Module 1: Part 3

The Profit Maximizing Framework: Set-up and Costs

Output and Costs:

Now we need to look at the other side of profits more carefully – costs.

That is, what is the relationship between our decision (Q) and our costs (TC)?

The main point in this section is that there are a wide variety of costs, some of which are
important to our decisions and others that aren’t. So our goal is to describe these costs,
and represent them with an equation that we can use to make our decision to maximize
profits.

Step 1: Opportunity Costs

Remember, we are trying to improve our decision-making process. A key to good

decision-making is understanding what you give up when you make a certain decision.

Opportunity costs of a decision is the value of the next best alternative given up.

For example, what are the opportunity costs of:

1. attending this program
2. saving for you children’s education

In economics, when we identify TC, and hence total profits, we implicitly include
opportunity costs.

As such, we make a distinction between economic profits and accounting profits:

Economic profits are revenues minus all costs (including opportunity costs)
Accounting profits are revenues minus only those costs you actually pay (called explicit
costs).

Step 2: Fixed Costs:

There are some costs that, during the output choice period, do NOT change when we
change our output decision. We call these costs “fixed costs” because they do not change
when we alter our decision.

Examples of fixed costs:

  rent
 painting example

Step 3: Sunk Costs:

Sunk costs are costs that are nonrecoverable – there is nothing that can be done to recoup
them.

For example: Suppose I buy a $7 ticket for a movie, and while I go back to my car to
pick up something I lose my ticket and cannot get a refund. Should I buy another ticket?

The $7 is sunk, and as the old saying goes – don’t cry over spilt milk….

Sunk costs do NOT influence your decision!

Step 4: Variable Costs:

These are costs that will change when we change our output choice. When we want to
produce more we need more materials, more labor, more capital use, ect.

An important question is how do variable costs change when we change our output?

This is a question that we will explore in more detail later…

Step 5: Total Costs

Let’s put the picture together, and examine total costs…

Total costs are fixed + variable costs: TC = FC + VC

FC are a constant number: For example FC = 3.

Variable costs will depend upon how much we produce (Q): For example, VC = 5Q.

Overall, we have: TC = 3 + 5Q which shows us the relationship between our decision

(Q) and the other half of profits – total costs.