7.2 Production, Costs, and Profits

Question 1

What dose each firm require to produce a good or service?

Answer 1

In order to produce the goods or services that it sells, each firm needs inputs.

Question 2

What are the four broad categories of inputs?

Answer 2

• inputs that are output from some other firm, such as spark plugs, electricity, and steel
• inputs that are provided directly by nature, such as the land owned or rented by the firm
• inputs that are the services of labor, provided by workers and managers employed by the firm
• inputs that are the services of physical capital, such as the facilities and machines used by the firm

Question 3

What are intermediate products?

Answer 3

intermediate products
All outputs that are used as inputs by other producers in a further stage of production.

Question 4

If we trace back intermediate products, where do they all come from?

Answer 4

If these intermediate products are traced back to their sources, all products can be accounted for by the services of the other three kinds of input, which we first discussed in Chapter 1 and which are called factors of production. These are the gifts of nature, such as soil and raw materials, called land; physical and mental efforts provided by people called labor; and factories, machines, and other human-made aids to production, called capital.

Question 5

What is the production function?

Answer 5

A functional relation showing the maximum output that can be produced by any given combination of inputs.

The production function describes the technological relationship between the inputs that a firm uses and the output that it produces.

Q=f(K, L)

where Q is the flow of output, K is the flow of capital services, and L is the flow of labor services. f is the production function itself.

Question 6

How are changes in the firm’s technology that alter the relationship between inputs and outputs reflected in the production function?

Answer 6

Changes in the firm’s technology, which alter the relationship between inputs and output, are reflected by changes in the function f.

Question 7

What does the production function specify about the output?

Answer 7

The production function specifies the maximum amount of output that can be obtained from any given amounts of inputs.

Question 8

How do firms arrive at what they call profits?

Answer 8

Firms arrive at what they call profits by taking the revenues they obtain from selling their output and subtracting all the costs associated with their inputs. When all costs have been correctly deducted, the resulting profits are the return to the owners’ financial investment in the firm.

Question 9

What is an explicit cost?

Answer 9

By explicit costs, we mean the costs that actually involve the purchase of goods or services by the firm.

Question 10

How do accountants measure profits?

Answer 10

Compared with accountants, economists use somewhat different concepts of costs and profits. When accountants measure profits, they begin with the firm’s revenues and then subtract all of the explicit costs incurred by the firm.

Question 11

What are some examples of explicit costs?

Answer 11

The obvious explicit costs include the hiring of workers, the rental of equipment, interest payments on debt, and the purchase of intermediate inputs.

Question 12

The formula for accounting profits.

Answer 12

Accounting profits=Revenues−Explicit costs

Question 13

What are implicit costs?

Answer 13

These are items for which there is no market transaction but for which there is still an opportunity cost for the firm that should be included in the complete measure of costs.

Question 14

What are the two most important implicit costs?

Answer 14

The two most important implicit costs are the opportunity cost of the owner’s time and the opportunity cost of the owner’s capital.

Question 15

What is Economic Profit?

Answer 15

The difference between the revenues received from the sale of output and the opportunity cost of the inputs used to make the output. Negative economic profits are called economic losses.

Sometimes called Pure Profit

Question 16

What is the formula for Economic Profit?

Answer 16

Economic profits=Revenues (Explicit costs+Implicit costs)

= Accounting profits−Implicit costs

Question 17

Opportunity Cost of Time

Answer 17

For example, an entrepreneur who opens a restaurant may pay herself only $1000 per month while she is building her business, even though she could earn $4000 per month in her next best alternative job. In this case, there is an implicit cost to her firm of $3000 per month that would be missed by the accountant who measures only the explicit cost of her wage at $1000 per month.

Question 18

What is the opportunity cost of the financial capital that owners have invested in a firm?

Answer 18

First, ask what could be earned by lending this amount to someone else in a riskless loan. The owners could have purchased a government bond, which has no significant risk of default. Suppose the return on this is 3 percent per year. This amount is the risk-free rate of return on capital. It is clearly an opportunity cost, since the firm could close down operations, lend out its money, and earn a 3 percent return.

Next, ask what the firm could earn in addition to this amount by lending its money to another firm where risk of default was equal to the firm’s own risk of loss. Suppose this is an additional 4 percent. This is the risk premium, and it is clearly also a cost. If the firm does not expect to earn this much in its own operations, it could close down and lend its money out to some equally risky firm and earn 7 percent (3 percent risk-free return plus 4 percent risk premium).

Question 19

How can we sum up the main difference between how economists and accountants deduce profits?

Answer 19

Economists include both implicit and explicit costs in their measurement of profits, whereas accountants include only explicit costs. Economic profits are therefore less than accounting profits.

Question 20

What happens if firms accounting profits represent a return just equal to what is available if the owner’s capital and time were used elsewhere.

Answer 20

If a firm’s accounting profits represent a return just equal to what is available if the owner’s capital and time were used elsewhere, then opportunity costs are just being covered.

Question 21

Why are economic profits less than accounting profits?

Answer 21

Economic profits are less than accounting profits because of implicit costs.

Question 22

Is the concept of explicit costs and implicit costs better than the other?

Answer 22

No. Firms are interested in the financial return to their owners, which is what they call profits. They must also conform with tax laws, which define profits in the same way. In contrast, economists are interested in how profits affect resource allocation; their definition is best for that purpose and is the definition used throughout this book.

Question 23

What role do economic profits take in the determination of uses of factors or production?

Answer 23

Economic profits in an industry are the signal that resources moved into that industry will earn more than if they remain in their current use. Losses are the signal that resources will earn more if they are moved elsewhere.

Question 24

What symbol do we use to represent the level of output that maximizes a firm’s economic profit?

Answer 24

Our next step in developing a theory of supply is to determine the level of output that maximizes a firm’s economic profit, to which we give the symbol π (the lowercase Greek letter pi).

Question 25

What is the formula for Profit-Maximizing output?

Answer 25

π=TR−TC

Question 26

What is the benefit of determining the profit-maximizing level?

Answer 26

By determining the profit-maximizing level of output for any given firm, we will be closer to understanding that firm’s supply curve, which naturally helps us to better understand the origin of market supply curves.

Question 27

What are the three ways that economists classify the decisions that firms make?

Answer 27

(1) how best to use existing plant and equipment—the short run
(2) what new plant and equipment and production processes to select, given known technical possibilities—the long run
(3) how to encourage, or adapt to, the development of new techniques—the very long run.

Question 28

How do we define “The short run”?

Answer 28

short run
A period of time in which the quantity of some inputs cannot be changed.

The short run is a time period in which the quantity of some inputs, called fixed factors, cannot be changed.

Question 29

What is a fixed factor?

Answer 29

An input whose quantity cannot be changed in the short run.

A fixed factor is usually an element of capital (such as plant and equipment), but it might be land, the services of management, or even the supply of skilled labor.

Question 30

What are Variable factors

Answer 30

Inputs that are not fixed but instead can be varied in the short run are called variable factors.
An input whose quantity can be changed over the time period under consideration.

Question 31

What is “The long-run”?

Answer 31

The long run is a time period in which all inputs may be varied but in which the basic techniques of production cannot be changed. Like the short run, the long run does not correspond to a specific length of time.

A period of time in which all inputs may be varied, but the existing technology of production cannot be changed.

Question 32

What kind of situations does a firm’s long run correspond to?

Answer 32

The long-run corresponds to the situation the firm faces when it is planning to go into business, to expand the scale of its operations, to branch out into new products or new areas, or to change its method of production.

Question 33

What kind of decisions are a firms “planning decisions”?

Answer 33

The firm’s planning decisions are long-run decisions because they are made from given technological possibilities but with freedom to choose from a variety of production processes that will use factor inputs in different proportions.

Question 34

How can we define “The very long run”?

Answer 34

The very long run is the length of time over which all the firm’s factors of production and its technology can be varied.