economics 4 - TOPIC 4 PRODUCTION AND COST TOPICS Economic...

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TOPIC 4 PRODUCTION AND COST
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TOPICS Economic and accounting profit Firm as a production unit Decision time frames for a firm Production function Nature of production cost
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ECONOMIC COST In economics, cost refers to opportunity cost which is defined as the value of the best alternative forgone. A firm’s cost of production has two components: Explicit cost : The actual payments a firm makes to its factors of production and other suppliers. Implicit cost : All the firm’s opportunity costs of the resources supplied by the firm’s owners.
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Economic cost Economic cost - takes into account all opportunity costs that include all the implicit costs and explicit costs that are relevant to the activity under consideration. Accounting cost Accounting cost - does not take into account all opportunity costs, it excludes some implicit costs like the opportunity costs of owner’s equity. ECONOMIC COST vs. ACCOUNTING COST
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Profit ( π ) = Total Revenue - Total Cost = TR - TC Two Concepts of Profit Economic profit = Total revenue - Economic cost Accounting profit = Total revenue - Accounting cost PROFIT
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EXAMPLE Peter was initially earning $20,000 per month as a programmer. He quitted his job and invested $400,000 out of his savings to run a software store. Therefore he has given up his labour income of $20,000 and interest income of $2,000 (at an interest rate of 6% p.a.) per month. His store has a revenue of $35,000 per month.
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Income Statement (Accountant) REVENUE $35,000 EXPENSES Rent $8,000 Material $4,000 Misc. $1,000 $13,000 Accounting profit = $22,000 Income Statement (Economist) REVENUE $35,000 EXPENSES Rent $8,000 Material $4,000 Misc. $1,000 O.C. labor $20,000 O.C. capital $2,000 $35,000 Economic profit = $ 0
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SUNK COSTS A sunk cost is a cost incurred by the firm and cannot be changed. e.g. If a firm’s plant has no resale value, the amount paid for it is a sunk cost. Sunk costs are irrelevant to a firm’s decisions. Examples of sunk costs
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DECISION OF A FIRM DECISION OF A FIRM Firms are production units. They decide the quantity of inputs to be employed. They also decide the amount of outputs to be produced. Do they need to decide the price? It depends on the market structure, which will be discussed in the next topic.
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TYPES OF INPUTS (FACTORS OF PRODUCTION) Category Nature Factor Reward Labour Mental and physical human efforts Wage Capital Human-made production equipment Interest
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