1. 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

2. 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

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

4. 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

5. 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)

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

7. 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)

8. 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

9. 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

10. 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

11. Let’s do another Example…

12. 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?

13. 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”

14. 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.

15. 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

16. Should Leo keep making Pizza???

17. 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

18. 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

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