Costs and profits are crucial concepts in microeconomics. Firms must consider both explicit costs, which involve direct payments, and implicit costs, which represent opportunity costs. Understanding these distinctions is key to making informed business decisions.

Profit calculations differ between accounting and economic perspectives. While accounting profit only considers explicit costs, economic profit factors in both explicit and implicit costs. This difference impacts how firms evaluate their financial performance and make strategic choices.

Costs and Profit in Microeconomics

Explicit vs implicit costs

• Explicit costs require direct monetary payment (wages, rent, materials, utilities)
• Implicit costs do not involve direct monetary payment but still represent a cost to the firm
  • Opportunity costs of using resources owned by the firm (foregone interest, rental income, wages)
  • Sunk costs, which are past expenses that cannot be recovered, are not considered in decision-making

Calculation of profit types

• Accounting profit calculated as total revenue minus explicit costs
  • $Accounting Profit = Total Revenue - Explicit Costs$
  • Does not consider implicit costs
• Economic profit calculated as total revenue minus both explicit and implicit costs
  • $Economic Profit = Total Revenue - (Explicit Costs + Implicit Costs)$
  • Considers all costs, including opportunity costs
• Relationship between accounting and economic profit
  • Economic profit always less than or equal to accounting profit
  • Positive economic profit implies positive accounting profit
  • Zero economic profit means accounting profit equals implicit costs (normal profit)
  • Negative economic profit can still result in positive accounting profit

Cost structure impact on decisions

• Short run has at least one fixed input (capital), only variable inputs (labor, materials) can be adjusted to change output
  • Decisions focus on minimizing short-run costs and maximizing short-run profits (adjusting production levels, changing variable input quantities)
• Long run has all inputs variable, including capital
  • Decisions focus on minimizing long-run costs and maximizing long-run profits (investing in technology, expanding/contracting facilities, entering/exiting markets)
• Impact of cost structure
  • Higher fixed costs emphasize long-run decisions, higher variable costs emphasize short-run decisions
  • Economies of scale (decreasing long-run average costs) may encourage expanding production
  • Diseconomies of scale (increasing long-run average costs) may lead to finding optimal production level

Cost Analysis and Efficiency

• Marginal cost: The additional cost of producing one more unit of output
• Average cost: The total cost divided by the quantity produced
• Break-even point: Where total revenue equals total cost, resulting in zero economic profit
• Allocative efficiency: Achieved when the price of a good equals its marginal cost of production
• Productive efficiency: Occurs when a firm produces at the lowest possible average total cost