Overview
This lecture introduces the concept of costs in firm theory, explaining different types of profit and the importance of explicit and implicit costs as foundational tools for analyzing industry structures.
Introduction to Firm Theory and Market Structures
- The next four chapters focus on firm theory: how firms decide output, pricing, and employment.
- Market structure defines industry competitiveness, categorized into four types: perfect competition, monopoly, monopolistic competition, and oligopoly.
- Perfect competition involves many firms with identical products; monopoly involves one firm with no similar products.
- Monopolistic competition features many firms with similar (not identical) products; oligopoly has few firms, regardless of product similarity.
The Importance of Cost in Firm Decisions
- All firms are assumed to maximize profit, defined as total revenue minus total cost.
- Revenue is calculated as price times quantity sold; cost includes all expenses required to operate.
Types of Costs
- Explicit costs are out-of-pocket monetary payments (wages, rent, supplies).
- Implicit costs are the opportunity costs of using resources, such as the owner’s time or foregone investment returns.
Types of Profit
- Accounting profit equals total revenue minus explicit costs.
- Economic profit equals total revenue minus both explicit and implicit costs, showing true economic viability.
Example: Fred’s Legal Practice
- Fred’s explicit costs: $50,000 (rent) + $35,000 (law clerk) = $85,000.
- Expected revenue: $200,000; accounting profit: $115,000.
- If Fred’s previous job paid $125,000 (implicit cost), economic profit: $115,000 - $125,000 = -$10,000.
- Negative economic profit means the new business is less profitable than his old job.
Key Terms & Definitions
- Profit — total revenue minus total cost.
- Explicit Costs — direct, out-of-pocket payments required to operate a business.
- Implicit Costs — opportunity costs of using owned resources for business instead of other uses.
- Accounting Profit — total revenue minus explicit costs.
- Economic Profit — total revenue minus explicit and implicit costs.
- Opportunity Cost — the value of the best alternative forgone.
Action Items / Next Steps
- Complete homework question comparing economic and accounting profit.
- Prepare for the next lecture on cost structures in the short run.