Unit 3: Costs of Production and Perfect Competition Copyright ACDC Leadership 2015

Revenue = Price x Quantity Revenue and Profit Revenue = Price x Quantity

Accountants vs. Economists Accountants look at only EXPLICIT COSTS Explicit costs (out of pocket costs) are payments paid by firms for using the resources of others. Example: Rent, Wages, Materials, Electricity Bills Accounting Profit Total Revenue Accounting Costs (Explicit Only) Economists examine both the EXPLICIT COSTS and the IMPLICIT COSTS Implicit costs are the opportunity costs that firms “pay” for using their own resources Example: Forgone Wage, Forgone Rent, Time Economic Profit Total Revenue Economic Costs (Explicit + Implicit) Copyright ACDC Leadership 2015

From now on, all costs we discuss will be ECONOMIC COSTS Accountants vs. Economists Accountants look at only EXPLICIT COSTS Explicit costs (out of pocket costs) are payments paid by firms for using the resources of others. Example: Rent, Wages, Materials, Electricity Bills From now on, all costs we discuss will be ECONOMIC COSTS Accounting Profit Total Revenue Accounting Costs (Explicit Only) Economists examine both the EXPLICIT COSTS and the IMPLICIT COSTS Implicit costs are the opportunity costs that firms “pay” for using their own resources Example: Forgone Wage, Forgone Rent, Time Economic Profit Total Revenue Economic Costs (Explicit + Implicit) Copyright ACDC Leadership 2015

No Economic Profit = Normal Profit Practice Assume the following: David left his job as a lawyer earning $8,000 a month to open up an ice cream shop Last month he sold 5,000 sundaes for $2 each and 8,000 cones for $1 each His rent is $1000 per month His other expenses like labor, ice cream, cones, etc. add up to $9,000 per month Last month he took a family vacation that cost $5000 Calculate David’s accounting profit Calculate David’s economic profit Should David go back to being a lawyer? What must be true for accounting profit if economic profit is zero? No Economic Profit = Normal Profit $8,000= Revenue ($18,000) minus explicit costs ($10,000). Don’t include the family vacation since it is not a business expense. $0= Revenue minus explicit costs and implicit costs ($8,000 forgone wage) Not necessarily, he makes just as much money per month with his shop as he did being a lawyer. Accounting profit must be positive when economic profit is zero Copyright ACDC Leadership 2015

Normal Profit In an efficient competitive market, firms that have identical products will make a normal profit. They will break even and make no economic profit Traffic Analogy When there is heavy traffic, why do all lanes go the same slow speed? Cars leave slower lanes and enter faster lanes. Similarly, what happens in perfectly competitive markets if firms earn excessive profit? 6 Copyright ACDC Leadership 2015

Maximizing PROFIT! 7 Copyright ACDC Leadership 2015

Assume every unit can be sold for $10. Which unit maximizes profit? Use marginal analysis to explain why you should never produce 5 units Marginal Cost Price $12 $10 $8 $6 Marginal Revenue Quantity 1 2 3 4 5 Copyright ACDC Leadership 2015

Short-Run Profit Maximization What is the goal of every business? To Maximize Profit!!!!!! To maximum profit firms must make the right output Firms should continue to produce until the additional revenue from each new output equals the additional cost. Example (Assume the price is $10) Should you produce… …if the additional cost of another unit is $5 …if the additional cost of another unit is $9 …if the additional cost of another unit is $11 Copyright ACDC Leadership 2015

Profit Maximizing Rule Short-Run Profit Maximization MR=MC Short-Run Profit Maximization What is the goal of every business? To Maximize Profit!!!!!! To maximum profit firms must make the right output Firms should continue to produce until the additional revenue from each new output equals the additional cost. Example (Assume the price is $10) Should you produce… …if the additional cost of another unit is $5 …if the additional cost of another unit is $9 …if the additional cost of another unit is $11 10 Copyright ACDC Leadership 2015