digression: accounting profit vs economic profit accounting profit = total revenue - explicit cost...

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Digression: Accounting Profit vs Economic Profit Accounting Profit = Total Revenue - Explicit cost – Example: Self-employed C.P.A. who owns office • Total revenue = $55,000 • Supplies = ($2,000) • Accounting Profit = $53,000 Accountants aged 35-45 earn around $65,000 Office space of like size rents for $13,000/yr

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Page 1: Digression: Accounting Profit vs Economic Profit Accounting Profit = Total Revenue - Explicit cost – Example: Self-employed C.P.A. who owns office Total

Digression: Accounting Profit vs Economic Profit

• Accounting Profit = Total Revenue - Explicit cost– Example: Self-employed C.P.A. who owns office

• Total revenue = $55,000• Supplies = ($2,000)• Accounting Profit = $53,000

• Accountants aged 35-45 earn around $65,000• Office space of like size rents for $13,000/yr

Page 2: Digression: Accounting Profit vs Economic Profit Accounting Profit = Total Revenue - Explicit cost – Example: Self-employed C.P.A. who owns office Total

Accounting Profit vs Economic Profit

• Economic Profit = Total Revenue - Explicit Cost- Opportunity Cost

– Example: Self-employed C.P.A.• Total revenue = $55,000• Supplies = ($2,000)• Opportunity Cost

of Office = ($13,000)• Opportunity Cost

of CPA Time = ($65,000)Economic Profit = -$25,000

Page 3: Digression: Accounting Profit vs Economic Profit Accounting Profit = Total Revenue - Explicit cost – Example: Self-employed C.P.A. who owns office Total

Examples of Explicit and Implicit Costs

Page 4: Digression: Accounting Profit vs Economic Profit Accounting Profit = Total Revenue - Explicit cost – Example: Self-employed C.P.A. who owns office Total

Accounting Profit vs Economic Profit

• Normal Accounting Profit – may be around 10% of investment

• Normal Economic Profit – revenue covers explicit and opportunity cost– assumed to equal zero

• Returns have to cover the opportunity cost of the investment

For remaining lecture, we will refer to profit as economic profit

Page 5: Digression: Accounting Profit vs Economic Profit Accounting Profit = Total Revenue - Explicit cost – Example: Self-employed C.P.A. who owns office Total

When should a firm go out of the business in the short-run?

1) When P = MC > ATC

Profit = P*Q - ATC*Q= (P - ATC)*Q > 0

Economic Profit > 0 Example P = 3, ATC = 2.054

Page 6: Digression: Accounting Profit vs Economic Profit Accounting Profit = Total Revenue - Explicit cost – Example: Self-employed C.P.A. who owns office Total

Average and Marginal Costs

0.5

1

1.5

2

2.5

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3.5

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4.5

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0 100 200 300 400 500 600 700

Output

$

Marginal Cost

Avg Variable Cost

Avg Total Cost

Revenue = P*Q

Page 7: Digression: Accounting Profit vs Economic Profit Accounting Profit = Total Revenue - Explicit cost – Example: Self-employed C.P.A. who owns office Total

Average and Marginal Costs

0.5

1

1.5

2

2.5

3

3.5

4

4.5

5

0 100 200 300 400 500 600 700

Output

$

Marginal Cost

Avg Variable Cost

Avg Total Cost

Total Cost = ATC*Q

Page 8: Digression: Accounting Profit vs Economic Profit Accounting Profit = Total Revenue - Explicit cost – Example: Self-employed C.P.A. who owns office Total

Average and Marginal Costs

0.5

1

1.5

2

2.5

3

3.5

4

4.5

5

0 100 200 300 400 500 600 700

Output

$

Marginal Cost

Avg Variable Cost

Avg Total CostΠ П= (P-ATC)*Q

Page 9: Digression: Accounting Profit vs Economic Profit Accounting Profit = Total Revenue - Explicit cost – Example: Self-employed C.P.A. who owns office Total

When should a firm go out of the business in the short-run?

2) When P = MC AVC < P < ATC = AFC + AVC

Profit = P*Q - ATC*Q = (P - ATC)*Q <0 (lose money)= {(P - AVC )- AFC}*Q> -AFC*Q = -FC

Keep producing in short run because better than swallowing FC, even though economic profit <0

Page 10: Digression: Accounting Profit vs Economic Profit Accounting Profit = Total Revenue - Explicit cost – Example: Self-employed C.P.A. who owns office Total

When should a firm go out of the business in the short-run?

Example 2: AVC < P < ATC P = $1.75AVC = $1.55ATC = $1.83AFC = $0.28Q = 357

Profit = (P - AVC - AFC)*Q= (1.75 – 1.83)*357 = -$28.56 > -0.28*357 = -100$

Page 11: Digression: Accounting Profit vs Economic Profit Accounting Profit = Total Revenue - Explicit cost – Example: Self-employed C.P.A. who owns office Total

Revenue

ATC > P > AVC

Page 12: Digression: Accounting Profit vs Economic Profit Accounting Profit = Total Revenue - Explicit cost – Example: Self-employed C.P.A. who owns office Total

Total Cost

ATC > P > AVC

Page 13: Digression: Accounting Profit vs Economic Profit Accounting Profit = Total Revenue - Explicit cost – Example: Self-employed C.P.A. who owns office Total

LOSS

ATC > P > AVC

Page 14: Digression: Accounting Profit vs Economic Profit Accounting Profit = Total Revenue - Explicit cost – Example: Self-employed C.P.A. who owns office Total

LOSS with Shutdown

ATC > P > AVC

Page 15: Digression: Accounting Profit vs Economic Profit Accounting Profit = Total Revenue - Explicit cost – Example: Self-employed C.P.A. who owns office Total

When should a firm go out of the business in the short-run?

3) When P = MC <AVC; P-AVC < 0

Profit = P*Q - ATC*Q= (P - ATC)*Q = {(P – AVC) – AFC}*Q< -AFC*Q = -FC

Stop producing in short run because swallowing FC is better than producing and losing even more

Page 16: Digression: Accounting Profit vs Economic Profit Accounting Profit = Total Revenue - Explicit cost – Example: Self-employed C.P.A. who owns office Total

When should a firm go out of the business in the short-run?

Example 3: P = MC <AVCP = $1.25AVC = $1.50ATC = $2.00AFC = $0.50Q = 200

Profit = (P - ATC)*Q= (1.25 – 2.00)*200 = -$150 < -$100 = -FC

Page 17: Digression: Accounting Profit vs Economic Profit Accounting Profit = Total Revenue - Explicit cost – Example: Self-employed C.P.A. who owns office Total

Revenue

Page 18: Digression: Accounting Profit vs Economic Profit Accounting Profit = Total Revenue - Explicit cost – Example: Self-employed C.P.A. who owns office Total

Total Cost

Page 19: Digression: Accounting Profit vs Economic Profit Accounting Profit = Total Revenue - Explicit cost – Example: Self-employed C.P.A. who owns office Total

Loss

Page 20: Digression: Accounting Profit vs Economic Profit Accounting Profit = Total Revenue - Explicit cost – Example: Self-employed C.P.A. who owns office Total

Loss with Shutdown

Page 21: Digression: Accounting Profit vs Economic Profit Accounting Profit = Total Revenue - Explicit cost – Example: Self-employed C.P.A. who owns office Total

When should a firm go out of the business?

SHORT RUN• Produce in the short run at P = MC when MC > AVC• Shut down when P < AVC

LONG RUN• In long run, need to make back fixed costs, so only

produce if P = MC >= ATC