when we studied consumer Theory we assumed that people had preferences and that their goal was to achieve outcomes ranked highly in their preferences what is the goal of a firm people might start a business for all sorts of reasons they may want to work on something they're passionate about or something that is going to make the world a better place others and this is a perfectly good reason might start a business because they want to make money all of these reasons can coexist with the claim that the goal of a firm is to make profits as can imagine all sorts of companies we wouldn't want to be a part of due to various beliefs we hold but since people differ in these beliefs we should expect any profitable void to be filled by someone who doesn't hold such compunctions and in the competitive Marketplace firms which can achieve the same outcomes more profitably will consume those that can't by out bidding them for scarce resources just as competition in nature selects for traits that are more likely to reproduce themselves competition in the marketplace selects for firms which are more likely to generate profits the main thing to remember before you cast a moral judgment though is that in a free market profits are only available to firms which deliver things people genuinely want and will freely pay for so what is this thing called profits that firms are trying to maximize the equation is simple profits which we often represent with the Greek letter Pi are equal to the total revenue a farm makes selling their products minus their total costs from producing those products but there's more to this than meets the eye total revenue is easy to understand it depends on the price charged and the quantity sold if we sell 100 calculators for ten dollars each we will have made one thousand dollars which is a hundred times ten in total revenue total costs are much harder though because we aren't just thinking about what firms have to pay for the resources they use for our economic model of the firm total costs include both explicit costs and implicit costs explicit costs are the costs which require a money outlay if we open up a lemonade stand our explicit costs are what we have to pay to get the cups and lemons and sugar and water and ice all the things we need to make lemonade with that's money that comes out of our pockets to get production going implicit costs are the costs of a foregone opportunity perhaps we could make more money mowing lawns or selling candy or perhaps we just value our time more than what we could earn selling lemonade implicit costs are much more important than explicit costs when thinking about the behavior of firms all of us right now could probably go make a profit selling lemonade on some Street somewhere but I would guess that none of us are doing so and that is because of the implicit costs we Face the other opportunities we have here is a real life example of how implicit costs Drive business decisions there used to be a video rental store near where I live called video Paradise they outlasted Blockbuster by years but in the mid-2010s they decided to close their doors when I asked the owner why they were shutting down he said that they could have probably stayed in business for a few more years but Dollar Tree a chain of discount stores offered him a bunch of money to vacate the storefront they were in so they could put a new location there these numbers I have in the table are all made up but they highlight the difference between accounting profit and economic profit If Video Paradise stayed in business they would be reporting ten thousand five hundred dollars in monthly profit to the IRS that is their accounting profit and that is probably how you would have defined profit before now but it's easy to see that even though their bookkeeper reports positive operating income the business is actually losing money for the owners because those accounting profits are not sufficient to cover the money they could have if they sell the retail space to Dollar Tree their economic profit is negative because the resources they're using are more profitable somewhere else namely in use as a Dollar Tree and so they would be wise to take the money and while I miss video Paradise I probably spend more money each year at that Dollar Tree this idea of implicit costs is the same as our previous concept of opportunity costs when we evaluate our options we do a little cost benefit analysis but part of the cost of each option is the net benefit we give up by not choosing the next best option available to us if a farmer could make fifty thousand dollars in accounting profit growing and selling corn but could make one hundred thousand dollars in accounting profit growing and selling soybeans then growing and selling corn means they're losing money they get positive accounting profits either way but their economic profits from corn would be negative fifty thousand dollars while their economic profits from soybeans would be positive fifty thousand dollars the true profitability of something takes the revenue earned and subtracts both the explicit costs and the implicit costs let's look at an example this is Brian's bread Baking Company we bake bread in order to bake and sell bread we need lots of resources we'll need things like a storefront to sell from baking equipment like ovens and mixers Bakers and other workers to do the baking and selling and of course the raw materials we need to make bread we can split these different resources into fixed costs and variable costs variable costs are costs that vary depending on how many loaves of bread we Bank if we want to make more bread we need to we need more Bakers and more ingredients and so how much we pay in those costs depends on how many loaves we decide we want to produce fixed costs are costs that do not vary with output no matter how many loaves of bread we bake we will be paying the same rent on our storefront and we will have already paid for all of our baking equipment if we produce nothing we can quickly fire everyone and stop buying ingredients and bring our variable costs down to zero but we can't do that with our fixed costs we're paying those no matter what remember also that we have a lot of implicit costs in there too instead of devoting our time to this business we could be selling pies instead or we could go get a job working for someone else earning a salary or we could use our time for leisure everyone even business owners eventually calls it a day and goes home that means they must value that personal time more than the amount of money they could make continuing to work nevertheless our total costs are going to be equal to our fixed costs plus our variable costs get some insight on how producers decide how much to produce let's think about how they would make the that decision day to day some of our resources are fixed for example we may own only one oven we won't be able to change that in the short run meaning that for now we are limited to one oven but it would be pretty easy to call people in and get more Bakers working in the kitchen let's say we schedule just one of our Bakers to work today and we pay this Baker 15 an hour with all the baking equipment to themselves let's say they produce 30 loaves of bread per hour that means just looking at our labor costs here each loaf of bread cost us 50 cents to produce perhaps we schedule two Bakers for the day instead that second Baker will need to share a lot of the equipment with the first and so each of them might produce less than they could produce alone and so by adding a second Baker we wouldn't necessarily double our output instead we might increase our output by 25 loads per hour since we pay the second Baker the same fifteen dollars an hour that means these additional 25 loads cost us 60 cents on average and if we call up another one of our Bakers and have them come in perhaps we could boost output by a further 20 loaves per hour those lows would cost us about 75 cents each in the short run firms face increasing marginal costs as we increase output the marginal cost of producing one additional unit tends to rise increasing marginal costs is a consequence of the law diminishing marginal returns as we add more workers we increase output but by less and less each time because each input tends to cost the same our cost per unit will be rising as we add more inputs like labor of course this could change in the long run when we're able to make bigger changes to our business imagine that I have a company that just digs holes in the ground we have 10 shovels and 10 workers each worker has a shovel to dig holes with and so we dig a lot of holes if I hire another 10 workers but we don't buy more shovels those 10 workers won't be nearly as productive they might be able to borrow a shovel when someone goes on break but they won't be able to dig as many holes as the first 10 workers and if I hire 10 more their productivity will be even lower than that they can still help maybe by digging holes slowly with their hands but the marginal output will be less when one of our resources is fixed adding more of the other resources can only do so much one of the decisions that firms must make is how much they want to produce on this graph the horizontal axis represents the quantity produced and the vertical axis measures money assuming they can sell what they produce at some price their total revenue will be a nice upward sloping line as the quantity produced goes up the revenue earned goes up but they won't get to keep all of this Revenue as profit no matter what quantity they produce they will have to pay their fixed costs which appear on the graph as a horizontal line at the dollar amount of those fixed costs marginal costs as we noted are rising with quantity when you want to produce more you need more and more of the resources used and so the variable costs of each unit are rising as we go along marginal costs represent only the cost of that particular unit so our total costs are our fixed costs plus the cumulative total of marginal costs up to that point when marginal costs are rising it means total costs will be exponential let's connect that idea to our bread baking business if we have a small outfit that normally bakes 100 loaves per day and we get a call for an order for 200 loads we could probably do it we call in all the resources we can and work overtime to over produce for a day and meet the order but that is going to be a lot more expensive than usual since we will need to calm more people in and because we're using more valuable resources like time we would not normally give and if the next day we get an order for 400 loads we might decline because the costs spiral up exponentially and it just isn't economically profitable for us to meet the order whatever the case our goal as entrepreneur is to find the quantity which gives us the most profit which is the biggest gap between total revenue and total cost if we choose this quantity our profit is represented by the solid line connecting total revenue and total cost but it looks like we could make more profit at this higher quantity since the Gap is bigger but it would be a mistake to increase production Beyond this point where profits get smaller again so how do we determine which quantity maximizes our profits