Chapter 7 | Opportunity Costs, Economic Profits/Losses, Miracle of Markets Flashcards
What Accountants Miss: Accounting Profits and Hidden Opportunity Costs
Accounting profits equal revenues minus all obvious costs, including depreciation. But accounting profits miss the hidden, implicit opportunity costs of a business owner’s time and money.
Obvious costs (explicit costs)
— costs a business pays directly. Accountants count all obvious business costs and include depreciation:
depreciation:
– decrease in the value of equipment over time because of wear and tear and because it becomes obsolete.
– allowable yearly depreciation cost is the price of equipment divided by number of years it lasts.
Accounting profits
— Revenues – Obvious Costs (including depreciation).
Implicit costs
— hidden opportunity costs of what business owner could earn elsewhere with time and money invested.
– Opportunity cost of time — best alternative use of business owner’s time.
– Opportunity cost of money — best alternative use of business owner’s money invested in the business; must include compensation for risk.
Risk compensation depends on attitudes toward risk.
– A risk-loving investor does not require much compensation for taking risks.
– A risk-averse (risk-avoiding) investor requires a high compensation for taking risks.
What Economists Find: Normal Profits and Economic Profits
Smart business decisions return at least normal profits — what a business owner could earn from the best alternative uses of her time and money. There are economic profits over and above normal profits when revenues are greater than all opportunity costs of production, including hidden opportunity costs.
Normal profits:
– compensation for business owner’s time and money
– sum of hidden opportunity costs (implicit costs)
– what business owner must earn to do as well as best alternative use of time and money
– average profits in other industries
Economic profits equal
– Revenues minus all Opportunity Costs
– Revenues − (Obvious Costs + Hidden Opportunity Costs)
– Revenues − (Obvious Costs + Implicit Costs)
– Revenues − (Obvious Costs + Normal Profits)
Key difference between economists and accountants is that economists subtract hidden opportunity costs when calculating profits.
– Economic profits are less than accounting profits.
Economic losses
— negative economic profits.
Economic losses — negative economic profits.
– If revenues are less than all opportunity costs, business owner has not made a smart decision and would be better off in alternative uses of time and money.
– With economic losses, business owner is earning less than normal profits, less than average profits in other industries.
How Economic Profits Direct the Invisible Hand
The simplest rule for smart business decisions is “Choose only when economic profits are positive.” When businesses pursue economic profits, markets produce the products and services consumers want.
Economic profits (and losses) serve as signal for smart business decisions.
– With economic losses (red light): businesses leave industry, supply decreases, pushing prices up, until prices just cover all opportunity costs of production and economic profits are zero.
– With breakeven point (yellow light): businesses just earning normal profits. Market equilibrium with zero economic profits or losses. No tendency for change.
– With economic profits (green light): businesses expand and enter industry, supply increases, pushing prices down, until prices just cover all opportunity costs of production and economic profits are zero.
With breakeven point (yellow light):
businesses just earning normal profits. Market equilibrium with zero economic profits or losses. No tendency for change.
