Chapter 8

accounting profit

Accounting Profit = Total Revenue−Total Explicit Cost The sales revenues minus the expenses of a firm over a designated time period, usually one year. Accounting profits typically make allowances for changes in the firm's inventories and depreciation of its assets. No allowance is made, however, for the opportunity cost of the equity capital of the firm's owners, or other implicit costs.

economic profit

Economic Profit = Total Revenue−Total Costs The difference between the firm's total revenues and its total costs, including both the explicit and implicit cost components. Or accounting profit - implicit costs.

diseconomies of scale

Increases in the firm's per-unit costs associated with increases in firm size due to inefficiencies and monitoring problems. Example: Suppose that as a pizza company increases the number of pizza parlors it operates in the long run, inefficiencies and monitoring problems increase the per-unit cost of a pizza.

sunk costs

Costs that have already been incurred as a result of past decisions. They are sometimes referred to as historical costs.

How does economic profit differ from normal profit?

Economic profit is total revenues minus total costs, where the latter includes both explicit and implicit costs. Normal profit, on the other hand, refers to an economic profit of zero; thus, it is a level of profit that provides just the competitive rate of return on capital (and labor) of owners. An above-normal profit will draw entry into the market, whereas a below-normal profit will lead to exit of investors and capital.

The opportunity cost of borrowed funds is the interest payments incurred in obtaining the funds.

If a firm borrows financial capital from a bank or other private source, the firm will have to make interest payments. When a firm acquires financial capital by issuing shares of stock, shareholders will expect a return from their investment in the form of dividend payments or rising share value. Either way, acquiring capital has an opportunity cost. See section: The economic role of costs.

The opportunity cost of equity capital is the return investors must earn to induce them to supply financial capital.

If a firm borrows financial capital from a bank or other private source, the firm will have to make interest payments. When a firm acquires financial capital by issuing shares of stock, shareholders will expect a return from their investment in the form of dividend payments or rising share value. Either way, acquiring capital has an opportunity cost. See section: The economic role of costs. Economists use the normal return on financial capital as a basis for determining the implicit opportunity cost of equity capital. If the normal rate of return on financial capital is 10%, for example, investors will not continue to supply equity capital unless they can earn this normal return. Thus, the normal rate of return is an opportunity cost of equity capital.

True or False: The firm's accounting statement takes implicit costs into account.

The correct answer is false. Since the use of resources owned by the firm generally does not involve an explicit monetary payment or a financial transaction, accounting statements often fail to account for implicit costs.

Suppose the wage Caroline pays her workers increases to $20 per hour.

Labor, a resource in production, is considered a variable cost because the number of workers employed can vary over a typical short-run time horizon. Therefore, an increase in the price of labor causes the AVC curve to shift upward, while the AFC curve remains unchanged. Because ATC=AVC+AFCATC=AVC+AFC, the ATC curve also shifts upward.

explicit costs

Payments by a firm to purchase the services of productive resources.

Suppose the sales tax on pepperoni is removed, so the price of pepperoni decreases to $6 per pound.

Pepperoni, a resource in production, is categorized as a variable cost because the amount used will change depending on the number of pizzas produced. Therefore, a decrease in the price of pepperoni due to the removal of a sales tax causes the AVCAVC curve to shift downward, while the AFC curve remains unchanged. Because ATC=AVC+AFCATC=AVC+AFC, the ATC curve also shifts downward.

shirking

Shirking occurs when employees work at less than the rate of productivity expected of them. Examples of shirking include taking long breaks between tasks and wasting time surfing the Internet instead of researching. As illustrated by this example, some workers are more likely to shirk when they are not monitored.

Under current tax law, firms can record the opportunity cost of borrowed funds as an expense but cannot do the same for the opportunity cost of equity capital. True or False: The tax structure encourages equity rather than debt financing.

The correct answer is false. The tax structure encourages debt rather than equity financing because the firm's tax liability is inversely related to its debt-equity ratio. Thus, more debt financing will increase the debt-equity ratio and decrease the firm's tax liability. See section: The economic role of costs.

Residual claimants have a strong incentive to supply goods that consumers value ____________ relative to cost.

The correct answer is highly. Residual claimants are business owners who personally receive the excess, if any, of revenues over costs. Residual claimants gain if the firm's costs are reduced or if revenues increase. Since the wealth of residual claimants is directly tied to the success of their firm, they have a strong incentive to ensure that resources under their direction are used efficiently and directed toward the production of goods that are valued more highly than their costs. See section: The organization of the business firm.

Which of the following are relevant to a firm's decision to increase output in the long run? Check all that apply. Short-run total variable cost Short-run marginal cost Long-run average total cost

The correct answer is long-run average total cost. Although marginal costs are relevant to a firm's production decisions in the short run, average total costs are the relevant cost consideration in the long run. Before entering an industry (or purchasing capital assets to expand output), a profit-maximizing decision-maker will compare the expected market price with the expected long-run average total cost of that output level. Profit-seeking producers will supply (or increase the production of) the product if, and only if, they expect the market price to exceed their long-run average total cost. See section: The economic way of thinking about costs.

Residual claimants gain if the firm's costs are ____________.

The correct answer is reduced. Residual claimants are business owners who personally receive the excess, if any, of revenues over costs. Residual claimants gain if the firm's costs are reduced or if revenues increase. Since the wealth of residual claimants is directly tied to the success of their firm, they have a strong incentive to ensure that resources under their direction are used efficiently and directed toward the production of goods that are valued more highly than their costs. See section: The organization of the business firm.

What is relevant to a firm's decision to increase output in the short run?

The correct answer is short-run marginal cost. For short-run supply decisions, the marginal cost of producing additional units is the relevant cost to consider. To maximize profits, the decision-maker should compare the expected marginal costs with the expected additional revenue from larger sales. If the latter exceeds the former, output (the quantity supplied) should be expanded. See section: The economic way of thinking about costs.

Which of the following are relevant to a firm's decision to increase output in the short run? Check all that apply. Short-run average total cost Short-run marginal cost Short-run total variable cost

The correct answer is short-run marginal cost. For short-run supply decisions, the marginal cost of producing additional units is the relevant cost to consider. To maximize profits, the decision-maker should compare the expected marginal costs with the expected additional revenue from larger sales. If the latter exceeds the former, output (the quantity supplied) should be expanded. See section: The economic way of thinking about costs.

Under current tax law, firms can record the opportunity cost of borrowed funds as an expense but cannot do the same for the opportunity cost of equity capital. True or False: The tax structure encourages debt rather than equity financing.

The correct answer is true. The tax structure encourages debt rather than equity financing because the firm's tax liability is inversely related to its debt-equity ratio. Thus, more debt financing will increase the debt-equity ratio and decrease the firm's tax liability. See section: The economic role of costs.

Consider a machine purchased one year ago for $9,000. The machine is being depreciated $3,000 per year throughout a three-year period. Its current market value is $8,000, and the expected market value of the machine one year from now is $2,000. If the interest rate is 10%, the expected cost of holding the machine during the next year is $6,800 current market value - expected market value + (cmv*interest rate) 8000-2000+800=6800

The cost of holding the machine for the next year includes not only the decline in market value of $8,000−$2,000=$6,000$8,000−$2,000=$6,000, but also the potential interest on funds that could be obtained if the machine were sold and the funds from the sale were invested. In this case, if the machine were sold for its market value of $8,000, and those funds were invested, the interest gained over the next year would be $8,000×10%=$800$8,000×10%=$800. Thus, the expected cost of holding the machine for the next year is $6,000+$800=$6,800$6,000+$800=$6,800.

implicit costs

The opportunity costs associated with a firm's use of resources that it owns. These costs do not involve a direct money payment. Examples include wage income and interest forgone by the owner of a firm who also provides labor services and equity capital to the firm.

law of diminishing returns

The postulate that as more and more units of a variable resource are combined with a fixed amount of other resources, using additional units of the variable resource will eventually increase output only at a decreasing rate. Once diminishing returns are reached, it will take successively larger amounts of the variable factor to expand output by one unit. Example: Suppose that when a firm hires more labor but keeps capital the same, the marginal product of labor decreases in the short run.

normal profit rate

Zero economic profit, providing just the competitive rate of return on the capital (and labor) of owners. An above-normal profit will draw more entry into the market, whereas a below-normal profit will lead to an exit of investors and capital.