ACCOUNTING PROFITS VS ECONOMIC PROFITS

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ACCOUNTING PROFITS VS ECONOMIC PROFITS
The measurement of profits for our
purposes will be different from the standard
financial accounting measurement. In economics
we are interested in resource allocation and
decision making. Our measurement of profits
will indicate whether resources will move into or
out of the production of a good. The following
example contrasts the difference between
accounting profits and economic profits.
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ACCOUNTING PROFITS VS ECONOMIC PROFITS
A house suitable for rental income has become
available. The house can be purchased for
150,000, and its market value is expected to
increase by 2000 per year for at least the next
five years. The rental rate of 1200 per month
will maximize net rental revenue. Property taxes
are 3500 per year and maintenance costs are
expected to be 1400 per year. A 100,000
mortgage can be obtained, at an annual interest
rate of 8. The down payment can be made by
selling 50,000 in bonds currently earning 5
interest per year. Is this a good investment?
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ACCOUNTING PROFITS VS ECONOMIC PROFITS
ACCOUNTING INCOME
STATEMENT Revenue 1200 x 12
14,400 Less Costs Property taxes
3500 Maintenance 1400 Mortgage
interest 8000 Depreciation 3000
15,900 Accounting Profit (Loss)
( 1,500)
ECONOMIC INCOME
STATEMENT Revenue 1200 x 12
14,400 Less Costs Property taxes
3500 Maintenance 1400
Mortgage Interest 8000 Economic
Depreciation -2000 Opportunity cost
2500 13,400 Economic Profit (Loss)
1,000
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ACCOUNTING PROFITS VS ECONOMIC PROFITS
If the house is acquired, an accounting income
statement for the first year would include
rental revenue for the year of 14,400. Costs
include property taxes (3500), maintenance costs
(1400), interest on the mortgage (8000), and
depreciation (3000). Accounting depreciation
spreads the cost of the house over its expected
useful life. Assuming a fifty year useful life,
3000 per year (150,000/50) is allocated to
depreciation. Then
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ACCOUNTING PROFITS VS ECONOMIC PROFITS
PROFIT REVENUE - COSTS. Then accounting
profit is a loss of 1500 since accounting costs
exceed revenues. One would be tempted to assert
that the house is not a good investment because
it has an annual accounting loss. However the
accounting income statement is not designed to
make this decision -- it is only a historical
summary of payments and receipts.
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ACCOUNTING PROFITS VS ECONOMIC PROFITS
Examining the accounting income statement, there
are explicit costs of taxes, maintenance and
mortgage interest. However depreciation is not
an accurate measurement of the explicit cost of
the change of the value of the house. Since the
house is increasing in value by 2000,
allocating 3000 as a cost of the house is not
correct. The 1500 accounting loss needs to be
adjusted by adding back the 3000 plus the 2000
increase in value. This
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ACCOUNTING PROFITS VS ECONOMIC PROFITS
An adjusted profit of (-150030002000)
3500. However, this is still not sufficient
information to decide whether the house is a
good investment. If there was an opportunity to
earn 10,000 on some other investment, then, in
comparison, the house is not a good investment.
Therefore we must compare the house to other
opportunities to make a decision. In fact the
house should be compared to the next best
opportunity. Assuming this is the bonds
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ACCOUNTING PROFITS VS ECONOMIC PROFITS
earning 2500 per year (50,000 x 0.05), the
house earns 1000 more than the next best
opportunity (the bonds). The difference between
what the house earns and what the next best
opportunity (the bonds) earns is called economic
profit. The economic income statement on slide
3 calculates this economic profit. Since the
house has a larger economic profit than its next
best opportunity, the house is a good investment
an should be undertaken.
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ACCOUNTING PROFITS VS ECONOMIC PROFITS
The difference between accounting profits
and economic profits is that in calculating
economic profits, implicit opportunity costs are
included in the costs, and explicit costs are
adjusted for the actual change in market
value. A positive economic profit indicates that
resources will move to, or stay in, this
business, because it
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ACCOUNTING PROFITS VS ECONOMIC PROFITS
earns more than the next best opportunity. If
a business has an economic loss resources will
move away from the business to the next best
opportunity. Finally, a business with zero
economic profit is generally earning an
accounting profit (equal to the accounting profit
in the next best opportunity).
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PRODUCTION FUNCTION
We assume that every firm produces its
output according to technological rules for
combining inputs into output. The technological
rule for a a given firm is called a production
function Quantity of Output
F(Inputs), where F is the technological rule
of function.
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PRODUCTION FUNCTION
For example, with only two inputs, capital
(buildings and machinery, K) and labor (L), the
quantity of output (Q) might be determined by
the function Q F(K,L) 10
K0.3 L0.8.
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SHORT RUN AND LONG RUN
The short run is defined as the period when
at least one input is variable and at least one
input is fixed. For example, it may take a year
to build a new factory, so that the capital is
fixed during the year, while the amount of the
labor input is variable. The long run is a
period when all inputs are variable.
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THE LAW OF DIMINISHING RETURNS
When increasing amounts of a variable input is
added to a fixed input, a point is reached when
the quantity of output begins to increase at a
decreasing rate. This point is called the point
of diminishing returns. Since there are fixed
and variable inputs, the law of diminishing
returns affects short-run production.
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PRODUCTION FUNCTION
Consider a factory that has a fixed amount of
floor space and a fixed number of machines.
The only way that the quantity of output can be
changed is by changing the number of hours of
labor input. The following slide gives the
weekly output that can be obtained from various
hours of labor supplied per week. The numbers in
red indicate the additional output obtained from
the additional labor.
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PRODUCTION FUNCTION
Hours Units of of Labor Output 0
0 10 32 20 106 30
219 40 368 50 550 60
762 70 1001 80 1264 90 1548
100 1850 110 2167
Hours Units of of Labor Output 120
2496 130 2834 338 140 3178
344 150 3525 347 160 3872 347
170 4216 344 180 4554 338 190
4883 200 5200 210 5502
220 5786 230 6049
Hours Units of of Labor Output 240
6288 250 6500 260 6682
270 6831 280 6944 290
7018 300 7050
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PRODUCTION FUNCTION
Changing labor from 120 to 130 changes output by
338 (from 2496 to 2834). These changes are
rising up to 150 hours of labor and begin to
diminish after 160 hour of labor. Therefore 160
hours of labor is the point of diminishing
returns. The production function is graphed in
panel (a) of the next slide.
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PRODUCTION FUNCTION
Point of diminishing returns
(a)
(b)
(c)
Panel (b) is panel (a) viewed from behind,
and panel (c) is panel (b) rotated 900 clockwise.
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THE COST FUNCTION
Panel (c) of the previous slide is reproduced on
the left with the lettering written normally. If
each hour of labor costs 1, then the vertical
axis can be interpreted as the cost of the
variable input, labor. If labor costs 10 per
hour, then the vertical axis can be rescaled to
measure labor cost without changing the shape of
the curve.
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THE COST FUNCTION
Variable cost (VC), the cost of the variable
input, is graphed on the left. Its shape mirrors
the shape of the production function. The fixed
input does not change with output, so that its
cost, fixed cost (FC), remains constant at 100.
VC
FC
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THE COST FUNCTION
TC
Adding fixed cost to variable cost gives total
cost (TC). Since fixed cost is constant, total
cost has the same shape as variable cost, which it
Point of diminishing returns
VC
FC
inherits from the shape of the production
function.
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COSTS
The table to the left are hypothetical costs for
a firm. We are interested in calculating average
costs Average Fixed Cost AFC
FC/Q Average Variable Cost AVC VC/Q
OUTPUT FIXED VARIABLE TOTAL (Q)
COST COST COST
(FC) (VC) (TC) 0
10 0
10 1 10 10
20 2 10
16 26 3
10 20 30 4
10 24 34
5 10 30
40 6 10
38 48 7 10
48 58
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COSTS
and Average Total Cost ATC
TC/Q and Marginal Cost MC DTC/DQ. Since
DFC0, DTCDVC and MC DVC/DQ.
OUTPUT FIXED VARIABLE TOTAL (Q)
COST COST COST
(FC) (VC) (TC) 0
10 0
10 1 10 10
20 2 10
16 26 3
10 20 30 4
10 24 34
5 10 30
40 6 10
38 48 7 10
48 58
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COSTS
Variable costs are rising at a decreasing rate up
to 3 units of output. Diminishing returns
begin after the 4th unit of output.
Q FC VC TC AFC AVC
ATC MC 0 10 0
10 -- -- --
-- 1 10 10 20 10
10 20 10 2
10 16 26 5 8
13 6 3 10
20 30 3.3 6.7 10
4 4 10 24 34
2.5 6 8.5 4
5 10 30 40 2
6 8 6 6 10
38 48 1.6 6.3
8 8 7 10 48
58 1.4 6.9 8.3
10 8 10 60 70 1.3
7.5 8.8 12
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COSTS
Marginal costs are falling up to 3 units
of output and begin rising after the point
of diminishing returns.
Q FC VC TC AFC AVC
ATC MC 0 10 0
10 -- -- --
-- 1 10 10 20 10
10 20 10 2
10 16 26 5 8
13 6 3 10
20 30 3.3 6.7 10
4 4 10 24 34
2.5 6 8.5 4
5 10 30 40 2
6 8 6 6 10
38 48 1.6 6.3
8 8 7 10 48
58 1.4 6.9 8.3
10 8 10 60 70 1.3
7.5 8.8 12
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COSTS
MC is equal to AVC when AVC is minimum, and MC
is equal to ATC when ATC is minimum.
Q FC VC TC AFC AVC
ATC MC 0 10 0
10 -- -- --
-- 1 10 10 20 10
10 20 10 2
10 16 26 5 8
13 6 3 10
20 30 3.3 6.7 10
4 4 10 24 34
2.5 6 8.5 4
5 10 30 40 2
6 8 6 6 10
38 48 1.6 6.3
8 8 7 10 48
58 1.4 6.9 8.3
10 8 10 60 70 1.3
7.5 8.8 12
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COSTS
AFC, AVC, ATC and MC from the table on the
previous slide are graphed on the left.

MC
ATC
AVC
AFC

Q