Firms, Opportunity Costs, and Profits Review for AP Economics
Review questions for this study guide can be found at:
Main Topics: The Firm, Accounting and Economic Profit, Explicit and Implicit Costs, Short Run and Long Run
When we talk about consumers, it's very easy to imagine yourself in the leading role. However, when the conversation switches to the firm, it is often much more difficult to visualize what it is, or who we are talking about. The firm can bring to mind many things to many different people. The firm can be an independent bookstore in your town, or it can be Barnes & Noble. It can be a street vendor selling hot dogs or it can be Oscar Mayer. Regardless of the size of the business, a firm is defined as: "An organization that employs factors of production to produce a good or service that it hopes to profitably sell."
Profit and Cost: When CPAs and Economists Collide
Before we launch into a technical discussion of production and costs, we need to take care of, well, a technicality. The bottom line is that the accountant sees profit differently than does the economist.
Upon completion of her undergraduate double major in accounting and economics, Molly creates a firm that sells lemonade on a busy street corner in her small town. Selling cups of lemonade at $1 each, Molly sells 1000 cups per month. The accountant and the economist in her agree (imagine a little devil and little angel on each shoulder—you can decide which is the CPA) that monthly total revenues (TR) = $1 * 1000 cups = $1000.
Molly's accounting textbooks clearly state that profit (π) is calculated by subtracting total production costs (TC) from total revenue. She rents a table from her parents at $75 per month, spends $300 per month on lemons, sugar, and cups, and purchases a monthly vendor's license at $25. These direct, purchased, out-of-pocket costs are referred to as accounting, or explicit costs.
Accounting π =TR – explicit cost = $1000 – 75 – 300 – 25
= $600, a tidy profit!
The economist on Molly's other shoulder disagrees. Are these the only costs of running the lemonade stand? What about the opportunity costs of resources not accounted for above? For example, Molly has chosen to give up a monthly salary of $1000 at a bank. The economist knows that this opportunity cost must be subtracted from total revenue to better measure profitability. These indirect, non-purchased, opportunity costs, are called economic, or implicit costs.
Economic π = TR – explicit cost – implicit costs = $1000 – 75 – 300 – 25 – 1000
= –$400, a painful loss!
Other implicit costs borne by many entrepreneurs include the interest given up when savings are liquidated, or rent forgone if the individual works out of a home or garage. Here's one way to try to keep explicit and implicit costs straight.
- Were the dollars paid to outside resource suppliers (employees, a landlord, a wholesale food store)? Did money actually change hands? Explicit.
- Were the resources supplied by the entrepreneur herself (salary or interest given up)? Implicit.
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