The Firm
A firm is an institution that hires factors of production and organizes them to produce and sell goods and services.
The main goal of a firm is to maximize profit.
Types of Costs
Explicit Costs
Costs that involve an actual monetary payment.
Examples:
- Wages
- Raw materials
- Rent
- Interest on borrowed funds
Implicit Costs
Non-monetary opportunity costs of using resources owned by the firm or owner.
Examples:
- Salary the owner gives up by running the business
- Interest the owner gives up by using personal savings
Economic Profit and Accounting Profit
Accounting Profit
Economic Profit
Economic profit is less than or equal to accounting profit because it includes implicit costs.
When economic profit is zero, the firm earns a normal profit.
Sunk Costs
A sunk cost is a cost that has already been paid and cannot be recovered.
Sunk costs are ignored in decisions. Only future costs are compared with expected revenue.
Shutdown Rule
In the short run, fixed costs are sunk. They are paid whether the firm operates or not.
A firm should shut down iff total revenue is less than total variable cost.
Total cost is the wrong comparison, since it includes fixed costs that shutting down does not avoid.
Worked Examples
Accounting and Economic Profit
Akash sells 1,000 bottles at Rs. 100 each. Raw materials cost Rs. 20,000. Capital of Rs. 100,000 is half his own savings and half borrowed at 10% interest. He could instead lend his savings at 10% or work elsewhere for Rs. 40,000. Find the accounting profit and the economic profit.
Solution Reveal Hide
Explicit costs are the raw materials and the loan interest.
Implicit costs are the forgone wage and the forgone interest on his own savings.
The accounting profit is Rs. 75,000 and the economic profit is Rs. 30,000.
Closing Time
When should a grocery store close at night?
- Total costs of staying open are less than total revenue
- Total costs of staying open are greater than total revenue
- Variable costs of staying open are less than total revenue
- Variable costs of staying open are greater than total revenue
Solution Reveal Hide
The store should close when the variable costs of staying open are greater than total revenue.
Fixed costs are sunk and are paid whether the store is open or closed. Comparing total costs with revenue is the trap, since it includes those fixed costs.
Completing a Project
An ice-cream hut has already cost Rs. 1,000. Another Rs. 300 is needed to finish it. Expected sales are now Rs. 800. Find the remaining cost below which completing the hut is worthwhile.
Solution Reveal Hide
The Rs. 1,000 is a sunk cost and is ignored.
Completing is worthwhile while the remaining cost is below the expected revenue of Rs. 800.
At a remaining cost of Rs. 300, the net gain is Rs. 500.
