Introduction to Firms and Economic Costs

TL;DR

Firms combine resources to produce goods and services, aiming to maximise profits by making smart decisions about production and pricing. Understanding their costs, both explicit and implicit, is crucial to seeing how these decisions are made. Economic profit, which considers all costs including opportunity costs, is different from accounting profit and guides long-term business choices.

1. The Mental Model

Think of a firm as a chef in a kitchen. They take ingredients (inputs), transform them into a meal (output), and sell it. Their goal is to make the most money, considering not just what they spend on ingredients, but also what they could've earned doing something else.

2. The Core Material

What is a Firm?

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A firm is an organisation that brings together factors of production (land, labour, capital, entrepreneurship) to produce goods or services for sale. Their primary objective is generally profit maximisation.

Types of Costs: Accounting vs. Economic

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This is where things get a bit tricky but it's super important.

• Accounting Costs (Explicit Costs): These are the straightforward, out-of-pocket expenses that a firm pays. Think wages, rent, raw materials, utility bills, and interest payments on loans. These are easy to track and show up in financial statements.

  • Example: A baker pays $500 for flour, $1000 for rent, and $2000 in wages. Total accounting cost = $3500.

• Economic Costs (Opportunity Costs): These include both explicit costs and implicit costs. Implicit costs are the value of the best alternative that was foregone when resources were used for a particular purpose. They don't involve a direct money payment.

  • Example (continuing from above): The baker used to be a highly paid corporate lawyer earning $5000 a month. By baking, she's giving up that $5000. This is an implicit cost. Also, she invested $10,000 of her own savings into the bakery instead of putting it in a bank to earn $500 in interest. This $500 is another implicit cost.
  • Total economic cost = Explicit costs + Implicit costs = $3500 (accounting) + $5000 (foregone salary) + $500 (foregone interest) = $9000.

Types of Profit: Accounting vs. Economic

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The distinction between costs leads directly to different types of profit.

• Accounting Profit: This is simply Total Revenue minus Accounting Costs (explicit costs). It's what most businesses report.

  • Example: If the baker's total revenue is $6000, her accounting profit = $6000 - $3500 = $2500.

• Economic Profit: This is Total Revenue minus Economic Costs (explicit + implicit costs). This is the profit measure economists care about most because it reflects the true profitability of a business decision, taking into account all opportunities.

  • Example: The baker's economic profit = $6000 - $9000 = -$3000. This means even though she's making an accounting profit, she'd be $3000 better off if she went back to being a lawyer and earned interest on her savings.

This negative economic profit tells her she's not making the best use of her resources compared to other available options. A positive economic profit means she's earning more than the value of her next best alternative. Zero economic profit means she's earning just enough to cover all her costs, including her opportunity costs – she's doing just as well as her next best alternative.

Here's how these concepts link up:

graph TD
    A["Firm's Goal (Profit Maximisation)"] --> B{"Decision Making"}
    B --> C["Revenue"]
    B --> D{"Costs"}
    D --> D1["Explicit Costs (Accounting)"]
    D --> D2["Implicit Costs (Opportunity Costs)"]
    C & D1 --> E1["Accounting Profit (Revenue - Explicit Costs)"]
    C & D1 & D2 --> E2["Economic Profit (Revenue - Explicit & Implicit Costs)"]
    E1 --> F1["Used for financial reporting"]
    E2 --> F2["Guides long-term resource allocation"]
    E2 --> G{"Business Viability (True Profitability)"}

Normal Profit

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When a firm earns zero economic profit, it's said to be earning normal profit. This isn't a bad thing! It means the firm is covering all its explicit costs and all its implicit costs (including the minimum return required to keep the entrepreneur in the business). The entrepreneur is earning just enough to stay in this line of business rather than pursuing their next best alternative. Anything above normal profit is supernormal profit (positive economic profit).

3. Worked Example

Let's say you decide to open a small coffee shop.

• Your Explicit Costs per month:

  • Rent: $1,500
  • Coffee beans & supplies: $1,000
  • Wages for one part-time employee: $800
  • Utilities: $200
  • Total Explicit Costs = $1,500 + $1,000 + $800 + $200 = $3,500

• Your Implicit Costs per month:

  • You quit a job paying $3,000 a month to run the coffee shop. This is a foregone salary.
  • You invested $10,000 of your own savings into the shop, which could have earned you $50 a month in interest if you'd left it in a savings account.
  • Total Implicit Costs = $3,000 + $50 = $3,050

• Your Total Revenue per month from the coffee shop: $6,000

Now, let's calculate your profits:

1. Accounting Profit:

   • Total Revenue - Explicit Costs
   • $6,000 - $3,500 = $2,500

2. Economic Profit:

   • Total Revenue - (Explicit Costs + Implicit Costs)
   • $6,000 - ($3,500 + $3,050)
   • $6,000 - $6,550 = -$550

Even though you're making an accounting profit of $2,500, your economic profit is negative $550. This means you're actually worse off by $550 each month compared to your next best alternative (your old job plus the interest on your savings). Economically, this venture isn't sustainable unless things improve, as you'd eventually be better off pursuing your next best option.

4. Key Takeaways

• Firms aim to maximise profit by efficiently combining inputs to produce outputs.
• Accounting costs are explicit, out-of-pocket expenses, easily recorded.
• Implicit costs are opportunity costs, representing the value of foregone alternatives.
• Economic costs include both explicit and implicit costs, giving a full picture of resource use.
• Accounting profit is total revenue minus explicit costs.
• Economic profit is total revenue minus all economic costs (explicit + implicit).
• Zero economic profit (normal profit) means a firm is covering all its costs, including opportunity costs, and is doing as well as its next best alternative.

Common Mistakes to Avoid:
- Don't confuse accounting profit with economic profit; economists care about economic profit for decision-making.
- Remember that implicit costs are not direct cash payments but represent foregone opportunities.
- Don't think zero economic profit means the firm is failing; it's earning a competitive return.
- Don't forget to include the owner's foregone wages or capital returns as implicit costs.

5. Now Try It

Imagine you own a small tech startup. For one month, your revenue is $15,000. Your explicit costs are $8,000 (salaries, rent, software licenses). Before starting the company, you earned $5,000 a month at a large tech firm, and you invested $20,000 of your own money which could have earned $100 in interest elsewhere. Calculate your accounting profit and your economic profit for that month. What does the economic profit tell you about your startup's performance compared to other opportunities?