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By the end of this section, you will be able to:

  • Explain the difference between explicit costs and implicit costs
  • Understand the relationship between cost and revenue

Private enterprise , the ownership of businesses by private individuals, is a hallmark of the U.S. economy. When people think of businesses, often giants like Wal-Mart, Microsoft, or General Motors come to mind. But firms come in all sizes, as shown in [link] . The vast majority of American firms have fewer than 20 employees. As of 2010, the U.S. Census Bureau counted 5.7 million firms with employees in the U.S. economy. Slightly less than half of all the workers in private firms are at the 17,000 large firms, meaning they employ more than 500 workers. Another 35% of workers in the U.S. economy are at firms with fewer than 100 workers. These small-scale businesses include everything from dentists and lawyers to businesses that mow lawns or clean houses. Indeed, [link] does not include a separate category for the millions of small “non-employer” businesses where a single owner or a few partners are not officially paid wages or a salary, but simply receive whatever they can earn.

(Source: U.S. Census, 2010 www.census.gov)
Range in size of u.s. firms
Number of Employees Firms (% of total firms) Number of Paid Employees (% of total employment)
Total 5,734,538 112.0 million
0–9 4,543,315 (79.2%) 12.3 million (11.0%)
10–19 617,089 (10.8%) 8.3 million (7.4%)
20–99 475,125 (8.3%) 18.6 million (16.6%)
100–499 81,773 (1.4%) 15.9 million (14.2%)
500 or more 17,236 (0.30%) 50.9 million (49.8%)

Each of these businesses, regardless of size or complexity, tries to earn a profit:

Profit = Total Revenue – Total Cost

Total revenue    is the income brought into the firm from selling its products. It is calculated by multiplying the price of the product times the quantity of output sold:

Total Revenue = Price × Quantity

We will see in the following chapters that revenue is a function of the demand for the firm’s products.

We can distinguish between two types of cost: explicit and implicit. Explicit costs are out-of-pocket costs, that is, payments that are actually made. Wages that a firm pays its employees or rent that a firm pays for its office are explicit costs. Implicit costs are more subtle, but just as important. They represent the opportunity cost of using resources already owned by the firm. Often for small businesses, they are resources contributed by the owners; for example, working in the business while not getting a formal salary, or using the ground floor of a home as a retail store. Implicit costs also allow for depreciation of goods, materials, and equipment that are necessary for a company to operate. (See the Work it Out feature for an extended example.)

These two definitions of cost are important for distinguishing between two conceptions of profit, accounting profit and economic profit. Accounting profit is a cash concept. It means total revenue minus explicit costs—the difference between dollars brought in and dollars paid out. Economic profit is total revenue minus total cost, including both explicit and implicit costs. The difference is important because even though a business pays income taxes based on its accounting profit, whether or not it is economically successful depends on its economic profit.

Calculating implicit costs

Consider the following example. Fred currently works for a corporate law firm. He is considering opening his own legal practice, where he expects to earn $200,000 per year once he gets established. To run his own firm, he would need an office and a law clerk. He has found the perfect office, which rents for $50,000 per year. A law clerk could be hired for $35,000 per year. If these figures are accurate, would Fred’s legal practice be profitable?

Step 1. First you have to calculate the costs. You can take what you know about explicit costs and total them:

Office rental :    $50,000 Law clerk's salary : +$35,000 ____________ Total explicit costs :    $85,000

Step 2. Subtracting the explicit costs from the revenue gives you the accounting profit.

Revenues : $200,000 Explicit costs : –$85,000 ____________ Accounting profit : $115,000

But these calculations consider only the explicit costs. To open his own practice, Fred would have to quit his current job, where he is earning an annual salary of $125,000. This would be an implicit cost of opening his own firm.

Step 3. You need to subtract both the explicit and implicit costs to determine the true economic profit:

Economic profit = total revenues – explicit costs – implicit costs = $200,000 – $85,000 – $125,000 = –$10,000 per year

Fred would be losing $10,000 per year. That does not mean he would not want to open his own business, but it does mean he would be earning $10,000 less than if he worked for the corporate firm.

Implicit costs can include other things as well. Maybe Fred values his leisure time, and starting his own firm would require him to put in more hours than at the corporate firm. In this case, the lost leisure would also be an implicit cost that would subtract from economic profits.

Now that we have an idea about the different types of costs, let’s look at cost structures. A firm’s cost structure in the long run may be different from that in the short run. We turn to that distinction in the next section.

Key concepts and summary

Privately owned firms are motivated to earn profits. Profit is the difference between revenues and costs. While accounting profit considers only explicit costs, economic profit considers both explicit and implicit costs.

Problems

A firm is considering an investment that will earn a 6% rate of return. If it were to borrow the money, it would have to pay 8% interest on the loan, but it currently has the cash, so it will not need to borrow. Should the firm make the investment? Show your work.

Got questions? Get instant answers now!

References

2010 U.S. Census. www.census.gov.

Questions & Answers

what is equilibrium
Daniel Reply
it is intersect point of economics line in graph, but everytime not graph
Ahmet
it is the intersection point of supply and demand curves
tesfie
GDP is domestic gross product. refer my site amanchabukswar.wordpress.com
Aman Reply
Hi everyone
AWOYEMI
hello lovely where am I?
Becky
Good morning
AWOYEMI
morning
Daniel
hi dear bro
tesfie
why does a firm continue operating at a breakeven point
Prince Reply
to retain its customers for later coming profits.
tesfie
this is because the firm's revenu is covering the variable cost so the firm should continuos business
Florencia
and zero profit is a normal profit which covers entrepreneur's profit along with recovering wages, interest and rent.
Farooq
what economic trend can we expect after lifting of 10 year long sanctions in an national economy?
tesfie Reply
difference between change in demand and change in quantity demanded
Maurice Reply
how
kumar
how to change
kumar
For a demand with repect to price. change in demand refers to the shifting of demand curve, where as change in quantity demanded means movement along the given demand curve.
Farooq
According to lional Robbins how did he explain economics
Raphael Reply
He defined economics as a science which studies human behavior as a relationship between ends and scares which has alternative uses.
Emmanuel
What is economics
Nasiru Reply
why are some countries producing inside the ppf
Claire Reply
prove or disprove that balance of trade of trade deficit is a cause of an abnormal demand curve?
Chioma Reply
what's the fixed cost at output zero
Saidou Reply
fixed cost stay the same regardless of the level of output
Luka
what are the differences between change in demand and change in quantity demand
Sulaiman Reply
what is consumers behaviour
Marfo Reply
importance of income
Emmanuel Reply
Tfor settlement of debt. For purchases. For payment of bills. For daily transactions. For social & recreational enjoyment. For business purposes etc
Oyetunde
thanks
Emmanuel
For investment purposes For security purposes For purpose of forecasting & strategizing.
Oyetunde
what is the real definition of economics
jegede Reply
Economics is the study of the use and allocation of (scarce) resources
demsurf
Jegede, what is the "non" real definition of economics then?
Ernest
Economics is a study of how human use limited resources to fulfil their unlimited want
Musa
the study of how a society use scarce factors of production efficiently so as meet aggregate social demand
Marc
what is oligopoly?
Sailo
Oligopoly can be defines as a market where by there is only tmo or more sellers of a commodity
Paamat
Sory not tmo but two
Paamat
incidence of production there is a choice do you agree? justify
Oduro Reply
What is incidence of production? do u mean incidence of tax?
Aryeetey

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Source:  OpenStax, Principles of economics. OpenStax CNX. Sep 19, 2014 Download for free at http://legacy.cnx.org/content/col11613/1.11
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