Economic Cost, Profit, and Production in the Short Run and Long Run

Study Guide - Smart Notes

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Learning Objectives

Distinguish between economic and accounting measures of a firm's cost of production and profit.
Explain the relationship between a firm's output and labor employed in the short run.
Explain the relationship between a firm's output and costs in the short run.
Derive and explain a firm's long-run average cost curve.

Economic Cost and Profit

The Firm's Goal

Firms exist to organize production and sell goods or services. The primary goal of most firms is to maximize profit. Profit maximization means making choices that increase the difference between total revenue and total cost.

Total revenue is the income from selling goods or services.
Total cost includes all costs of production, both explicit and implicit.

Other possible goals (such as growth, market share, or employee satisfaction) are important but are generally considered means to the end of profit maximization.

Accounting Cost and Profit

Accounting profit is calculated as total revenue minus explicit costs (costs paid in money, such as wages, rent, and materials) and depreciation. Accountants focus on historical costs and use standard rules for depreciation and expense recognition.

Explicit costs: Direct, out-of-pocket payments for inputs to production (e.g., wages, rent, materials).
Depreciation: The fall in value of capital assets over time.

Opportunity Cost

Opportunity cost is the value of the next best alternative forgone when a choice is made. In production, it includes:

The value of the owner's time (what they could earn elsewhere).
The return on capital invested (what the money could earn in another use).
The return on entrepreneurship (normal profit).

Economists include both explicit and implicit costs (opportunity costs) in their calculation of total cost.

Explicit Costs and Implicit Costs

Explicit costs: Payments made for resources purchased or hired (e.g., wages, rent, materials).
Implicit costs: The opportunity costs of using resources owned by the firm (e.g., owner's time, capital, entrepreneurship).

For example, if an owner uses their own capital in the business, the implicit cost is the interest income forgone by not investing that capital elsewhere.

Economic Profit

Economic profit is total revenue minus total cost, where total cost includes both explicit and implicit costs:

Economic profit = Total revenue - (Explicit costs + Implicit costs)

If a firm earns zero economic profit, it is earning a normal profit (the minimum required to keep resources in their current use). Positive economic profit means the firm is earning more than the normal profit; negative economic profit means the firm is not covering all opportunity costs.

Comparison of Economic and Accounting Profit

	Economic View	Accounting View
Total Revenue	Price × Quantity Sold
Explicit Costs	Included	Included
Implicit Costs (including normal profit and economic depreciation)	Included	Not included
Depreciation	Economic depreciation (change in market value)	Accounting depreciation (historical cost)
Profit Calculation	Economic profit = Total revenue - (Explicit + Implicit costs)	Accounting profit = Total revenue - Explicit costs - Depreciation

Short Run and Long Run

The Short Run: Fixed Plant

The short run is a period in which at least one factor of production (usually capital or plant size) is fixed. Firms can only adjust variable inputs, such as labor, in the short run.

Examples of fixed inputs: buildings, major equipment.
Examples of variable inputs: labor, raw materials.
Short-run decisions: How much labor to hire, how much output to produce.

The Long Run: Variable Plant

The long run is a period in which all factors of production can be varied. Firms can change plant size, install new equipment, or enter/exit the industry.

Long-run decisions: Whether to expand or contract plant size, enter or exit a market.

Short-Run Production

Total Product, Marginal Product, and Average Product

To analyze how output changes as more labor is employed (with a fixed plant), economists use three key concepts:

Total Product (TP): The total quantity of output produced in a given period.
Marginal Product (MP): The change in total product resulting from employing one more unit of labor.
Average Product (AP): The total product divided by the number of units of labor employed.

Total Product Example

Quantity of labor (workers)	0	1	2	3	4	5	6	7
Total product (gallons per hour)	0	1	3	6	8	9	9	8

The table and corresponding graph (total product curve) show how output changes as more workers are employed. The curve initially rises, reflecting increasing output, but eventually flattens and can decline, indicating diminishing returns.

Key Points

Points on the total product curve represent efficient production.
Points below the curve are attainable but inefficient (not maximizing output for given inputs).
Points above the curve are unattainable with current resources.

Formulas

Marginal Product (MP):
Average Product (AP):
Economic Profit:

Additional info:

Normal profit is the minimum return required to keep an entrepreneur in business; it is considered an implicit cost.
Short-run production is subject to the law of diminishing returns: as more units of a variable input are added to fixed inputs, the marginal product of the variable input eventually decreases.