7.1Explicit and Implicit Costs, and Accounting and Economic Profit

When people think of businesses, often corporate giants like Wal-Mart, Microsoft, or General Motors come to mind. However, firms come in all sizes, as Table 7.1 shows. The vast majority of American firms have fewer than 20 employees. As of 2010, the U.S. Census Bureau counted 5.7 million firms with employees in the U.S. economy. Slightly less than half of all the workers in private firms are at the 17,000 large firms, meaning they employ more than 500 workers. Another 35% of workers in the U.S. economy are at firms with fewer than 100 workers. These small-scale businesses include everything from dentists and lawyers to businesses that mow lawns or clean houses. Table 7.1 does not include a separate category for the millions of small “non-employer” businesses where a single owner or a few partners are not officially paid wages or a salary, but simply receive whatever they can earn. Number of Employees Firms (% of total firms) Number of Paid Employees (% of total employment) Total 5,734,538 112.0 million 0–9 4,543,315 (79.2%) 12.3 million (11.0%) 10–19 617,089 (10.8%) 8.3 million (7.4%) 20–99 475,125 (8.3%) 18.6 million (16.6%) 100–499 81,773 (1.4%) 15.9 million (14.2%) 500 or more 17,236 (0.30%) 50.9 million (49.8%) TABLE 7.1Range in Size of U.S. Firms(Source: U.S. Census, 2010 www.census.gov)

7.1 Explicit and Implicit Costs, and Accounting and Economic Profit

LEARNING OBJECTIVES By the end of this section, you will be able to:

• Explain the difference between explicit costs and implicit costs
• Understand the relationship between cost and revenue

Each business, regardless of size or complexity, tries to earn a profit: Total revenue is the income the firm generates from selling its products. We calculate it by multiplying the price of the product times the quantity of output sold: We will see in the following chapters that revenue is a function of the demand for the firm’s products. Total cost is what the firm pays for producing and selling its products. Recall that production involves the firm converting inputs to outputs. Each of those inputs has a cost to the firm. The sum of all those costs is total cost. We will learn in this chapter that short run costs are different from long run costs. We can distinguish between two types of cost: explicit and implicit. Explicit costs are out-of-pocket costs, that is, actual payments. Wages that a firm pays its employees or rent that a firm pays for its office are explicit costs. Implicit costs are more subtle, but just as important. They represent the opportunity cost of using resources that the firm already owns. Often for small businesses, they are resources that the owners contribute. For example, working in the business while not earning a formal salary, or using the ground floor of a home as a retail store are both implicit costs. (See the Work It Out feature for an extended example.) These two definitions of cost are important for distinguishing between two conceptions of profit, accounting profit, and economic profit. Accounting profit is a cash concept. It means total revenue minus explicit costs—the difference between dollars brought in and dollars paid out. Economic profit is total revenue minus total cost, including both explicit and implicit costs. The difference is important because even though a business pays income taxes based on its accounting profit, whether or not it is economically successful depends on its economic profit. WORK IT OUT Calculating Implicit Costs Consider the following example. Eryn currently works for a corporate law firm. She is considering opening her own legal practice, where she expects to earn $200,000 per year once she establishes herself. To run her own firm, she would need an office and a law clerk. She has found the perfect office, which rents for $50,000 per year. She could hire a law clerk for $35,000 per year. If these figures are accurate, would Eryn’s legal practice be profitable? Step 1. First you have to calculate the costs. You can take what you know about explicit costs and total them: Step 2. Subtracting the explicit costs from the revenue gives you the accounting profit. However, these calculations consider only the explicit costs. To open her own practice, Eryn would have to quit her current job, where she is earning an annual salary of $125,000. This would be an implicit cost of opening her own firm. Step 3. You need to subtract both the explicit and implicit costs to determine the true economic profit: Eryn would be losing $10,000 per year. That does not mean she would not want to open her own business, but it does mean she would be earning $10,000 less than if she worked for the corporate firm. Implicit costs can include other things as well. Maybe Eryn values her leisure time, and starting her own firm would require her to put in more hours than at the corporate firm. In this case, the lost leisure would also be an implicit cost that would subtract from economic profits. Now that we have an idea about the different types of costs, let’s look at cost structures. A firm’s cost structure in the long run may be different from that in the short run. We turn to that distinction in the next few sections.

7.2 Production in the Short Run

LEARNING OBJECTIVES By the end of this section, you will be able to:

• Understand the concept of a production function
• Differentiate between the different types of inputs or factors in a production function
• Differentiate between fixed and variable inputs
• Differentiate between production in the short run and in the long run
• Differentiate between total and marginal product
• Understand the concept of diminishing marginal productivity

In this chapter, we want to explore the relationship between the quantity of output a firm produces, and the cost of producing that output. We mentioned that the cost of the product depends on how many inputs are required to produce the product and what those inputs cost. We can answer the former question by looking at the firm’s production function.

FIGURE 7.3The production process for pizza includes inputs such as ingredients, the efforts of the pizza maker, and tools and materials for cooking and serving. (Credit: “Grilled gluten-free BBQ chicken pizza” by Keith McDuffee/ Flickr, CC BY 2.0) Production is the process (or processes) a firm uses to transform inputs (e.g., labor, capital, raw materials) into outputs, i.e. the goods or services the firm wishes to sell. Consider pizza making. The pizzaiolo (pizza maker) takes flour, water, and yeast to make dough. Similarly, the pizzaiolo may take tomatoes, spices, and water to make pizza sauce. The cook rolls out the dough, brushes on the pizza sauce, and adds cheese and other toppings. The pizzaiolo uses a peel—the shovel-like wooden tool—to put the pizza into the oven to cook. Once baked, the pizza goes into a box (if it’s for takeout) and the customer pays for the good. What are the inputs (or factors of production) in the production process for this pizza? Economists divide factors of production into several categories: