-------------Chapter 4- Business Behaviour: The Cost of Production-------
ECONOMIC COSTS
Economic costs exist because resources are SCARCE and have ALTERNATIVE USES. This means that every time we
chaos to use a resource in one way, we give up the opportunity to use it in another way.
Example:
Imagine you have R500 to spend. You can either:
Buy a gym membership for the month OR Go out with your friends every weekend.
If you choose the gym membership, you give up the ability to go out with your friends. The cost of this decision is
the value of the alternative you gave up. This is called opportunity cost.
Key Definitions (Recap):
What is an Economic Cost? A payment that must be made to obtain and retain the services of a resource supplier
to attract the resource away from an alternative use.
What is an Opportunity Cost? The value of the next best alternative forgone when making a choice.
EXPLICIT VS. IMPLICIT COSTS
Payments to resource suppliers are EXPLICIT (revealed and expressed) or IMPLICIT (present but not obvious). So in
producing products, firms incur EXPLICIT COSTS and IMPLICIT COSTS.
(1) Explicit Costs
The monetary payment a firm must make to an outsider to obtain a resource.
In simpler terms: Actual money payments made for goods and services.
Example: A business paying wages, rent and raw materials. These are visible and recorded in accounting.
(2) Implicit Costs
The monetary income a firm sacrifice when it uses a resource it owns rather than supplying the resource in
the market. It is equal to what the resources could have earned in the best-paying alternative employment. It
includes a NORMAL PROFIT.
In simpler terms: The opportunity cost of using resources owned by the firm instead of renting them out or
using them elsewhere.
Example: If you own a shop, instead of renting it out for R10,000 per month, you use it for your own
business. The implicit cost is the R10,000 rental income you gave up.
Key Takeaway: Total Economic Cost= Explicit Cost + Implicit Cost
,Normal Profit as a Cost
The payment you could otherwise receive for performing entrepreneurial functions is indeed an IMPLICIT COST.
What is a normal profit?? The payment made by a firm to obtain and retain ENTREPRENEURIAL ABILITY. It is the
minimum income entrepreneurial ability must receive to induce it to perform entrepreneurial functions for a firm.
Economic Profit
What is Economic Profit? The total revenue of a firm less its economic costs (which includes explicit costs and
implicit costs). It is also called “pure profit” and “above-normal profit”.
In simpler terms: This is the real profit that considers all costs, including opportunity costs.
What is the formula for calculating the economic profit?
𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − (𝐸𝑥𝑝𝑙𝑖𝑐𝑖𝑡 𝐶𝑜𝑠𝑡𝑠 + 𝐼𝑚𝑝𝑙𝑖𝑐𝑖𝑡 𝐶𝑜𝑠𝑡𝑠)
If economic profit is ZERO, it means the firm is covering all its costs, including the OPPORTUNITY COST of running
the business instead of doing something else.
EXAMPLE
Running a T-shirt Store
Let's say you were earning R80,000 per year as an Economist. One day, you decide to quit your job and open a T-
shirt store.
Your store’s financials:
Total Sales Revenue = R350,000
Cost of T-shirts = R80,000
Clerk’s Salary = R54,000
Utilities (Water & Electricity) = R16,000
Total Explicit Costs = R150,000
Accounting Profit = R200,000 (Revenue - Explicit Costs)
Now let’s consider the hidden (implicit) costs:
Forgone salary (you quit your job) = R80,000
Forgone rental income (if you owned the shop) = R45,000
Forgone interest on savings (if you invested R70,000 elsewhere) = R7,000
Forgone entrepreneurial income = R30,000
Total Implicit Costs = R162,000
ECONOMIC PROFIT CALCULATION:
ECONOMIC PROFIT = TOTAL REVENUE - (EXPLICIT + IMPLICIT COSTS)
= R350,000 - (R150,000 + R162,000)
= R38,000
Key Takeaway: Even if accounting profit is high (R200,000), economic profit considers the real opportunity cost
and shows whether the business is profitable compared to the best alternative.
, Short Run Vs. Long Run
In Economics, businesses operate in two time frames.
(1) SHORT RUN (FIXED PLANT)
In MICROECONOMICS, it is a period in which producers can change the quantities of some but not all of
the resources they employ.
Some inputs (like factory size) are FIXED, while others (like labour) are VARIABLE.
In MACROECONOMICS, it is a period in which NOMINAL WAGES and other INPUT PRICES do not change in
response to a change in the price level.
In simpler terms: Some inputs are fixed while others can change.
Example: a bakery can hire more workers to bake more bread, but it cannot expand its shop overnight.
(2) LONG RUN (VARIABLE PLANT)
In MICROECONOMICS, it is a period long enough to enable producers of a product to change the quantities
of all the resources they employ.
It is a period in which all resources are VARIABLE, and no resources or costs are FIXED.
In MACROECONOMICS, it is a period sufficiently long for NOMINAL WAGES and other input prices to
change in response to a change in the nation’s PRICE LEVEL.
In simpler terms: All inputs can change, including factory size, number of machines, etc.
Example: A bakery can build a bigger factory to produce more bread,
Example
If Tiger Brands hires extra workers to increase cereal production → Short run adjustment.
If it builds a new factory → Long run adjustment.
REVIEW: IN THE SHORT RU, A FIRM’S PLANT CAPACITY IS FIXED. IN THE ONG RUN, A FIRM CAN VARY ITS PLANT SIZE
AND FIRMS CAN ENTER OR LEAVE THE INDUSTRY.
ECONOMIC COSTS
Economic costs exist because resources are SCARCE and have ALTERNATIVE USES. This means that every time we
chaos to use a resource in one way, we give up the opportunity to use it in another way.
Example:
Imagine you have R500 to spend. You can either:
Buy a gym membership for the month OR Go out with your friends every weekend.
If you choose the gym membership, you give up the ability to go out with your friends. The cost of this decision is
the value of the alternative you gave up. This is called opportunity cost.
Key Definitions (Recap):
What is an Economic Cost? A payment that must be made to obtain and retain the services of a resource supplier
to attract the resource away from an alternative use.
What is an Opportunity Cost? The value of the next best alternative forgone when making a choice.
EXPLICIT VS. IMPLICIT COSTS
Payments to resource suppliers are EXPLICIT (revealed and expressed) or IMPLICIT (present but not obvious). So in
producing products, firms incur EXPLICIT COSTS and IMPLICIT COSTS.
(1) Explicit Costs
The monetary payment a firm must make to an outsider to obtain a resource.
In simpler terms: Actual money payments made for goods and services.
Example: A business paying wages, rent and raw materials. These are visible and recorded in accounting.
(2) Implicit Costs
The monetary income a firm sacrifice when it uses a resource it owns rather than supplying the resource in
the market. It is equal to what the resources could have earned in the best-paying alternative employment. It
includes a NORMAL PROFIT.
In simpler terms: The opportunity cost of using resources owned by the firm instead of renting them out or
using them elsewhere.
Example: If you own a shop, instead of renting it out for R10,000 per month, you use it for your own
business. The implicit cost is the R10,000 rental income you gave up.
Key Takeaway: Total Economic Cost= Explicit Cost + Implicit Cost
,Normal Profit as a Cost
The payment you could otherwise receive for performing entrepreneurial functions is indeed an IMPLICIT COST.
What is a normal profit?? The payment made by a firm to obtain and retain ENTREPRENEURIAL ABILITY. It is the
minimum income entrepreneurial ability must receive to induce it to perform entrepreneurial functions for a firm.
Economic Profit
What is Economic Profit? The total revenue of a firm less its economic costs (which includes explicit costs and
implicit costs). It is also called “pure profit” and “above-normal profit”.
In simpler terms: This is the real profit that considers all costs, including opportunity costs.
What is the formula for calculating the economic profit?
𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − (𝐸𝑥𝑝𝑙𝑖𝑐𝑖𝑡 𝐶𝑜𝑠𝑡𝑠 + 𝐼𝑚𝑝𝑙𝑖𝑐𝑖𝑡 𝐶𝑜𝑠𝑡𝑠)
If economic profit is ZERO, it means the firm is covering all its costs, including the OPPORTUNITY COST of running
the business instead of doing something else.
EXAMPLE
Running a T-shirt Store
Let's say you were earning R80,000 per year as an Economist. One day, you decide to quit your job and open a T-
shirt store.
Your store’s financials:
Total Sales Revenue = R350,000
Cost of T-shirts = R80,000
Clerk’s Salary = R54,000
Utilities (Water & Electricity) = R16,000
Total Explicit Costs = R150,000
Accounting Profit = R200,000 (Revenue - Explicit Costs)
Now let’s consider the hidden (implicit) costs:
Forgone salary (you quit your job) = R80,000
Forgone rental income (if you owned the shop) = R45,000
Forgone interest on savings (if you invested R70,000 elsewhere) = R7,000
Forgone entrepreneurial income = R30,000
Total Implicit Costs = R162,000
ECONOMIC PROFIT CALCULATION:
ECONOMIC PROFIT = TOTAL REVENUE - (EXPLICIT + IMPLICIT COSTS)
= R350,000 - (R150,000 + R162,000)
= R38,000
Key Takeaway: Even if accounting profit is high (R200,000), economic profit considers the real opportunity cost
and shows whether the business is profitable compared to the best alternative.
, Short Run Vs. Long Run
In Economics, businesses operate in two time frames.
(1) SHORT RUN (FIXED PLANT)
In MICROECONOMICS, it is a period in which producers can change the quantities of some but not all of
the resources they employ.
Some inputs (like factory size) are FIXED, while others (like labour) are VARIABLE.
In MACROECONOMICS, it is a period in which NOMINAL WAGES and other INPUT PRICES do not change in
response to a change in the price level.
In simpler terms: Some inputs are fixed while others can change.
Example: a bakery can hire more workers to bake more bread, but it cannot expand its shop overnight.
(2) LONG RUN (VARIABLE PLANT)
In MICROECONOMICS, it is a period long enough to enable producers of a product to change the quantities
of all the resources they employ.
It is a period in which all resources are VARIABLE, and no resources or costs are FIXED.
In MACROECONOMICS, it is a period sufficiently long for NOMINAL WAGES and other input prices to
change in response to a change in the nation’s PRICE LEVEL.
In simpler terms: All inputs can change, including factory size, number of machines, etc.
Example: A bakery can build a bigger factory to produce more bread,
Example
If Tiger Brands hires extra workers to increase cereal production → Short run adjustment.
If it builds a new factory → Long run adjustment.
REVIEW: IN THE SHORT RU, A FIRM’S PLANT CAPACITY IS FIXED. IN THE ONG RUN, A FIRM CAN VARY ITS PLANT SIZE
AND FIRMS CAN ENTER OR LEAVE THE INDUSTRY.
