Economic Costs, Economic Profits
Dr. Abdullah Al Bahrani
www.abdullahalbahrani.com
dr.albahrani@uky.edu
Summer 2021
Cost Theory: accounting costs vs. economic
costs
Opportunity Cost—the most important intuition you
can develop for running a business ice cream shop
• Total revenue from sale of goods =
• Explicit costs of operating the business:
cost of goods sold
taxes and utilities
rent
• Accounting profit = $25,000
$80,000
$40,000
$5,000
$10,000
Additional information
• The owner works full time in the shop and doesn’t pay themself a salary.
They used to work as a mechanic and earned $24,000 per year.
• Owner and their spouse have $40,000 tied up in the business at any point in
time—working capital. They took that money out of an investment account
where they earned 5% per year.
• The owner had to buy a computer ($3,000) and install carpeting ($5,000)
when They opened the business. Both of these have an expected life of 4
years, at which point they will both have to be replaced.
If you were the owner, what would you do?
• Accounting profits = $25,000
• How much would you have at the end of the year if you were not
operating this shop and instead pursued your next best alternative?
• Implicit costs:
• opportunity cost of his time = $24,000
• foregone interest on investment = $2,000
• economic depreciation (annualized) = $2,000
Economic Profits
• Economic profits = Total Revenue – total explicit costs – total implicit
costs
• $80k - $55k - $28k = -$3,000
• You are doing $3,000 worse than his next best alternative!!
• You would be better off working as a secretary, earning interest on
your investments, and not putting money into carpet and a computer
that wear out.
What would you pay for this business if the
owner wants to retire and sell it?
• If you currently work as a mechanic earning $24,000 per year?
• answer: nothing—you’re better off staying in your current job
• If you are earning $18,000 per year working at Jimmy John’s
delivering sandwiches?
• Hint: calculate the economic profits you would earn if you quit JJ’s and bought
the owner out.
Opportunity Costs
• Whenever we talk about costs in this class we will talk about the cost
including the opportunity cost.
• This includes the cost of labor.
• what the workers could earn working somewhere else.
• As well as the cost of capital.
• The return the capital could earn invested somewhere else.
8
Own vs. Rent
You currently pay $10,000 per year in rent for a $100,000 house, which you are
considering purchasing. You can qualify for a loan of $80,000 at 9% if you put
$20,000 down on the house. To raise money for the down payment, you would
have to liquidate stock earning a 15% return. Neglect other concerns, like closing
costs, capital gains, and property taxes.
• Is it better to rent or own?
•
80,000×9%+20,000×15% = $10,200 > $10,000
• Suppose that you can deduct mortgage interest from federal taxes, and you
are in the 25% tax bracket. Is it better to rent or own?
•
80,000×9%×75%+20,000×15% = $8,400 < $10,000
Sunk Cost
• Another type of economic cost is Sunk Cost.
• Sunk Cost
•
•
Expenditure that has been made and cannot be recovered.
Should not influence a firm’s decisions.
10
Measuring Costs: Which Costs Matter?
• Next, consider fixed costs and variable costs.
• Total output is a function of variable inputs and fixed
inputs.
• Therefore,
TC = FC + VC
11
Measuring Costs: Which Costs Matter?
• Fixed Cost (FC)
• Does not vary with the level of output
• Variable Cost (VC)
• Cost that varies as output varies
12
Measuring Costs: Which Costs Matter?
• It is important to understand the distinction between fixed costs and
sunk costs.
• Fixed Cost
• Cost paid by a firm that is in business regardless of the level of output. Short
run concept
• Sunk Cost
• Cost that has been incurred and cannot be recovered
13
Fixed Costs
• Examples of Fixed Costs Include:
• Rent—A dentist must pay the rent on his office regardless of the number of
patients she sees
• Insurance
• Licenses fee—Dentist must also pay a yearly fee for her license which does
not vary with the number of patients
• Interest on debt
14
Variable Costs
• Costs that vary with the amount of output you produce include:
•
•
•
•
Wages
Electricity
Fuel
materials
• In general, anything we need more of to produce more output
15
Examples: Are these costs fixed or variable?
• Payments to your accountants to prepare your tax returns.
• Electricity to run the candy making machines.
• Fees to design the packaging of your candy bar.
• Costs of material for packaging.
Costs in the Short Run
• Marginal Cost (MC) is the cost of expanding output by one unit. Since
fixed cost has no impact on marginal cost, it can be written as:
DVC DTC
MC =
=
DQ
DQ
17
Costs in the Short Run
ØAverage Total Cost (ATC) is the cost per unit of
output, or average fixed cost (AFC) plus
average variable cost (AVC). This can be
written as:
TFC TVC
ATC =
+
Q
Q
18
Short-run Total Cost
Total
400
Cost ($)
Total Cost
is the vertical
sum of TFC
and TVC.
TC
TVC
Total variable cost
increases with
output. Its shape
reflects the law of
diminishing returns.
300
200
100
Total fixed cost does not
vary with output
TF
C
50
0
1 2 3 4 5 6 7 8 9 10
11
12
13
Output
19
Important concepts RE short-run cost curves
• Shape of AFC curve: “spreading one’s overhead”
• Shape of AVC curve: can you see the law of eventually diminishing marginal
returns at work?
• Shape of the MC curve: can you see the output at which diminishing returns set
in?
• Shape of the Short-run ATC curve: Always U-shaped!!
• SRATC = SRAFC + SRAVC [shape of AFC + shape of AVC => shape of ATC]
EXAMPLE 4: ATC and MC
When MC < ATC,
ATC is falling.
$175
When MC > ATC,
ATC is rising.
$150
$125
Costs
The MC curve
crosses the
ATC curve at
the ATC (and AVC)
curve’s minimum.
ATC
MC
$200
$100
$75
$50
$25
$0
0
1
2
3
4
Q
5
6
7
Long-Run Cost Curves
• Long-Run total costs (LTC) shows how costs
change with output when we vary all inputs
• Long-Run Average Cost (LAC) is given by:
LTC
LAC =
Q
• Long-Run Marginal Cost is given by:
DLTC
LMC =
DQ
24
Long-Run Cost Curves
• The shape of these curves depends on whether the production
function exhibits increasing, constant, or decreasing returns to scale.
25
Long-Run Average Cost (LAC)
•
Constant Returns to Scale
• If input is doubled, output will double, and average cost is constant at all
levels of output.
• LAC curve will be a flat line.
•
Increasing Returns to Scale
• If input is doubled, output will more than double and average cost decreases
at all levels of output.
• LAC curve is downward sloping.
26
Long-Run Average Cost (LAC)
•
Decreasing Returns to Scale
• If input is doubled, the increase in output is less than twice as large and
average cost increases with output.
• LAC curve is upward sloping.
27
Long-Run Average Cost (LAC)
•
In the long-run, firms initially experience increasing returns to scale at
low output and then decreasing returns to scale at higher output and
therefore long-run average cost is “U” shaped
•
Evidence suggests that it may “L” be shaped
28
Long-Run Average Cost and Long-Run
Marginal Cost
Cost
($ per unit
of output
LMC
LAC
Minimum efficient size
is the firm size where
long-run average cost
is at a minimum
A
At Q* firm is operating
at the minimum
efficient size
Q*
Quantity of Output
29
Choosing a plant size: Long-run average
costs and the firm’s planning curve
• Now let’s get serious about opening up a fast-food restaurant near the UK
campus. You find a location and choose a franchise chain. You set up a
meeting with company representatives, at which they open a briefcase and
pull out some spreadsheets and blueprints which contain the following
information:
• [see next slide]
• Then they ask you: How many customers do you envision yourself wanting
to serve each day?
• Answer #1: Duh?
• Answer #2: Well, I’ve done some demand forecasting and I envision
serving roughly X meals per day.
Long-Run costs with economies and diseconomies of
scale
Cost
(€ per unit
of output
SATC1
SATC2
SATC3
A
B
C
400
800
1000
Output
The LRAC curve and economies of scale
• Given sufficient time to plan and execute, firms can vary all inputs optimally
for whatever scale of operation they desire.
• So in reality, firms can choose from many different plant sizes. The LRAC
curve is the envelope of all the SRATC curves associated with each different
plant size.
• The LRAC curve tells us the minimum possible average total cost for
producing each output level.
• The shape of the LRAC curve tells us how per unit costs change as the firm
changes the scale of its operations.
How ATC Changes as
the Scale of Production Changes
Economies of scale:
ATC falls
as Q increases.
ATC
LRATC
Constant returns to
scale: ATC stays the
same
as Q increases.
Diseconomies of
scale: ATC rises
as Q increases.
Q
Returns to Scale
• Important to note that decreasing returns to scale is not the
same as the law of diminishing returns.
• The law of diminishing returns is a short-run concept and tells us
that marginal output will fall as we add more of one input holding
the other input fixed.
• Decreasing returns to scale is a long-run concept and says that
output goes up by less than twice as much when we double all
inputs.
34
Minimum Efficient Scale (MES)
• How big does the firm have to be in order to produce the product as
cheaply as possible?
• We call the scale of operations (Q) at which the LRAC curve reaches
its minimum level of cost the Minimum Efficient Scale, or MES.
• Firms operating at a smaller scale could lower their per unit costs by
increasing their scale. Firms operating at a sub-optimal scale will be
at a competitive disadvantage relative to firms that have attained
MES.
• MES, market demand, and the number of firms in a competitive
market? How many fast-food restaurants are there in Lexington? In
Nicholosville? Why?