Chapter 13- The Cost of Production
Definition of economic costsEdison lives in Philadelphia and runs a business that sells pianos. In an average year, he receives $793,000 from selling pianos. Of this sales revenue, he must pay the manufacturer a wholesale cost of $430,000; he also pays wages and utility bills totaling $301,000. He owns his showroom; if he chooses to rent it out, he will receive $15,000 in rent per year. Assume that the value of this showroom does not depreciate over the year. Also, if Edison does not operate this piano business, he can work as a financial advisor, receive an annual salary of $50,000 with no additional monetary costs, and rent out his showroom at the $15,000 per year rate. No other costs are incurred in running this piano business.The wages and utility bills that Edison pays – Explicit CostThe salary Edison could earn if he worked as a financial advisor – Implicit CostThe wholesale cost for the pianos that Edison pays the manufacturer – Explicit CostThe rental income Edison could receive if he chose to rent out his showroom – ImplicitExplicit costsrefer to all costs that require an outlay of money by the firm. In contrast, implicit costsrefer to all costs the firm incurs in production that do not involve any monetary transactions.The wholesale cost of $430,000 and the wages and utility expenses of $301,000 both involve an outlayof money by the firm. These are considered the explicit costs of running the piano business. On the other hand, the forgone salary and forgone rental income do not involve actual monetary transactions. They are Edison’s implicit costs of running the piano business.Accounting profitis equal to total revenue minus total explicit costs. In this case, total explicit costs are the sum of the wholesale cost and wages and utility bills. Therefore, you can compute accounting profit in the following way:Accounting Profit = Total Revenue – Total Explicits Costs793,000 - (430,000) + (301,000) = 731,000793,000 – 731,000 = 62,000On the other hand,economic profitis equal to total revenue minus total cost (which is the sum of explicit costs and implicit costs). In this case, total cost is the sum of the wholesale cost, wages and utility bills, forgone salary income, and forgone rental income. Therefore, you can compute economic profit in the following way:Economic Profit = Total Revenue – Total CostsTotal Revenue – ( Total Explicits Cost + Total Implicits Cost)793,000 – (731,000 + 65,000 (50000+15,000) 796,000= -3000Because economic profit is less than zero, an economic profit of -$3,000 is the same as an economic loss of $3,000. Inputs and OutputsMaria's Performance Pizza is a small restaurant in Miami that sells gluten-free pizzas. Maria's very tiny kitchen has barely enough room for the two ovens in which her workers bake the pizzas. Maria signed a lease obligating her to pay the rent for the two ovens for the next year. Because of this, and because Maria's kitchen cannot fit more than two ovens, Maria cannot change the number of ovens she uses in her production of pizzas in the short run.