Quiz 21: Costs and the Supply of Goods
Concept of economic profit: Profit is the excess of total revenue over total cost. Here total revenue will mean total value of commodities produced and sold. Total cost is the total expenses of manufacturing those products. It is also known as the residue left after making payment to all factor owners. There are four factors required for manufacturing a product. They are- 1. Land: It includes all god gifted items that are scarce and used in the manufacturing process. It includes plot of land, agriculture, minerals, animal product etc. 2. Labor: It is the manual and mental exhaustion of mankind used in production. It should not be voluntary in nature. It should be rendered to make some income. 3. Capital: It is man-made item like machine, which is used in the production process. 4. Organization: It is the special skill of owner of the enterprise. He collects all required factors, organizes production activities and undertakes the risk of marketing the produced units. Cost is the aggregate money value of factors used in production. Land owner is paid rent for using his factor. Laborer receives wages. Interest is paid to capital owner. After paying rent, wages and interest, whatever surplus is left will be received by the organizer. This surplus should not be less than the opportunity cost of organizers service. Here opportunity cost is the maximum earning that the organizer can make by using his service in best alternative available opportunity. A practicing doctor will not practice if he earns less in practice in comparison with the earning from employment. Here earning expected from employment is the opportunity cost of practice. This opportunity cost is the cost of organization. It is also known as normal profit. It is added along with other factor expenses to get total economic cost. Excess of total revenue over this total economic cost is known as economic profit. Therefore, economic profit may be written as - Difference between accountants profit and economic profit: In order to draw the difference between economic profit and accountant's profit, total cost as used in economics is divided into two parts. They are - 1. Explicit cost and 2. Implicit cost. Explicit costs are those elements of cost, against which outflow of money is inevitable. Example: Raw materials purchased for production or labor employed for production activity will require payment or outflow of money. So these elements of costs are included in explicit cost. Implicit costs: It includes all elements of costs that are essential for production, but no monetary payment is needed for them. Accountants will not consider them as cost. But economists will consider the opportunity cost of such factors as an element of total cost. Let us consider: Example: Mr. X a businessman owns a house where he can reside or can lend to outsiders at $50,000. He decided to use the building for his business work. Here Mr. X will not charge any rent on business since the business is also owned by him. So no money outflow will take place from business for using the house. It is an implicit cost of using the house. At the time of calculation of profit, Accountant considers only explicit costs against which money payment is required. But Economists consider both explicit cost and implicit costs in the total cost. Hence the profit under two concepts will differ. In the previous example, notional rent of the house owned by businessman will be included in total economic cost. Normal profit is also opportunity cost or notional cost of organizers service. So it is also included in economic profit. But it is not considered by accountant. The difference can be highlighted by the following assumed example: Situation with zero economic profit: A firm will continue its business even when the economic profit is zero. Here zero profit does not mean the firm is not making any profit. Total cost in economics includes normal profit which is considered as opportunity cost of using the service of organizer. Thus zero economic profit will mean only normal profit has been earned. If accountants profit is zero, then profit in real sense is zero. Normal profit is not earned. Hence firm owner may decide to discontinue its business.
a. In economics Sunk cost is very important concept. It is the cost which has already been incurred. Whatever be the current decision, sunk cost cannot be recovered. Once it has been incurred it cannot be reversed. This type of cost will never affect the current decision making process. Payment of $400 for economic course is a sunk cost. It cannot be recovered. Therefore, current decision of attending lecture on economics will not be affected by the past action of course payment. Utility derived from the lecture attainment is the focal point of taking decision. If utility is positive, lecture can be attended. When the lecture is useless and boring, it will not generate any positive satisfaction to the student. Hence he will not attend the lecture. b. Owning of house instead of taking it on rent does not mean it has no cost. Consider that a firm has taken a house on rent for undertaking production activity. Then it has to pay rent to the house owner on regular basis. There will be cash outflow. Accountant will enter such cash flow in accounting record as an element of cost. It is known as explicit cost. Instead of taking on rent, the house can be purchased and used for production activity. No rent is to be paid for owned house on regular basis. So there will not be any cash flow and accountant will not show any cost against that house. In order to ascertain true cost of production, it is necessary to include the equivalent cost of factors used in the production. Therefore it is necessary to ascertain, the rent that should be paid if a house equivalent to the owned one, is taken on rent in the same locality. Further money has been spent for buying the house. If it is not purchased, then the money can be invested in best available alternative opportunity and some income is earned. It is the opportunity cost of money invested in the house. If notional rent is not ascertainable, then the opportunity cost of invested money is taken as cost of using the house for production. c. On purchase of 100 shares at market price, money has been spent. It cannot be reversed. Such spending is known as sunk cost. It will not affect the current decision making process. At present, market price is lower than the purchase price of stock. Therefore invested money can be recovered only when market position changes. If the possibility of market reversal in near future is remote, then it is useless to wait for recovery of the market. Substantial time will elapse in the process of such waiting. Instead stock may be sold at current market price and amount can be reinvested in better alternative investment opportunities. In this process he may gain substantial amount. Also it should be remembered that stock market helps in proper allocation of scarce resources to the best alternative investment opportunity. If the price of the share purchased is falling, it will mean the future prospect of the company is bleak. So investor should sell it immediately and divert the fund in a more profitable share where market price is expected to go up. It will help the economy to maximize growth through best possible use of scarce resources. d. Private education is costly while private schooling is free. It does not mean that public education is always preferred than private education. Education is a service. With the help of education, a student will enhance his knowledge base, and make himself ready for employment. Whether he will get better job or not will depend upon the quality of knowledge he has acquired. By acquiring better knowledge from private education, he can get better job. His income will be substantially high from better employment. If he earns more, he can consume better and can get more satisfaction. Thus the selection of a method of education will depend upon consumer's surplus. It is the excess of utility received over the price paid for the service. If consumer's surplus of private education is higher than the consumer's surplus from public education, it is better to select private education, although it is costly.
Total cost implies the total money value of factors employed in the production of bicycle. It can be of two types. They are- 1. Explicit cost: It includes all items against which payment is required. 2. Implicit cost: It consists of factors against which no payment is made. Accounting statement includes only those items of costs against which some cash outflow is required. It is not necessary that cash outflow is needed immediately on its incurrence. It may be required after a certain period of time. Thus only explicit items of costs are included in accounting statement. Factors of implicit nature can be valued on the basis of opportunity cost. It is the cost of putting the factors in best possible alternative use. Accounting statement will not include opportunity costs of such implicit factors. Their inclusion is a must to make correct estimates of cost of bicycle. Following opportunity costs will not come in the accounting statement. 1. Factors owned by proprietor: Some factors used in cycle manufacture may belong to the owner of the bicycle firm. He will not charge any price for those factors. As per accountant, they are not included in accounting statement as the payment or cash outflow is not required. In order to make a proper estimate of the cost of bicycle, notional value of such factors should be estimated and included in cost. Here notional value will mean the opportunity cost. It is the cost of factors when they are put to alternative use. 2. Proprietors fund used in the firm: Another important item is opportunity cost of proprietor's fund. Owner has employed some money in the business as capital. He will not charge any interest for such capital. So it will not appear in the accounting statement. If this fund is invested in some other alternative opportunity then proprietor can earn some interest. This amount should be included if the firm wants to make a rational estimates of cost of producing bicycles. 3. Service of the proprietor: Finally consider the service of owner. If instead of running the firm he worked in some other best available opportunity, then he could have earned some money for his service. It is the opportunity cost which will not be included in accounting statement but should be considered as cost of bicycle in economics. Current decision: Any decision taken by the bicycle firm should be based on the total cost of factors used in the manufacturing process. It will include actual money value of explicit items plus opportunity cost or notional value of implicit items. Accounting statement does not include notional value of implicit item. Hence it will not be considered for decision making purpose. Economic cost includes all such items that explicit and implicit in nature. It will be used for decision making purpose.