Externalitites and Public goods - Production and Costs...

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Production and Costs Primary firm motive: maximize profits! Profit = Revenue – Cost I. Measurement of Costs A. Explicit Costs 1. Purchased or rented factors: e.g. $110 worth of textiles material = $110 cost. 2. Labor costs: wages or salary, plus any benefits, payroll taxes, unemployment insurance, worker’s comp, costs in meeting OSHA requirements, etc. 3. Borrowed money: the cost of borrowed money is the interest that must be paid. B. Implicit Costs: the opportunity cost of non-purchased inputs. 1. A firm’s own money Example: A firm uses $100,000 of its own money in a low-risk venture that returns $106,000 after one year. a. For the accountant, the firm would incur no costs (because it used its own funds), and so the profit would be $6,000. b. An economist would look at the opportunity cost. If the interest rate (low- risk) is 3%, then the firm could have put its money in the bank and earned $3,000, so the opportunity cost is $3,000 and the profit is $3,000. 2. Durable assets: depreciate over time Example: Suppose a firm spends $32,000 on a truck that is expected to last 8 years (for ease of explanation, assume the truck would have no salvage value at the end of the 8 years). a. An accountant chooses some depreciation method (since this is not an accounting course, we will pick the simplest method); straight-line depreciation. The accountant depreciates the truck evenly over the 8 years. In other words there is a cost of $4,000 each year.
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b. An economist will want to know the market value of the truck at the end of each year. If after 1 year, the market value of the truck is $25,000 then the implicit cost is $7,000.
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