Chapter 12: Production and Cost Analysis I
We are now focusing on the supply side of the market. That is, there are some basic
economic questions that producers (aka firms, businesses, or suppliers…these terms can
be used interchangeably) need to address.
To begin with, a “firm” in the economy is any organization that organizes and uses
factors of production (land, physical capital, labor, and raw materials) to produce and sell
output (“goods” – tangible objects that have positive value – or “services” – intangible
activities that have positive value). Therefore, a firm’s ROLE in the economy is to use
inputs to produce and sell output.
However, a firm’s GOAL (or objective) is to maximize profit. This is an assumption that
we will maintain in order to keep things “simple”. Profit is the difference between
revenue and costs. Revenue is what the firm can bring in from producing and selling
output and costs are what the firm expends in producing and selling output. This
assumption can be applied to ALL firms, whether the firm is a “for-profit” organization
or a “not-for-profit” organization….here the difference is who gets the profit. In a “for-
profit” organization, the profit is distributed among the owners of the firm. In a “not-for-
profit” organization, the profit is retained within the firm.
There are two types of profit:
Accounting profit = total revenue – outlay costs
[Outlay costs includes actual expenditures; it is sometimes referred to as
“historical costs”, “dollar outlay”, or “explicit costs”.]
Economic profit = total revenue – opportunity cost
[Opportunity cost refers to the loss of the next best alternative…or the
value of what the resources would otherwise be used for if they weren’t
being used in the current activity; it includes both “explicit costs” and
Which type of cost is better? That depends upon why you are looking at costs. An
accountant is interested in assets, liabilities, balance sheets, etc., so the focus would be on
explicit costs. An economist is interest in the scarcity of resources so the focus would be
on foregone opportunity.
Since this is a course in economics, we will be concerned with economic costs and thus,
Here is more terminology with respect to economic profit:
If total revenue is equal to total costs, then the economic profit is zero. This is sometimes
expressed as “the firm is making normal profit”. This is an “okay” situation! Remember
that economic profit includes opportunity cost so the firm is completely covering outlay
expenses as well as forgone opportunity, including an “income” to the owner(s) of the
firm, etc. The factors of production are receiving at least as much as they could be getting
in their next best alternative.