Unit V
Costs and Marginal Analysis (Chapter 9)
In this chapter, look for the
answers to these questions:

Why are implicit as well as explicit
costs important in decision making?

What is the difference between
accounting profit and economic profit?

Why is economic profit is the correct
basis for decisions?

What is the principle of marginal
analysis?

What are sunk costs?
Total Revenue, Total Cost, Profit
• We assume that the firm’s goal is to maximize
profit.
Profit = Total revenue – Total cost
the amount a
firm receives
from the sale
of its output
the market
value of the
inputs a firm
uses in
production
Costs: Explicit vs. Implicit
• Explicit costs – require an outlay of money,
e.g. paying wages to workers
• Implicit costs – do not require a cash outlay,
e.g. the opportunity cost of the owner’s time
– A cost that represents the value of resources used in
production for which no actual (monetary) payment is
made.
• Remember The cost of something is
what you give up to get it.
Explicit vs. Implicit Costs: An
Example
You need $100,000 to start your business.
The interest rate is 5%.
• Case 1: borrow $100,000
– explicit cost = $5000 interest on loan
• Case 2: use $40,000 of your savings,
borrow the other $60,000
– explicit cost = $3000 (5%) interest on the loan
– implicit cost = $2000 (5%) foregone interest
you could have earned on your $40,000.
In both cases, total (exp + imp) costs are $5000.
Opportunity Cost of Capital
• The available return on the next best
alternative investment (financial capital or
labor).
– economists consider this a cost of production,
and it is included in our cost examples
Economic Profit vs. Accounting
Profit
• Accounting profit
= total revenue minus total explicit
costs
• Economic profit
= total revenue minus total costs
(including explicit and implicit
costs)
• Accounting profit ignores implicit
costs, so it’s higher than
economic profit.
Economic Profit vs. Accounting
Profit
Accounting Profit
Total sales revenue
$120,000
Costs of T-shirts
Clerk’s salary
Utilities
Total (explicit) costs
63,000
Accounting profit
57,000
$40,000
18,000
5,000
Implicit Costs
Accounting profit
$57,000
Forgone interest $ 1,000
Forgone rent
5,000
Forgone wages
22,000
Forgone ent. Income 5,000
Total implicit costs
33,000
Economic profit
24,000
Accounting, Economic and
Normal Profit
Normal Profit
• Normal Profit - Zero economic profit. A
firm that earns normal profit is earning
revenue equal to its total costs (explicit
plus implicit costs). This is the level of
profit necessary to keep resources
employed in that particular firm.
– The cost of doing business
A C T I V E L E A R N I N G 1:
Economic profit vs. accounting profit
The equilibrium rent on office space has just
increased by $500/month.
Compare the effects on accounting profit
and economic profit if
a. you rent your office space
b. you own your office space
A C T I V E L E A R N I N G 1:
Answers
The rent on office space increases $500/month.
a. You rent your office space.
Explicit costs increase $500/month.
Accounting profit & economic profit each fall
$500/month.
b.You own your office space.
Explicit costs do not change,
so accounting profit does not change.
Implicit costs increase $500/month (opp. cost
of using your space instead of renting it),
so economic profit falls by $500/month.
Efficiency
• Marginal Benefit
– Marginal benefit is the benefit a person receives
from consuming one more unit of a good or
service.
– We can measure the marginal benefit from a good
or service by the dollar value of other goods and
services that a person is willing to give up to get
one more unit of it.
– The concept of decreasing marginal benefit
implies that as more of a good or service is
consumed, its marginal benefit decreases.
Efficiency
• The graph
shows the
decreasing
marginal
benefit from
each additional
slice of pizza,
measured in
dollars per
slice.
Efficiency
• Marginal Cost
– Marginal cost is the opportunity cost of producing
one more unit of a good or service. The measure
of marginal cost is the value of the best alternative
forgone to obtain the last unit of the good.
– We can measure the marginal cost of a good or
service by the dollar value of other goods and
services that a person is must give up to get one
more unit of it.
– The concept of increasing marginal cost implies
that as more of a good or service is produced, its
marginal cost increases.
Efficiency
• This graph
shows the
increasing
marginal cost
of each
additional slice
of pizza,
measured in
dollars per
slice.
Efficiency
• Efficiency and
Inefficiency
– If the marginal
benefit from a
good exceeds
its marginal
cost, producing
and consuming
more of the
good uses
resources more
efficiently.
Efficiency
• If the marginal
cost of a good
exceeds its
marginal
benefit,
producing and
consuming less
of the good
uses resources
more efficiently.
Efficiency
• If the marginal
cost of a good
equals its
marginal
benefit,
resources are
being use
efficiently.
• Allocative
efficiency will
occur when
MB = MC
Sunk Cost
• A cost incurred in the past that cannot be
changed by current decisions and therefore
cannot be recovered.
CHAPTER SUMMARY

Implicit costs do not involve a cash outlay,
yet are just as important as explicit costs
to firms’ decisions.
 Accounting profit is revenue minus explicit
costs. Economic profit is revenue minus total
(explicit + implicit) costs.
 According to the principle of marginal analysis,
the optimal quantity—the quantity that generates
the maximum possible total net gain—is the
quantity at which marginal benefit is equal to
marginal cost.
 A cost that has already been incurred and that
is nonrecoverable is a sunk cost. Sunk costs
should be ignored in decisions about future
actions—they have no effect on future benefits
and costs.