Section5 Flashcards
What is Total Revenue?
The amount of money a firm receives for the sale of its output.
Define Total Cost.
The market value of all inputs a firm uses in production.
What is Economic Profit?
= Total Revenue - Total Cost
(includes both explicit & implicit costs).
Explain Opportunity Cost.
Benefit/value of the most valuable alternative forgone.
Example of Opportunity Cost
If Mark buys pizza instead of a drink & hamburger, the opportunity cost is the value of the drink and hamburger.
I mean, I think there exist better examples hahah, but i think this was in the slides
Define Explicit Costs.
Input costs that require a direct outlay of money by the firm.
Define Implicit Costs.
- Input costs that do not require a direct outlay of money.
- Example: owner’s time.
The opportunity cost of capital is an important cost to include in any analysis of
firm performance.
What is Accounting Profit?
Accounting Profit = Total Revenue - Explicit Costs.
Difference between Economic and Accounting Profit
Economists consider implicit costs; accountants do not.
Economists are interested in studying how firms make production and pricing
decisions.
Accountants are interested in keeping track of the money that flows into and
out of the firm.
Fixed vs Variable Costs
- Fixed Costs: Not dependent on output (e.g., rent)
- Variable Costs: Dependent on output (e.g., raw materials)
Total Cost formula (short run)
TC = TFC + TVC
Total Cost = Total Fixed Costs + Total Variable Costs
Marginal Cost (MC) formula
-> Average Costs (short run)
MC = ΔTC / ΔQ
delta = ableitung
linear and non-linear
Linear function (𝑇C= 𝛼 + 𝛽Q): first derivative of the total cost function with respect to output
-> abgeleitet: MC = 𝛽
Log-log function (ln𝑇C= 𝛼 + 𝛽ln𝑄): first derivative of the total cost function with respect to output
-> abgeleitet: MC = 𝛽 = 𝜕𝑇C/𝜕𝑄 * 𝑄/𝑇C = cost elasticity
Economies of Scale
Long-run average total cost falls as output increases.
ES = 𝟏/𝑪ost 𝒆lasticity = 𝟏/(𝝏𝑻C/𝝏𝑸)*(𝑸/𝑻C)
ES>1: economies of scale
ES<1: diseconomies of scale
ES=1: constant returns to scale
Diseconomies of Scale
Long-run average total cost rises as output increases.
Learning Curve
Shows how production costs fall as experience and efficiency increase.
The learning curve shows the extent to which hours of labor needed per unit of output fall as the cumulative output increases.
Investment Decision Process
Involves assessing the Net Present Value (NPV) of future cash flows. -> firm perspective
Investment: production of good or acquisition of a good or an asset that will be used
to produce other goods -> consumer goods such as vegetables and investment goods such as machines
Investments show benefits and costs over a long period of time
Investment analysis can be done by:
Firms
Households (Building a new house, buying a car, go to the university,…)
State (building a new road, a park, a tunnel…)
From the society point of view, all costs and benefits should be considered (external
costs and external benefits)
Does a positive profit (on annual report) imply that all economic cost has been covered?
Profit is accounting
Accounting Profit = Total Revenue – Explicit Cost
Economic profit = costs implicit and explicit
Economic Profit = Total Revenue – Total Cost
Total Cost = Explicit Cost + Implicit Cost
Cost of Production
A firm’s cost of production also includes all the opportunity costs of making its output of goods and services.
A firm’s cost of production includes explicit costs and implicit costs.
Example of an Implicit Cost: the Opportunity Cost of Capital
Example:
Bill uses 100’000$ of his savings to start a firm. This money was in a saving
account paying 5% interest.
Since Bill could have earned 5’000$ per year on his saving, we must include this
opportunity cost (implicit cost) in our analysis.
Note that an accountant would not count this 5000$ as part of the firm’s costs.
If Bill had instead borrowed from a bank 100’000$ with an interest rate of 5%
explicit cost.
Accountant would now count 5000$ in interest paid for the bank loan.
Implicit Environmental Costs From a Society Point of View
From an economic and society point of view:
The cost of production includes explicit costs and implicit costs that also
include all external/social costs (ex: health cost due to pollution).
Accounting Profit: Income Statement and Balance Sheet
The income statement measures the flows into and out of the firm.
The balance sheet measures the stocks of assets and liabilities at the
end of the accounting year.
Accounting
ROE = return on equity
Equity is the shareholder equity = net value of company
net income (group profit) / shareholders equity (equity)
Other Differences Between Economic Costs and Accounting Costs
Depreciation is not based on the actual life of a machine. It is mainly regulated by law.
* In Accounting Costs: Depreciation is treated as an expense on financial statements.
* In Economic Costs: The focus is on the asset’s actual value decline and opportunity cost, which may differ from accounting depreciation.
* Accounting View: The company records $10,000 per year in straight-line depreciation.
* Economic View: If the machinery could have been sold for a better investment or has a different market value depreciation rate, economic cost might differ.
Sunk Costs are part of accounting costs.
– Sunk costs are expenditures that have been made and cannot be recovered.
– Sunk costs will not be considered for future decisions.
– Ex: marketing
Social and environmental costs due to negative externalities (air
pollution, noise,…)
U-Shaped Cost Curves
- In the short run, when factors such as capital are fixed, variable factors tend to show an initial phase of increasing marginal product (a firm is capable of
engaging in specialization) followed by decreasing marginal product. - Marginal cost are decreasing followed by increasing marginal cost.
Average Cost formula (short run)
Average Fixed Cost: AFC =
Fixed Cost/Quantity = FC/Q
Average Variable Cost: AVC =
Variable Cost/Quantity = VC/Q
Average Total Cost: ATC =
Total Cost/Quantity = TC/Q
Costs in the Short and Long Run
- For many firms, the division of total costs between fixed and variable costs depends on the time horizon being considered.
In the short run, some costs are fixed.
In the long run, fixed costs become variable costs.
Because many costs are fixed in the short run but variable in the long run, a firm’s long run cost curve differs from its short run cost curve.
Different Shapes of the Average Cost Curve
Different Shapes of the Total Cost Curve
Non-competitive markets: L-shaped
Competitive markets: U-shaped
Non-competitive markets:
Competitive markets: s
Constant returns to scale
Constant returns to scale refer to
the property whereby long-run
average total cost stays the same as the quantity of output increases.
Reasons for Economies of Scale
Possible reasons for declining average cost when output increases:
Large initial investments in production capacity
Transaction cost does not increase proportionately with output
If the firm operates on a larger scale, workers can specialize in the activities in which they are most productive
Economies of Scope
Most companies do not offer just one single product but a wide range of products -> from multi-product firms.
If the joint output (Q) of a single firm is greater than the output that could be achieved by two different firms when each produces a single product, we
speak of economies of scope.
If the cost of producing (Costs) two outputs by one firm is lower than the cost of producing one output with a firm and the other with another, we have economies of scope.
SC = (C(Q1)+C(Q2)-C(Q1,Q2)) /C(Q1,Q2)
SC > 0 -> economies of scale
Reasons for Economies of Scope
Joint production -> better utilization of inputs (some inputs can be shared)
-> When a company produces multiple products jointly, it can share resources like raw materials, labor, and facilities, leading to more efficient input utilization and lower costs.
Better load factor on machines because of product differentiation
-> If a firm produces different types of products using the same machines, it can maximize machine usage (better load factor), reducing idle time and increasing productivity.
Better utilization of labor because of product differentiation
-> A diversified product line allows a firm to use labor more efficiently, as workers can shift between different production tasks rather than remain idle.
Risk diversification in fields of R&D
-> By investing in research and development (R&D) across multiple product lines, a firm reduces the risk associated with reliance on a single product, making innovation efforts more stable and sustainable.
Evaluating Investment Projects
Net Present Value = NPV = Summe of )Ft/(1+i)^t)− IV
Ft: Net cash flow in year t
IV: Investment in year 0 (initial investment)
i: Discount rate
We can think of i as the firm’s opportunity cost of capital -> rate of return that one could earn by investing in alternative projects with similar risk. But also time
preference argument
We need a discount rate because revenues and costs accrue (Sich ansammeln, anfallen) at different dates.
Numbers in the calculation may be in real or nominal terms, as long as they are consistent.
real = excludes the effect of inflation and represents the rate of return in terms of actual purchasing power -> adjusted for inflation
nominal = includes the effect of inflation and represents the rate as it is expressed in current monetary terms (real is included) not adjusted for inflation
Time Value of Money
Discount factor: interest rate used to determine the present value of future incomes/cash flows
Discount factor= 1/(1+i)^t
Where: i =discount rate; t =years
The fundamental procedure used by economists is based on the premise that 1 franc today is worth more than 1 franc tomorrow.
Present Value of a Project (discount rate)
Investments with future cash flows that are certain: risk-free interest rate
i= risk free return (for example interest rate on government bond)
Example: If a government bond has an interest rate of 3%, the discount rate for that investment is 3%.
Investments with future cash flows that are not certain: (e.g., stocks, business projects)
i = risk free return + risk premium
Risk premium calculated with the Capital asset pricing model
Example: Suppose the risk-free rate is 3%, and the expected market return is 8%.
If a company’s beta (β) is 1.2, then:
Risk Premium = 1.2 * (8% - 3%) = 6%
The total discount rate (i) for this investment would be:
i = 3% + 6% = 9%
Beta (β) is a measure of an investment’s systematic risk (market risk) compared to the overall market. It quantifies how much an asset’s price moves relative to the market index (e.g., S&P 500).
Most Challenging Parts of an Investment Analysis
Most challenging parts of the analysis:
estimate the future cash flows, e.g. estimate the future revenues and costs
…oil price in 20 years?
select the discount rate (risk free return + risk premium)
Investment Decisions by Consumers
Present Discounted Value (PDV) of the cost of buying and operating a product a by assuming a lifetime of n years and no sale with the following formula.
Pa is the purchase price of the product
OCa is the average annual operating cost of the product
PDV = Pa+OCa + OCa/(1+i)1 + OCa/(1+i)^2 +….. + OCa/(1+i)n
For the discount factor, the consumer should apply the same approach used by
firms: the discount rate i is the opportunity cost of capital, but not only ..??
Interpreting NPV
- Positive NPV (> 0): The investment is profitable and should be considered.
- Zero NPV (≈ 0): The investment breaks even; it’s neither a gain nor a loss.
- Negative NPV (< 0): The investment will lose money and should be reconsidered.
