Profits and Costs Behind Supply: Finding Producers’ Bottom Line

Finding Producers’ Bottom Line

Introduction

This section explores how businesses determine profits and costs, focusing on the distinction between accounting and economic profits, the role of opportunity costs, and the impact of these concepts on supply decisions in microeconomics.

Accounting Profits and Hidden Opportunity Costs

Explicit and Implicit Costs

• Explicit costs: Direct, out-of-pocket payments a business makes (e.g., rent, wages, materials).

• Implicit costs: Hidden opportunity costs of using resources owned by the business, such as the owner’s time and invested money.

• Depreciation: The annual decrease in the value of equipment due to wear, tear, or obsolescence. Calculated as the price of equipment divided by its useful life in years.

Accounting profits are calculated as:

$\text{Accounting Profits} = \text{Revenues} - \text{Explicit Costs (including depreciation)}$

• Accounting profits do not include implicit costs.

• Must include compensation for risk.

Example: Calculating Accounting Profits

Total Expected Revenues	$60,000
Explicit Costs
Depreciation	$5,000
Rent	$14,000
Web Hosting	$3,000
Phone	$1,000
Advertising	$2,000
Total Explicit Costs	$25,000
Accounting Profits	$35,000

Implicit Costs and Opportunity Costs

• Implicit costs: The value of what a business owner could earn elsewhere with their time and money.

• Opportunity cost of time: The best alternative use of the owner’s time.

• Opportunity cost of money: The best alternative use of the owner’s money invested in the business.

• Must include compensation for risk.

Example: Opportunity Cost Calculation

Investment	$40,000
Bank interest	5%
Risk premium	15% above bank interest
Guaranteed from Bank	$2,000
Expected from Business	$8,000

Wahid is equally pleased with either outcome, reflecting the need for risk compensation.

Risk Attitudes

• Risk-loving investors require less compensation for taking risks.

• Risk-averse investors require more compensation for taking risks.

Normal Profits and Economic Profits

Definitions

• Normal profits:

  • Compensation for a business owner’s time and money.

  • Sum of implicit costs (hidden opportunity costs).

  • What a business owner must earn to do as well as the best alternative use of time and money.

  • Average profits in other industries with comparable risk.

• Economic profits:

  • Revenues minus all opportunity costs (explicit + implicit costs).

  • Formulas:

    • $\text{Economic Profits} = \text{Revenues} - (\text{Explicit Costs} + \text{Implicit Costs})$

    • $\text{Economic Profits} = \text{Revenues} - (\text{Explicit Costs} + \text{Normal Profits})$

  • Economic profits are less than accounting profits because they subtract implicit costs.

• Economic losses: Negative economic profits; revenues are less than all opportunity costs.

Example: Economic Profits Calculation

Total Expected Revenues	$60,000
Explicit Costs
Depreciation	$5,000
Rent	$14,000
Web Hosting	$3,000
Phone	$1,000
Advertising	$2,000
Total Explicit Costs	$25,000
Accounting Profits	$35,000
Implicit Costs
Wahid’s Time	$38,000
Wahid’s Money	$8,000
Total Implicit Costs	$46,000
Economic Profits	($11,000)

Scenarios Table

Scenario	One	Two	Three
Revenues	$60,000	$71,000	$80,000
Total Explicit Costs	$25,000	$25,000	$25,000
Total Implicit Costs	$46,000	$46,000	$46,000
Accounting Profits	$35,000	$46,000	$55,000
Economic Profits	($11,000)	$0	$9,000

Economic Profits and Market Signals

Red Light, Green Light: How Economic Profits Direct the Invisible Hand

• The simplest rule for smart business decisions: Choose only when economic profits are positive.

• Economic profits signal businesses to expand or enter an industry; economic losses signal contraction or exit.

• When businesses pursue economic profits, markets produce the products and services consumers want.

Market Equilibrium

• Short-run market equilibrium: Quantity demanded equals quantity supplied, but economic profits or losses lead to changes in supply.

• Long-run market equilibrium: Quantity demanded equals quantity supplied, economic profits = zero, no tendency for change. The price just covers all opportunity costs, including normal profits.

Short-Run and Long-Run Market Equilibrium (Fig. 8.4)

Scenario	Economic Profits	Market Response
Losses	Negative	Firms exit, supply decreases, prices rise
Profits	Positive	Firms enter, supply increases, prices fall
Zero Profit	Zero	No entry or exit, equilibrium reached

Adam Smith on Normal Profits

Adam Smith observed that if one employment is more advantageous than others, people will enter it until profits return to the average level. This is the foundation of the concept of normal profits in competitive markets.

Short-Run Costs and Diminishing Marginal Productivity

Short Run vs. Long Run

• Short run: Some inputs are fixed, others are variable.

• Long run: All inputs are variable.

Types of Costs

• Fixed costs: Do not change with the quantity of output produced.

• Variable costs: Change with the quantity of output produced.

• Total cost: $\text{Total Cost} = \text{Fixed Costs} + \text{Variable Costs}$

Productivity Concepts

• Total product: Total output produced by labor with all fixed inputs.

• Marginal product: Additional output from adding one more unit of labor.

• Diminishing marginal productivity: As more of a variable input is added to fixed inputs, the marginal product eventually decreases.

Marginal Cost

• Diminishing marginal productivity causes marginal costs to increase as output increases.

• Marginal cost is the most important cost concept for profit-maximizing businesses.

Example Table: Output and Marginal Cost

Labourers	Total Product (bushels)	Marginal Product (bushels)	Marginal Cost ($/bushel)
1	300	300	1.00
2	600	300	1.00
3	900	300	1.00
4	1,150	250	1.20
5	1,350	200	1.50
6	1,500	150	2.00
7	1,600	100	3.00
8	1,650	50	6.00

Additional info: Table values inferred from standard microeconomics examples.

Summary Table: Economic Profits and Market Signals

Economic Profits	Market Signal	Business Response
Negative	Red Light	Exit/Contract
Zero	Yellow Light	No Change (Breakeven)
Positive	Green Light	Enter/Expand

Key Formulas

• $\text{Accounting Profits} = \text{Revenues} - \text{Explicit Costs}$

• $\text{Economic Profits} = \text{Revenues} - (\text{Explicit Costs} + \text{Implicit Costs})$

• $\text{Total Cost} = \text{Fixed Costs} + \text{Variable Costs}$

Conclusion

Understanding the difference between accounting and economic profits, and the role of opportunity costs, is essential for making smart business decisions. Economic profits serve as signals for market entry and exit, guiding resources to their most valued uses and ensuring efficient production in the long run.