Total+cost+including+implicit+and+explicit+costs

In order to understand how business decisions are made by firms considering alternatives, economists distinguish between the concepts of accounting and economic profits. Accounting profits are those profits defined by what appears on the firm’s financial statements. Very broadly, accounting profits can be defined by the following formula: > **//Accounting profit = total revenue - costs//** > These profits are the result of an analysis of historic information of actual revenues less the costs used to realize those revenues. Accounting profits are generally determined for review by a firm’s managers and stakeholders.

By contrast, economic profits are the difference between the total revenue and the total opportunity cost of producing the firm’s services or products. Economic profits are not so much a statement of what is, but a statement of what would have been had the firm chosen different alternatives. Expressed as an equation: > **//Economic profit = total revenue – total opportunity costs//** > Economic profits are usually discussed amongst a firm’s managers at the time of decision making but are not necessarily shared with the stakeholders. So, for any good decision, opportunity costs must be assessed.

Opportunity costs themselves have two components – implicit and explicit costs. > **//Total opportunity costs = explicit costs + implicit costs//** > Implicit costs are best understood as the costs associated with the next best alternative use of resources. Implicit costs are non-cash costs because no actual money exchanges hands. Instead, the implicit costs of a decision are the costs resulting from the selection of one opportunity over another. For example, if a person accepts a job from one company paying $50,000 over another offering $40,000, that decision has an implicit cost of $40,000 because that amount represents the total payments given up in favor of the higher paying job.

Explicit costs are the actual payments to non-owners of a firm in exchange for resources used. When a company manufactures a good, the explicit costs will be the sum of payments necessary to produce and sell the good. These explicit costs include but are not limited to payments for direct labor and materials, medical insurance, salaries, marketing expenses, etc.

Total opportunity costs are not simply some esoteric economic construct; they are an integral part of individual, business, and social policy planning. Individually, full-time MBA students are giving up a salary now in exchange for a greater salary later. Their implicit cost is the salary and savings they could realize for two years. Their explicit costs are tuition, room, books, meals, etc. While their current economic profits may be negative now (few full-time MBA students have notable revenue), they are betting that their future positive economic profits will more than offset their current losses. In business, total opportunity costs frequently arise in considerations of make-or-buy analyses, expansion plans, and project reviews for capital expenditure funding. In the social arena, opportunity costs are often a part of the analysis for welfare, crime (the economic profit of crime is the loot received from the crime less the opportunity cost of getting convicted and sent to jail), and tax policies (how will people restructure their financial assets in response to tax law changes).


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[For Questions 1 & 2] The Acme Anvil Corporation fabricates anvils for customers across the United States, and sells them for $10 each. Acme has been approached by W.E. Coyote with a request for 10 anvils every month for one year. Because Acme currently operates at 100% capacity, it must expand its operations to meet the order demand. The expansion will cost $800 and will be funded by cash from an account that earns 5% annually.

1) What is the total opportunity cost of accepting the order and expanding if Acme supplies the anvils for 1 year? > a. $800 > b. $1,200 > c. $760 > d. $840 > e. $360

2) What economic profit will Acme realize if it expands and accepts the order? > a. $800 > b. $1,200 > c. $760 > d. $840 > e. $360

3) It is possible for a welfare recipient in Massachusetts to receive welfare benefits whose value is equivalent to a pre-tax wage of $30,600. Assuming 2080 work hours in a year, and all else being equal, will this person accept a full-time job offer that pays $14.50 per hour? > a. The person will accept the job offer because his explicit costs are greater than the implicit costs. > b. The person will refuse the job offer because the opportunity cost of accepting the job is greater than the opportunity cost of continuing to receive the welfare benefits. > c. The person will accept the job offer because his economic profit will be greater than zero. > d. The person will refuse the job offer because his transaction costs will be less than the opportunity costs from accepting the job. > 4) A busy commission salesperson is simultaneously pursuing two possible sales, A & B, when a third sales opportunity emerges (C). The salesperson figures he has 25% chance of winning that $2M sale, but in order to win it, he must contribute all of his time to the effort which leaves no time to close sales A & B. The salesperson estimates that he has a 50% chance of winning sale A worth $1M and a 33% chance of winning sale B worth $750K. What should the salesperson do? > a. Pursue sales opportunity A only because that represents the best chance for making a sale. > b. Pursue sales A & B because the explicit cost of them are greater than the implicit cost of sale C. > c. Pursue sales A & B because the opportunity cost is less than the opportunity cost of sale C. > d. Pursue sale C because its opportunity cost is greater than that the opportunity costs of sales A & B combined.

5) Which of the following is typically a non-cash expense? > a. Explicit cost > b. Transaction cost > c. Opportunity cost > d. Implicit cost

1) (d) The explicit costs of Acme expanding total $800 because these are the costs that would be paid to non-owners of the firm in order to secure resources. The implicit cost is the amount of money that will be earned if expansion does not occur. In this case, that amount is $800 x 5% which equals $40. The total opportunity cost is the sum of the explicit and implicit costs: $800 + $40 which equals $840.
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2) (e) The economic profit is the difference of total revenue and total opportunity costs. Total revenue is the price per unit sold multiplied by the quantity sold. In this case that number is: (10 anvils/month) x ($10/anvil) x (12 months) which equals $1,200. Since economic profit is total revenue minus total opportunity cost, we have: $1,200 - $840 which equals $360.

3) (b) In order to make the determination, we have to compare the opportunity costs of each decision. First we calculate how much the job offer is worth on a comparable time scale. With 2080 work hours for a full-time job, the person could earn (2080 hours) x ($14.50/hour) = $30,160. The opportunity costs of accepting the job is $30,600 (the value of the welfare benefits), and the opportunity cost of continuing to receive benefits is $30,160 (the wage given up). Since people will tend to maximize their economic profit by minimizing their costs, the person ought to refuse the job offer and continue to receive benefits (the lower of the two opportunity costs).

4) (c) Again, we must compare the opportunity costs of each decision. Those opportunity cost of each decision is simply the potential value of the sale adjusted for the odds of winning the sale. The opportunity cost of each sale is calculated below: > Sale A: 50% x $1,000,000 = $500,000 > Sale B: 33% x $750,000 = $250,000 > Sale C: 25% x $2,000,000 = $500,000 If the salesperson decides to pursue sales A & B, the opportunity cost is the potential value of sale C or $250,000. If the salesperson pursues sale C, the opportunity cost is the sum of the potential values of sales A & B or $500,000 + $250,000 = $750,000. Therefore, the salesperson will minimize his opportunity costs and pursue sales A & B over C.

5) (d) Implicit costs are typically non-cash expenses representing the next best alternative. Explicit costs are cash payments to non-owners of a firm in exchange for resources. Opportunity costs are both cash and non-cash expenses. Transaction costs are costs in excess of the actual cost of the service or product purchased. Transaction costs may be either implicit or explicit costs depending on the analysis.

Baye, Michael R. 2006. __Managerial Economics and Business Strategy__. McGraw-Hill/Irwin: New York, NY. Tucker, Irvin B. 2006. __Survey of Economics__. Thomson South-Western: Mason, OH. Tanner, Michael, Stephen Moore, and David Hartman. 1995. The Work Versus Welfare Trade-Off: An Analysis of the Total Level of Welfare Benefits by State. __Cato Policy Report: Cato Policy Analysis No. 240__. Cato Institute: Washington D.C. Becker, Gary S. 1968. Crime and Punishment: An Economic Approach. __Journal of Political Economy__ 78, 169-217.
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