Profit - opportunity costs including implicit costs and explicit costs, the difference between economic and accounting costs, economic profit, economic losses, and zero economic profit ---
- Matthew Gray
Profit - Total revenue minus total cost.
Maximum Profit - P=MR=MC
Opportunity Cost - The cost of the explicit and implicit resources that are forgone when a decision is made.
Implicit Costs - Costs with no directly measurable value. For example the cost of time spent running a business versus what someone else may have paid you, or the forgone rent that could have been paid for a facility rather than using it for a business. The cost of attending college versus gaining employment.
Explicit Costs - Accounting costs, or direct measurable costs.
Accounting Costs -The total amount of money taken in from sales (Total revenue, or price times quantity solid) minus the dollar cost of producing goods or services. Accounting profits are what shows up on a firms income statement, and are typically reported to the manager by the firms accounting department.
Economic Profit - The difference between total revenue and total opportunity cost of producing a firms good or service. Price > ATC
Zero Economic Profit - No difference between total revenue and total opportunity cost of producing a firms good or service. Price = ATC
Concerning Opportunity Costs:
Opportunity costs can be considered as what could have been earned if another course of action was taken. For example, one would have to consider the opportunity costs of accepting a short term, good profit customer, versus taking on a more long term lower earning customer that may bring on more projects in the future. If you take the short run customer, your opportunity costs would be the the loss of future projects (high implicit costs) over the course of the next few years. However, you're need for immediate cash flow (high explicit costs) in the short run may out way your long run needs, so you could very well decided to stick with the short run customer once you've considered both your implicit and explicit opportunity costs. Be careful you are sure to cover all implicit costs of working with a particular customer. Anyone who's worked in industry knows that there are just certain customers that are going to need a lot more hand holding then others. The time these customers take in meetings, quality reviews, and engineering reviews are your implicit costs, and should be considered when taking on these types of customers. Put simply, when you add value to the time you are spending with them, are they worth the trouble?
Explicit Costs:
Explicit costs are very straight forward. These costs are what your account department considers, anything with a directly quantifiable value. Some examples would be rents, payroll, or material costs.
An interesting article discussing the implications of economic loss and the law:
When making short term and long term competitive decisions firms will need to consider economic profits and losses. When a firm is making economic profits, it will face competition from new firms entering the market. New firms will force price to go down and drive competition, eventually some firms will begin to see economic loss. When a firm is seeing economic losses, it, or other firms will begin exiting the market. Because of this competitive marketplace, in the long run, firms will see zero economic profit. In the short run, firms will consider strategies to reflect current market conditions, they may change plant size, enter a market, or exit a market.
I've been spending most of my time since the last post considering two topics in particular; opportunity cost, and economic costs. While listening to a story on NPR regarding the Solindra mess, I began to think about the renewable energy market in total. What price points the technologies are going to have to break? What infrastructure changes are going to be required? What, if any subsidies should we provide? A big question that struck me is, are we paying enough for the energy we currently consume, that is, are we considering our opportunity costs. When looking at the price we pay for a gallon of gas, we pay the market price, based on futures, build on top of the cost of extracting and processing the oil, and finally taxes. What we don't take into consideration are many of the opportunity costs of the gasoline. The time and effort we spend securing our sources over seas, the environmental harm from disasters and spills, and our global impact in CO2 emissions and global warming. We also heavily subsidies the current oil industry in their rent for deep see platforms to exploration costs. That led me into my next question, some of these costs are very real, and aren't we already paying for them in our taxes? The answer to that was, a little, yes, and not really. I say, a little, yes because ultimately, we do have to pay for our overseas military and diplomatic activities, but currently we are bankrolling these costs into ever higher and higher debt burdens, rather than paying them off. One might argue than that in taking such action, the opportunity costs of not securing those sources would be higher than what it would be securing them. I say not really because we do not pay for the cost in environmental damage we cause in pursuit of our resources. The reason we don't is because we aren't seeing the affects yet. Humans are terrible about realizing long term threats, but excellent at addressing short term ones. Once our actions begin to have a direct impact on our lives and environment, things will likely start to change. In some places, such as Britain where there is a CO2 tax on cars, they are already beginning to address the unaccounted for costs of our activities. At this point I do not have hard numbers put together, but I can comfortably wager that the economic costs of securing our over seas oil is in the hundreds of billions. As consumers, we need to recognize our opportunity costs, we are spending hundreds of billions of dollars in securing off shore sources of energy, versus spending and subsidizing hundreds of billions of dollars on lower economic cost sources of energy.
This week I would like to take a better look at profits earned by oil companies and how price drivers in crude oil influence those profits. Primarily, I think there are many misconceptions about how these companies are earning their profits, and why they were earning record profits prior to the 2008 recession, and again, now that the markets have recovered. First, we should understand that these companies operate with relatively fixed production costs per unit of output, so an increase in demand with a limited supply, while pushing prices up, also adds extra revenue for every additional gallon of gasoline sold. Exxon is also citing a reduction in fixed costs during the 3rd qrt 2011, so this will also attribute to an increase in profits. They also site increased world wide demand as another contributing factor. Looking back at 2008, we can also see what affect speculation in the crude oil market can have on profits for oil companies. Investors were seeing the beginning of the recession in 2008 and, and seeking a safe haven, turned to oil. Speculative purchases on oil sent the price soaring up to $145 a barrel at its peak, and naturally, oil companies were setting record setting profits. Of course this was short lived as we all will recall the market crash later in October of that year, sending the world into a deep recession. But something interesting had begun happened before the crash, once the price of gasoline breached $4 a gallon, Americans actually began to change their driving habits (explicit costs of gasoline were now leading consumers to zero or negative economic profit in their purchase), and reduced the amount of oil we were consuming as a nation. It wasn't much, but that reduction combined with the unwinding of the inflated futures market send the price of oil plummeting over the curse of the next year. This should serve as a reminder of how inelastic a good gasoline is, in that even a small shift in demand can have drastic affects on supply and cost.
1. Which of the following would be considered an implicit cost? A) Earnings that could have been gained going directly into the work force rather than going to college. B) The cost of tools needed to pursue another job. C) Cost of seeds used to grow a crop. D) Rent.
2. What might a producer consider when seeing accounting profits, but economic losses? A) Drop out of production. B) Continue with no operational changes. C) Continue production but find methods to reach economics profits or at lease zero economic profit. D) Get a new Accountant.
3. When a Consumer changes driving habits because of high gas prices, what is he considering? A) Opportunity Costs B) Accounting Costs C) Economic Profit D) Cheese Cake
4. Which of the following would be an explicit cost? A) Equipment B) Accounting Costs C) Economic Profit D) Future losses
5. A farmers accounting cost of making wheat is $40. He produced 20 bushels and sold them for $5 each. He spent 3, 8 hours days producing the wheat. A Local restaurant is willing to hire the farmer for $5 and hour. Should the farmer take the offer? A) Yes B) No
Answers: 1. A: Possible earnings from pursuing another activity is the only opportunity cost that cannot be accurately quantify.
2. C: While A may be the answer in the long run, the producer can continue to operate with accounting profits, but will stop if he can not make the operation more profitable than what it would be to pursue other opportunities.
3. A: If a consumer changes buying habits for gasoline because the price is high, he is considering what else he could be spending the money on, or what other opportunities he could be pursuing other than buying gas.
4. A: Equipment is a directly measurable cost, while accounting costs are explicit costs, in this instance, they are not an explicit cost.
5. A: In this problem, the farmer will make a profit of $100 selling his crop. If he would have worked for the restaurant, he would have earned $120. If he includes his opportunity costs, he is at an economic loss, and would be better off working for the restaurant.
Bibliography:
Baye, Michael Managerial Economics & Business Strategy. New York: McGraw-Hill, 2010.
Colander, David C. Economics: Middlebury College: McGraw-Hill, 2010.
- Matthew Gray
Profit - Total revenue minus total cost.
Maximum Profit - P=MR=MC
Opportunity Cost - The cost of the explicit and implicit resources that are forgone when a decision is made.
Implicit Costs - Costs with no directly measurable value. For example the cost of time spent running a business versus what someone else may have paid you, or the forgone rent that could have been paid for a facility rather than using it for a business. The cost of attending college versus gaining employment.
Explicit Costs - Accounting costs, or direct measurable costs.
Accounting Costs -The total amount of money taken in from sales (Total revenue, or price times quantity solid) minus the dollar cost of producing goods or services. Accounting
profits are what shows up on a firms income statement, and are typically reported to the manager by the firms accounting department.
Economic Profit - The difference between total revenue and total opportunity cost of producing a firms good or service. Price > ATC
http://www.discusseconomics.com
Economic Losses - When total opportunity costs exceed total revenue. Price < ATC
http://www.discusseconomics.com
Zero Economic Profit - No difference between total revenue and total opportunity cost of producing a firms good or service. Price = ATC
Concerning Opportunity Costs:
Opportunity costs can be considered as what could have been earned if another course of action was taken. For example, one would have to consider the opportunity costs of accepting a short term, good profit customer, versus taking on a more long term lower earning customer that may bring on more projects in the future. If you take the short run customer, your opportunity costs would be the the loss of future projects (high implicit costs) over the course of the next few years. However, you're need for immediate cash flow (high explicit costs) in the short run may out way your long run needs, so you could very well decided to stick with the short run customer once you've considered both your implicit and explicit opportunity costs. Be careful you are sure to cover all implicit costs of working with a particular customer. Anyone who's worked in industry knows that there are just certain customers that are going to need a lot more hand holding then others. The time these customers take in meetings, quality reviews, and engineering reviews are your implicit costs, and should be considered when taking on these types of customers. Put simply, when you add value to the time you are spending with them, are they worth the trouble?
Explicit Costs:
Explicit costs are very straight forward. These costs are what your account department considers, anything with a directly quantifiable value. Some examples would be rents, payroll, or material costs.
An interesting article discussing the implications of economic loss and the law:
http://www.hughesnassociates.com/articles/TH/MM/economic_loss.htm
An excellent analysis off the economics of Mexico's drug war, and rather fighting it is worth cost:
http://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=2&ved=0CCEQFjAB&url=http%3A%2F%2Fwww-old.gov.harvard.edu%2Fstudent%2Frios%2FMexicanDrugMarket_Riosv2.doc&ei=_Em3Tp73MaPm0QGHs9HRBw&usg=AFQjCNFbq-goC75ieInetM5AAsDsyQtOzQ&sig2=dBEIUBJyXWcfbATQkg3Spw
Economic Profit / Loss and Decision Making:
When making short term and long term competitive decisions firms will need to consider economic profits and losses. When a firm is making economic profits, it will face competition from new firms entering the market. New firms will force price to go down and drive competition, eventually some firms will begin to see economic loss. When a firm is seeing economic losses, it, or other firms will begin exiting the market. Because of this competitive marketplace, in the long run, firms will see zero economic profit. In the short run, firms will consider strategies to reflect current market conditions, they may change plant size, enter a market, or exit a market.
I've been spending most of my time since the last post considering two topics in particular; opportunity cost, and economic costs. While listening to a story on NPR regarding the Solindra mess, I began to think about the renewable energy market in total. What price points the technologies are going to have to break? What infrastructure changes are going to be required? What, if any subsidies should we provide? A big question that struck me is, are we paying enough for the energy we currently consume, that is, are we considering our opportunity costs. When looking at the price we pay for a gallon of gas, we pay the market price, based on futures, build on top of the cost of extracting and processing the oil, and finally taxes. What we don't take into consideration are many of the opportunity costs of the gasoline. The time and effort we spend securing our sources over seas, the environmental harm from disasters and spills, and our global impact in CO2 emissions and global warming. We also heavily subsidies the current oil industry in their rent for deep see platforms to exploration costs. That led me into my next question, some of these costs are very real, and aren't we already paying for them in our taxes? The answer to that was, a little, yes, and not really. I say, a little, yes because ultimately, we do have to pay for our overseas military and diplomatic activities, but currently we are bankrolling these costs into ever higher and higher debt burdens, rather than paying them off. One might argue than that in taking such action, the opportunity costs of not securing those sources would be higher than what it would be securing them. I say not really because we do not pay for the cost in environmental damage we cause in pursuit of our resources. The reason we don't is because we aren't seeing the affects yet. Humans are terrible about realizing long term threats, but excellent at addressing short term ones. Once our actions begin to have a direct impact on our lives and environment, things will likely start to change. In some places, such as Britain where there is a CO2 tax on cars, they are already beginning to address the unaccounted for costs of our activities.
At this point I do not have hard numbers put together, but I can comfortably wager that the economic costs of securing our over seas oil is in the hundreds of billions. As consumers, we need to recognize our opportunity costs, we are spending hundreds of billions of dollars in securing off shore sources of energy, versus spending and subsidizing hundreds of billions of dollars on lower economic cost sources of energy.
More to come.
A good article addressing more on this topic:
http://www.cbsnews.com/2100-215_162-6767046.html?tag=contentMain;contentBody
NOVEMBER 27TH 2011:
This week I would like to take a better look at profits earned by oil companies and how price drivers in crude oil influence those profits. Primarily, I think there are many misconceptions about how these companies are earning their profits, and why they were earning record profits prior to the 2008 recession, and again, now that the markets have recovered.
First, we should understand that these companies operate with relatively fixed production costs per unit of output, so an increase in demand with a limited supply, while pushing prices up, also adds extra revenue for every additional gallon of gasoline sold. Exxon is also citing a reduction in fixed costs during the 3rd qrt 2011, so this will also attribute to an increase in profits. They also site increased world wide demand as another contributing factor. Looking back at 2008, we can also see what affect speculation in the crude oil market can have on profits for oil companies. Investors were seeing the beginning of the recession in 2008 and, and seeking a safe haven, turned to oil. Speculative purchases on oil sent the price soaring up to $145 a barrel at its peak, and naturally, oil companies were setting record setting profits. Of course this was short lived as we all will recall the market crash later in October of that year, sending the world into a deep recession. But something interesting had begun happened before the crash, once the price of gasoline breached $4 a gallon, Americans actually began to change their driving habits (explicit costs of gasoline were now leading consumers to zero or negative economic profit in their purchase), and reduced the amount of oil we were consuming as a nation. It wasn't much, but that reduction combined with the unwinding of the inflated futures market send the price of oil plummeting over the curse of the next year. This should serve as a reminder of how inelastic a good gasoline is, in that even a small shift in demand can have drastic affects on supply and cost.
I really haven't broken profits out here as much as I would ultimately like too, but here are Exxon Mobil's press release for profits in 3qrt 2011.
http://www.exxonmobil.com/Corporate/Files/news_release_earnings_3q11.pdf
http://www.exxonmobil.com/Corporate/Files/news_presentation_3q11.pdf
http://ir.exxonmobil.com/phoenix.zhtml?c=115024&p=irol-EventDetails&EventId=4207582
http://www.exxonmobilperspectives.com/2011/04/27/gas-prices-and-industry-earnings-a-few-things-to-think-about/
http://www.time.com/time/magazine/article/0,9171,1812073,00.html
Questions:
1. Which of the following would be considered an implicit cost?
A) Earnings that could have been gained going directly into the work force rather than going to college.
B) The cost of tools needed to pursue another job.
C) Cost of seeds used to grow a crop.
D) Rent.
2. What might a producer consider when seeing accounting profits, but economic losses?
A) Drop out of production.
B) Continue with no operational changes.
C) Continue production but find methods to reach economics profits or at lease zero economic profit.
D) Get a new Accountant.
3. When a Consumer changes driving habits because of high gas prices, what is he considering?
A) Opportunity Costs
B) Accounting Costs
C) Economic Profit
D) Cheese Cake
4. Which of the following would be an explicit cost?
A) Equipment
B) Accounting Costs
C) Economic Profit
D) Future losses
5. A farmers accounting cost of making wheat is $40. He produced 20 bushels and sold them for $5 each. He spent 3, 8 hours days producing the wheat. A Local restaurant is willing to
hire the farmer for $5 and hour. Should the farmer take the offer?
A) Yes
B) No
Answers:
1. A: Possible earnings from pursuing another activity is the only opportunity cost that cannot be accurately quantify.
2. C: While A may be the answer in the long run, the producer can continue to operate with accounting profits, but will stop if he can not make the operation more profitable than what it would be to pursue other opportunities.
3. A: If a consumer changes buying habits for gasoline because the price is high, he is considering what else he could be spending the money on, or what other opportunities he could be pursuing other than buying gas.
4. A: Equipment is a directly measurable cost, while accounting costs are explicit costs, in this instance, they are not an explicit cost.
5. A: In this problem, the farmer will make a profit of $100 selling his crop. If he would have worked for the restaurant, he would have earned $120. If he includes his opportunity costs, he is at an economic loss, and would be better off working for the restaurant.
Bibliography:
Baye, Michael Managerial Economics & Business Strategy. New York: McGraw-Hill, 2010.
Colander, David C. Economics: Middlebury College: McGraw-Hill, 2010.
References:
http://www.exxonmobil.com/Corporate/Files/news_release_earnings_3q11.pdf
http://www.exxonmobil.com/Corporate/Files/news_presentation_3q11.pdf
http://ir.exxonmobil.com/phoenix.zhtml?c=115024&p=irol-EventDetails&EventId=4207582
http://www.exxonmobilperspectives.com/2011/04/27/gas-prices-and-industry-earnings-a-few-things-to-think-about/
http://www.time.com/time/magazine/article/0,9171,1812073,00.html
http://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=2&ved=0CCEQFjAB&url=http%3A%2F%2Fwww-old.gov.harvard.edu%2Fstudent%2Frios%2FMexicanDrugMarket_Riosv2.doc&ei=_Em3Tp73MaPm0QGHs9HRBw&usg=AFQjCNFbq-goC75ieInetM5AAsDsyQtOzQ&sig2=dBEIUBJyXWcfbATQkg3Spw
http://www.hughesnassociates.com/articles/TH/MM/economic_loss.htm
http://www.discusseconomics.com/