Economic Profit and Cost

August 22, 2017

Supply Side

Similar to demand side, the supply function is defined by the individual decisions that producers make.
Individuals are rational, i.e. their choices maximize a certain benefit function.
In case of producers, the benefit is described by profit function.
Unlike consumers, producers incur opportunity cost in addition to the cost of production.

We can write profit function as $\Pi = f(R, EC, IC)$.
$R$ is the firm's revenue and shows the effect of market's conditions (price, quantity) on the profit function. $R=P*Q$.
Revenue creates a feedback link that allows the market to affect the individual producers.
The role of revenue in the profit function differs for different markets. Sometimes revenue cannot be affected by the producers, thus a problem of profit maximization turns into a problem of cost minimization.

$EC$ is explicit costs. These costs consider the expenses associated with the factors of production, such as salary, interest, rent, etc. Explicit costs also include the costs of materials.
Explicit costs are also called direct costs, as they are realized by the fact of production itself.
$IC$ is implicit costs. These costs take into account the opportunity cost of doing business and foregone benefits of the alternative use of resources.
Implicit costs are known as indirect cost. They are not realized, but they need to be considered when making decisions in production.

Normal profit - a reward on entrepreneurship's factor of production. It should not be treated as a profit, but rather an additional entry of the cost.
Accounting profit - profit that is created after the explicit costs are extracted from the revenue. Normally, accounting profit is equal or close to normal profit. It is used to decide the quantity of production.
Economic profit - profit that is equal revenue minus total cost (explicit and implicit costs). It is used to decide on the fact of production itself.

Lee, a programmer, earned $35,000 in 2010, but in 2011, he began to manufacture body boards. After one year, he submitted the following data to his accountant.
He stopped renting out his cottage for $3,500 a year and used it as his factory. The market value of the cottage increased from $70,000 to $71,000.
He spent $50,000 on materials, phone, utilities, etc.
He leased machines for $10,000 a year.
He paid $15,000 in wages.
He used $10,000 from his savings account, which pays 5 percent a year interest.
He borrowed $40,000 at 10 percent a year from the bank.
He sold $160,000 worth of body boards.
Normal profit is $25,000.
Calculate Lee's explicit costs, implicit costs, and economic profit.
Lee's accountant recorded the depreciation on Lee's cottage during 2011 as $7,000. What did the accountant say Lee's profit or loss was?

Bob used to earn $ 50,000 a year, selling real estate, but he now sells greetings cards. The return to entrepreneurship in the greeting cards industry is $14,000 a year. Over the year, Bob bought $15,000 worth of cards from manufacturers of greeting cards and sold these cards for $49,000.
Bob rents a shop for $10,000 a year and spends $1,400 on utilities and office expenses. Bob owns a cash register, which he bought for $1,900 with funds from his savings account. Tbe bank pays 4 percent a year on savings accounts. At the end of the year, Bob was offered $1,700 for his cash register.
Find Bob's total costs.

When agents make decisions, it can result in two different scenarios.
If the decision cause immediate effect on the variable of interest, we call it short run decision.
If the decision cause delayed effect on the variable of interest, we call it long run decision.

In terms of productions, we consider the short run as the time fame in which the quntities of some resources are fixed.
For most firms, the fixed resources are the firm's technology and capital - its equipment and buildings. We call it fixed factors of production.
The resources that can vary are called variable factors of production.
The examples include labor, some materials, expendables.

The long run production is the time frame in which the quantities of all resources can be varies.
Unlike the short run, the long run decisions are large and not easily reversed.
The cost associated with the long run is usually considered to be sunk cost - the cost that cannot be recovered.

Total product ($TP$) - the total quantity of a good produced in a given period.
The graph, showing relationship between total product and a short run resource (labor) is called total product curve.
Total product curve gives us the idea on optimal level of short run needed to use in production.

Marginal product ($MP$) - the change in total product that results from a one-unit increase in the quantity of short run resourse employed.
\[ MP=\frac{\Delta TP}{\Delta amount \,\,of\,\, resource} \]
Marginal product represent a tangent line to the total product curve.
If the total product curve is convex (?), then the marginal product is an increasing function.
If the total product curve is concave (?), then the marginal product is a decreasing function.
If the total product is decreasing, then the marginal product is negative.

As a firm uses more of a variable factor of production, with a given quantity of fixed factors of production, the marginal product of the variable factor eventually decreases.

Average product ($AP$) - the total product per unit of the short run resource.
\[ AP=\frac{TP}{Quantity\,\,of\,\,resource} \]
Also known as productivity of the resource.
An important thing to note is when the margninal product increases, the average product increases as well. When the margninal product decreases, the average product also deccreases.

Labor	Product	Labor	Product
0	0	6	420
1	100	7	4300
2	220	8	430
3	300	9	400
4	360	10	360

We considered the link between individual producer's decisions and the market supply.
We showed the objective function for producers' benefit and its major dependencies.
We defined two types of costs: the implicit costs and the explicit costs and showed how they related to the different notions of the profit.