Economics Test

#3

Done By: Terrel D, Jaylon M, Zendae Y, Carisle

C, Kevin G
The Cost of Capital As an
Opportunity Cost
The Cost of Capital As an Opportunity Cost

For almost all firms, the opportunity cost for the financial resources invested
is important to consider.

For Example

Caroline has $300,000 in savings, and she uses it to purchase an existing

cookie factory. If Caroline had left her money in the savings account, she
would have earned $15,000 in interest per year. Caroline refused that extra
$15,000 a year to own her facility.This $15,000 is an opportunity cost to
Caroline's company.
Accounting Vs Economic View of Cost

Now if the situation had marginally changed, and Caroline had only
$100,000 of the $300,000 that she needed to buy a cookie factory; she'll
need to go to the bank to get a $200,000 loan. Let's say now that this
particular bank has a 5 percent interest rate.

Caroline's accountant only calculates explicit costs. He will only count the
$10,000 interest charged on the bank loan each year because this money
now flows through their firm.

An economist would suggest that 15,000 is still the opportunity cost of

owning the company. The opportunity cost is equivalent to the bank loan
interest, which is the explicit cost of $10,000, plus the forgotten savings
interest, which is the implied cost of $5,000.
Economic Profit
Verses
Accounting Profit
 Economic Profit Vs Accounting Profit

Both ways of finding these profits are measured differently.

An economist measures a firm's economic profit as the firm's total revenue

minus all the opportunity cost of producing goods and services sold.

An accountant measures accounting profit as the firms total revenue minus

only the explicit cost.

An explicit cost is a direct payment made to others in the course of running

a business, such as wage, rent and materials, as opposed to implicit costs,
where no actual payment is made.
Economic Profit Vs Accounting Profit

Since the accountant ignores implicit costs, accounting profit is usually

larger than the economic profit. For a business to be profitable, from a
economists stand point, total revenue most cover all the opportunity cost -
both explicit and implicit.

Economic profit is an important concept because it is what motivates the

firm that supplies goods and services.In other terms A firm making positive
economic profit will always stay in business .When a firm is making an
economic loss the business will eventually close down.

To understand business decisions we always need to keep and to eye on

the economic profit.
Production and Cost
Production and Cost

Firms experience cost when they buy raw materials from another company,
productions is when the firm take the same raw materials that they buy to
then create a product so that they can make a profit.
Questions For Review
Answers for Questions for Review

1. The relationship between a firm's total revenue, profit, and total

cost is profit equals total revenue minus total costs.

Terms to Know:

Total Cost - The market Value of the inputs a firm uses in production.

Average total cost - total divided by the quantity of output.

Marginal Cost - the increase in total cost that arises from an extra unit
of production.
Answers for Questions for Review

An example of an opportunity cost an accountant will not count as a

cost is the loss of production possibility. For example, If a farmer
chooses to produce more wheat than cane to sell. An accountant only
counts the production cost of the wheat but an not the opportunity cost
selling the cane.

Average cost and marginal cost are both related to each other. Marginal
cost is ever changing parameter since it can fluctuate with the changes
in the output. It is the ratio of the change in total cost to the change in
output. The average total cost decreases in the start but then increases
as a general behaviour. It depends upon the average variable costs
and the average fixed costs since it is the sum of them.
Thank You for Your Attention