Firms, Opportunity Costs, and Profits Review for AP Economics (page 2)
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.
So Which Should I Use?
Excellent question. The "quickie" answer is to turn to the title page of this book, and use that method. Of course, as a student of economics, you must include implicit economic costs in calculating economic profit. But why? Well, it's more accurate. An adept student of economics knows that the cost of something goes beyond the price tag. A friend of mine in graduate school once said that "nothing is free, it is just non-priced." If you visit your AP teacher's office, you might not have to pay to pass through the door, but you could be doing something else with your time. This is a non-priced economic cost. Molly's labor and effort at the lemonade stand appear to be free; this is why an accountant does not include that effort in calculating profit. An economist knows that it is not free—it is just non-priced. An economist tries to quantify that price by using the value of Molly's efforts in her next best alternative as the banker. Throughout this book, costs refer to economic costs, and profits refer to economic profits.
Short-Run and Long-Run Decisions
The short run is a time when at least one production input is fixed, and cannot be changed, to respond to a change in product demand. During the holiday season a local gift shop extends hours and increases the workers hired. Much more difficult to change is the total capacity of the shop. The capacity of the shop is fixed in the short run, but can be altered with enough time. The amount of time required to change the plant size is known as the long run. In other words, all inputs are variable in the long run. See Table 8.1.
When Molly pays $25 for a monthly vendor's license on January 1st, she is committed for a month. She cannot receive a refund if she fails to operate the lemonade stand and she does not have to pay more if she works 24 hours a day all month. For Molly, the long run is one month. On the other hand, at any point in the month, Molly can choose to purchase more lemons, cups or sugar, or employ assistants, if she is selling more cups of lemonade. This is a short-run decision.
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