs for a couple of reasons: Business’s capital could have been put to use in some other way. Capital in a business is the value of its assets (equipment, buildings, inventory, etc.). The implicit cost of that capital is the opportunity cost of the capital used by a business  the income the owner could have realized (gotten) from that capital if it had been used in its next best alternative way. Owner devotes time and energy to business that could have been used in some other way. When considering the cost of an activity, you should include the cost of using any of your own resources for that activity. The most personal of these resources is the value of the entrepreneur’s labor in the next best occupation (think salary!).

Babette’s Cajun Café—Economic Profit We assumed that Babette owns her equipment rather than renting. If she had rented that would have been an explicit cost. Because she owns them, no rent is paid, and depreciation is taken instead in the profit statement. Depreciation does not equal opportunity cost.

Babette’s Cajun Café—Economic Profit Instead of using the equipment, let’s say that the best alternative would have been for Babette to sell the equipment for $50,000 and put money into a bank account where it would interest of $3,000. That $3,000 is an implicit cost of running the business. Implicit cost of capital. Opportunity cost of capital used by a business. Income the owner could have realized from capital if it had been used in its next best alternative way. Babette also needs to take into account the opportunity cost of her own time. Instead of owning her own business, she could earn $34,000/year as a chef at Emeril’s (implicit cost).

Babette’s Cajun Café—Economic Profit Profit at Babette’s Cajun Cafe Revenue$100,000 Explicit Cost-60,000 Depreciation-5,000 Accounting Profit$35,000 Implicit Cost of Business Income potential on capital not used-3,000 Income potential on work opportunity-34,000 Economic Profit-2,000 This is a summary of Babette’s accounting and economic profit. Based on this table, should Babette continue to operate her business? Nope, she should go to Emeril’s.

Babette’s Cajun Café—Economic Profit Key point: Economic profit tells a business owner whether or not they should continue to run their business or do something else. But what if the costs were to change? Let’s say that Emeril’s is cheap, and only pays $30,000?

Babette’s Cajun Café—Economic Profit In this new scenario, her economic profit would be $2,000. Emeril’s would be a worse option. This is the decision-making process that pretty much every business has to make every year. Should I stay or should I go? And even if you’re in the negative, it’s still never an easy answer personally, but economically, it’s clear.

Babette’s Cajun Café—Economic Profit Summary Positive economic profit (gain)—current best use of resources. Negative economic profit (loss)—alternative is the better use of resources.

Normal Profit What if Babette’s economic profit equaled zero? An economic profit equal to zero is not a bad thing, it just simply means that the firm could not do any better using its resources in any alternative activity. Normal profit. Economic profit equals zero. It is an economic profit high enough to keep a firm engaged in its current activity.

Libby’s Lounge Libby borrows money from the Bank of Bordelon (BoB) and purchases that abandoned gas station on and opens up a lounge. Each month she writes a check to BoB on her debt. That expense is an explicit cost. Libby’s friend Billy is a real estate agent who tells her that Libby could actually rent her building at $1,000 per month to Alex, who wants to set up an antique shop. If Libby decides to use the building herself, she’s forgoing $1,000 she could get from Alex’s Antiques. This is an implicit cost.

Libby’s Lounge Libby used to be a real estate agent herself, and used to earn $45,000/year. When she quit the real estate gig, she now has a forgone salary of $45,000/year. That forgone salary is her implicit cost.

Libby’s Lounge Libby’s Lounge is a hit, of sorts, and she earns $250,000 in total revenue her first year. Here are her explicit costs: We can calculate Libby’s accounting profit from here. Explicit Costs $1200 to BoB’s loan x 12$14,400 Wages$35,000 Insurance and utilities$40,000 Inventory$150,000 Total$239,400

Libby’s Lounge Accounting π = TR – Total Explicit Costs Accounting π = $250,000 - $239,400 Accounting π = $10,600 Explicit Costs $1200 to BoB’s loan x 12$14,400 Wages$35,000 Insurance and utilities$40,000 Inventory$150,000 Total$239,400

Libby’s Lounge Looking for economic profit, we need to calculate her implicit costs: Implicit Costs Forgone rental income $1,000/month x 12 $12,000 Forgone salary$45,000 Total$57,000

Libby’s Lounge Economic π = TR – Total Explicit Costs – Total Implicit Costs Economic π = $250,000 - $239,400 - $57,000 Economic π = -$46,400 Explicit Costs $1200 to BoB’s loan x 12$14,400 Wages$35,000 Insurance and utilities$40,000 Inventory$150,000 Total$239,400 Implicit Costs Forgone rental income $1,000/month x 12 $12,000 Forgone salary$45,000 Total$57,000

Libby’s Lounge Libby’s accountant would report that she is earning a positive profit, but as an economic matter, she would be incurring an economic loss. She should have kept selling real estate. But what if her Total Revenue was $296,400, or exactly $46,400 higher than before? Economic π = $296,400 - $239,400 - $57,000 Economic π = $0 Libby would now be earning a normal profit.

Libby’s Lounge In this case, Libby’s “breaking even.” Awesome, but so what? If Libby has zero economic profit, Libby has sold enough beverages to do the following: Pay all of her explicit costs: wages, insurance, utilities, BoB and liquor suppliers. Compensate herself for all the rental income she gave up as well as her real estate agent salary. If you can earn enough revenue to cover every cost, then a normal profit isn’t a bad deal.