Online ECON - Chapter 12 Guided Reading – Costs of Production

Key Concepts:

Total Revenue, Total Cost, Profit

Explicit Costs vs. Implicit Costs

Accounting Profit vs. Economic Profit

Fixed Cost vs. Variable Cost

Marginal Cost

Economies of Scale

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Assignment: Read Chapter 12 Introduction, 12-1 Introduction and 12-1a

Note: In accounting courses, we are taught that the equation for profit is Total Revenue (TR) minus Total
Costs (TC) equals Profit.

Assignment: Read 12-1b

Note: In economics courses, we are taught the same equation for profit: TR – TC = Profit.

Note: It is important to note that economists, unlike accountants, include Implicit Costs in the
calculation of Total Costs.

Note: Accountants include only Explicit Costs when calculating Total Costs.

Note: Economists include both Explicit Costs and Implicit Costs when calculating Total Costs.

Note: An easy way to think of this: Explicit Costs take money out of your pocket; Implicit Costs do not
take money out of your pocket. Implicit Costs are the implied costs of using time and capital. For
instance, if you have to take money out of your savings account to open a new business, the foregone
interest (the interest you would have continued to earn if the money was still in your savings account) is
an Implicit Cost of opening the business.

Assignment: Read 12-1c and 12-1d

Note: At this point be sure you understand Figure 1.

Note: Fixed Costs do not vary with the output produced. Rent is usually a good example of a Fixed Cost.
If we have a pizza shop, it doesn’t matter how many pizzas we make and sell this month – we pay the
same rent regardless.

Note: Variable Costs do vary with the output produced. If we have a pizza shop, the more pizzas we
make and sell, the more we will need to spend on dough, sauce, toppings, etc.

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Assignment: Read 12-3a

Note: Marginal Cost is the increase in total cost that arises from producing an extra unit of production.
In other words, if we have made and sold 100 pizzas today, it is easy to calculate the average cost per
pizza by calculating the total costs for the day and dividing them by the 100 pizzas. But what if someone
comes in one minute before we close and wants to order a pizza? Will we have to cut a new bell pepper
and only use ¼ of it, and then have to throw the other ¾ of the pepper away because it can’t be saved
overnight? Will we have to pay our chef overtime to stay and cook this one extra pizza? In this example,
we can see that the marginal cost of making and selling this one extra pizza could be quite different than
the average cost of the pizzas made and sold that day.

Assignment: Read 12-4b

Note: Be sure you understand Economies of Scale, Diseconomies of Scale, and Constant Returns to
Scale.

Assignment: Answer the following three questions:

1) When deciding whether or not to attend graduate school, should you take into account
explicit costs, implicit costs, or both? Why? Fully explain giving examples of each.

Yes, one should consider both explicit and implicit costs of attending graduate school because the total
cost which is the sum of both should be considered One should consider the opportunity cost of the
time that you will spend in graduate school. If you would better off economically by working right away
instead going graduate school, then it would be considered too expensive to spend the time going to
graduate school. This is considering that after completing graduate school you still wouldn’t be better off
economically than if you started working right away.

2) Which will always be larger – accounting profit or economic profit? Why?

There will always be a larger accounting profit because accountants do not take implicit costs into
account when calculating revenue. Accountants only look at the explicit costs of the firm. Economic
profit considers both explicit and implicit costs.

3) Is the following statement true:

Fixed Costs + Variable Costs + Explicit Costs + Implicit Costs = Total Costs
Why/Why not?

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No this is incorrect because the total costs are the sum of implicit and explicit costs. This is the amount
that the firm pays to buy inputs. But there is a separate way to look at the firm’s total costs which is
divided into fixed costs and variable costs.

Assignment: Post your answers to these three questions in Course Discussion 12A in the course in
Blackboard. This Post is due before Friday, April 10 at 11:59 PM.

Assignment: Go back to the beginning of this document and, using your own words, explain each of
the Key Concepts listed.

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