Civil Engineering Reference
In-Depth Information
entrepreneurs are stupid: they may be willing to pay for the non-pecuniary benefits
of being the boss.
We have only considered the opportunity cost of capital and the opportunity
cost of labour, but the concept applies to all inputs. Whatever the input, its
opportunity cost must be taken into account when figuring out true economic
profits. Another way of looking at the opportunity cost of running a business is
that opportunity cost consists of all explicit (direct) and implicit (indirect) costs.
Accountants only take account of explicit costs. Therefore, accounting profit ends
up being the residual after explicit costs are subtracted from total revenues.
The term profits in economics means the income that entrepreneurs earn over
and above their own opportunity cost of time, plus the opportunity cost of the
capital they have invested in their business. Profits can be regarded as total revenues
minus total costs - which is how the accountants think of them - but economists
include all costs. We indicate this relationship in
Figure 7.1
.
The Goal of the Firm
In developing a model of the firm, we will generally assume that the main business
goal is maximisation of profits. In other words, a firm's goal is to make the positive
difference between total revenues and total cost as large as it can. We use this
profit-maximising model
because it allows us to analyse a firm's behaviour with
respect to the relationship between costs and units of output. Whenever this model
produces poor predictions, we will examine our initial assumption about profit
maximisation. We might have to conclude that the primary goal of some firms is
not to maximise profits but rather to maximise sales, or the number of workers,
or the prestige of the owners, and so on. However, we are primarily concerned
with generalisations. Therefore, providing the assumption of profit maximisation is
correct for most firms, the model serves as a good starting point.
Key Points 7.1
❍
A firm is any organisation that brings together production inputs in order
to produce a good or service that can be sold for a profit.
❍
Accounting profits differ from economic profits.
❍
Economic profits are defined as total revenues minus total costs, including
the full opportunity cost of all the factors of production.
❍
Small businesses and self-employed workers often fail to consider the
opportunity cost of the labour services provided by the owner.
❍
The full opportunity cost of capital invested in a business is generally not
included as a cost when accounting profits are calculated. Thus, accounting
profits overstate economic profits.
❍
Profit maximisation is regarded as the main objective when considering a
firm's behaviour.
