Presentation 3- Cost of Production
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Cash expenditures a firm makes to those who
supply labor services, materials, fuel,
transportation etc.
Cash payments for the use of resources
owned by others ($$ value)
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Opportunity cost of using self-owned, selfemployed resources
Amount of $$ that self-employed resources
could have earned in their best alternative
use
Ex- using a building rather than renting
it…the amount of rent you could have made
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The value or worth the resources used to
produce a good would have in its best
alternative use
Ex- steel in a building could be used for cars
Ex- for an assembly line worker making
computers, the contribution he could have
produced for another good
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The payments a firm must make, or the
incomes it must provide, to attract the
resources away from alternative production
opportunities.
These payments can be explicit or implicit.
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The minimum payment you must receive for
performing entrepreneurial functions for a
firm rather than for yourself
Included in implicit costs
 Profit
= Total RevenueExplicit Costs
 Profit
= Total Revenue –
Economic Costs (Implicit
and Explicit Costs)
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You have been earning $22,000/yr. You
decide to open your own T-Shirt company.
You invest $20,000 of savings that have
earning you $1000/year in interest. Your
firm will be in a small store that you own and
have been renting out for $5000/year. You
also hire a clerk for $18000/year. Calculate
Accounting and economic profit
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Total Sales Revenue………………..120,000
 Cost of t-shirts…………40000
 Clerk’s salary…………...18000
 Utilities…………………...5000
TOTAL COSTS (Explicit)………………………(63,000)
ACCOUNTING PROFIT…………………………$57,000
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$57,000 accounting profit looks good but
doesn’t include implicit costs and overstates
the economic success of the company.
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By providing your own financial capital,
building and labor you incur implicit costs
(forgone income):
Accounting Profit………………………57000
 Forgone interest……………………….1000
 Forgone rent…………………………...5000
 Forgone wages………………………..22000
 Forgone entrepreneurial income….5000
TOTAL Implicit Costs…………………………….(33000)
Economic Profit……………………………………$24000
ECONOMIC Profit = TR-ECONOMIC COSTS
= 120000 – 63000-33000
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= $24000
Gomez runs a small pottery firm. He hires one
helper at $12,000 per year, pays annual rent of
$5,000 for his shop, and spends $20,000 per year
on materials. He has $40,000 of his own funds
invested in equipment (pottery wheels, kilns, and
so forth) that could earn him $4,000 per year if
alternatively invested. He has been offered
$15,000 per year to work as a potter for a
competitor. He estimates his entrepreneurial
talents are worth $3,000 per year. Total annual
revenue from pottery sales is $72,000. Calculate
accounting profits and economic profits for
Gomez’s pottery.
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Explicit costs: $37,000 (= $12,000 for the
helper + $5,000 of rent + $20,000 of
materials). Implicit costs: $22,000 (=
$4,000 of forgone interest + $15,000 of
forgone salary + $3,000 of
entrepreneurship).
Accounting profit = $35,000 (= $72,000
of revenue - $37,000 of explicit costs);
Economic profit = $13,000 (= $72,000 $37,000 of explicit costs - $22,000 of
implicit costs).