Unit 3:
Costs of Production and
Perfect Competition
Copyright
ACDC Leadership 2015
1
Revenue and Profit
Revenue = Price x Quantity
2
Accountants vs. Economists
Accountants look at only EXPLICIT COSTS
•Explicit costs (out of pocket costs) are payments
paid by firms for using the resources of others.
•Example: Rent, Wages, Materials, Electricity Bills
Accounting
Profit
Total
Revenue
Accounting Costs
(Explicit Only)
Economists examine both the EXPLICIT COSTS and
the IMPLICIT COSTS
•Implicit costs are the opportunity costs that firms
“pay” for using their own resources
•Example: Forgone Wage, Forgone Rent, Time
Economic
Profit
Copyright
ACDC Leadership 2015
Total
Revenue
Economic Costs
(Explicit + Implicit)
3
Accountants vs. Economists
Accountants look at only EXPLICIT COSTS
•Explicit costs (out of pocket costs) are payments
paid by firms for using the resources of others.
•Example: Rent, Wages, Materials, Electricity Bills
From now
on, all costs
Total
Accounting Costs
Revenue will be
we discuss
(Explicit Only)
Economists ECONOMIC
examine both the EXPLICIT
COSTSCOSTS and
Accounting
Profit
the IMPLICIT COSTS
•Implicit costs are the opportunity costs that firms
“pay” for using their own resources
•Example: Forgone Wage, Forgone Rent, Time
Economic
Profit
Copyright
ACDC Leadership 2015
Total
Revenue
Economic Costs
(Explicit + Implicit)
4
Practice
Assume the following:
• David left his job as a lawyer earning $8,000 a
month to open up an ice cream shop
• Last month he sold 5,000 sundaes for $2 each
and 8,000 cones for $1 each
• His rent is $1000 per month
• His other expenses like labor, ice cream, cones,
etc. add up to $9,000 per month
• Last month he took a family vacation that cost
$5000
1. Calculate David’s accounting profit
2. Calculate David’s economic profit
3. Should David go back to being a lawyer?
4. What must be true for accounting profit if
economic profit is zero?
No Economic Profit = Normal Profit
Copyright
ACDC Leadership 2015
Normal Profit
In an efficient competitive market, firms that have
identical products will make a normal profit.
They will break even and make no economic profit
Traffic Analogy
When there is heavy traffic,
why do all lanes go the same
slow speed?
Cars leave slower lanes and
enter faster lanes.
Similarly, what happens in
perfectly competitive markets
if firms earn excessive profit?
Copyright
ACDC Leadership 2015
6
Maximizing
PROFIT!
Copyright
ACDC Leadership 2015
7
1. Assume every unit can be sold for $10. Which
unit maximizes profit?
2. Use marginal analysis to explain why you
should never produce 5 units
Marginal
Cost
Price
$12
$10
$8
$6
Copyright
ACDC Leadership 2015
Marginal
Revenue
1
2
3
4
5
Quantity
8
Short-Run Profit Maximization
What is the goal of every business?
To Maximize Profit!!!!!!
•To maximum profit firms must make the right
output
•Firms should continue to produce until the
additional revenue from each new output
equals the additional cost.
Example (Assume the price is $10)
• Should you produce…
…if the additional cost of another unit is $5
…if the additional cost of another unit is $9
…if the additional cost of another unit is $11
Copyright
ACDC Leadership 2015
9
Short-Run Profit Maximization
What is the goal of every business?
To Maximize Profit!!!!!!
•To maximum profit firms must make the right
output
•Firms should continue to produce until the
additional revenue from each new output
equals the additional cost.
Example (Assume the price is $10)
• Should you produce…
…if the additional cost of another unit is $5
…if the additional cost of another unit is $9
…if the additional cost of another unit is $11
Profit Maximizing Rule
MR=MC
Copyright
ACDC Leadership 2015
10