Applied Economics

Lesson 2
Opportunity Costs

Prepared by:
Mr. Jose Mari Uy Martinez III
Learning Objectives:
To understand what is economic profit
To identify the different input of economic resources
To learn the meaning of implicit and explicit cost and its difference
To distinguish accounting profit from economic profit
To learn how to compute for economic profit and understand if an
individual is getting wealthier or not
 • Economic profits are not
accounting profits

Economi • Economic profits are equal to

revenues minus economic costs
c Profits
• All economic costs are measured
in terms of opportunity costs
Economic
Opportunity cost of using any resource.
Cost of It is what a firm’s owners give up to use
resources to produce goods or services.
Resources
 The method of Inputs of Resources:
measuring 1. Market-supplied resources
opportunity costs • Owned by others & hired,
differs for rented, or leased
various kinds of
inputs of 2. Owner-supplied resources
resources used by • Owned & used by the firm
businesses.
 • Total Economic Cost
• Sum of opportunity costs of both market-

Total
supplied resources & owner-supplied resources

• Explicit Costs
Economi • Monetary payments to owners of market-
supplied resources

c Cost • Implicit Costs

• No monetary payments or opportunity costs of
using owner-supplied resources
Types of Implicit Costs
1. Opportunity cost of cash provided by owners
i.e. Equity capital
2. Opportunity cost of using land or capital owned by the firm
3. Opportunity cost of owner’s time spent managing or
working for the firm
 Economic Cost of Using Resources (Figure 1.2)

=
Economic Profit VS.
Accounting Profit
Economic profit = Total revenue – Total economic cost
= Total revenue – (Explicit costs + Implicit costs)

Accounting profit = Total revenue – Explicit costs

• Accounting profit does not subtract implicit costs from total revenue.
• Firm owners must cover all costs of all resources used by the firm
• Objective is to maximize economic profit
In 2007 Terry Brady, the legendary athlete from
Indiana, decided to leave his job as head football
coach at Mattoon High School to open Brady
Advantage, his own sporting goods store, in Terre
Haute.
By locating Brady Advantage halfway between St.
Louis and Indianapolis, Brady hoped to attract
customers from both large metropolitan markets. A
partial income statement for Brady Advantage
follows:
Prior to opening his store;
• Terry Brady’s coaching job at Mattoon High paid $45,000 of annual salary and benefits.
• To get the sporting goods store opened, Brady used $50,000 of his personal savings,
which was earning a guaranteed 12 percent annual rate of return.
• Brady opened his store in a building that he owned in Terre Haute. The building was
rented for $24,000 per year.

Analysis:
1. In 2007, Brady Advantage incurs $_______________ of total explicit costs for using market-supplied resources.
2. In 2007, the opportunity cost of Brady’s equity capital is $______________.
3. The total implicit cost of using owner-supplied resources in 2007 is $____________.
4. The total opportunity cost of resources used by Brady Advantage in 2007 is $_______________. The total economic
cost in 2007 is $_______________.
5. The accounting profit for Brady Advantage in 2007 is $_______________.
6. Based on his profit in 2007, did Terry Brady increase his wealth by quitting his job at Mattoon High and opening
Brady Advantage? Explain your answer carefully. [Hint: Compute economic profit in 2007].
1. In 2007, Brady Advantage incurs $_______________ of total explicit costs for using
market-supplied resources.

Remember:
Explicit Cost - Are Monetary payments to owners of market-supplied resources
2. In 2007, the opportunity cost of Brady’s equity capital is $______________.

Remember:
Implicit Costs - No monetary payments or opportunity costs of using owner-supplied resources
 1. Opportunity cost of cash provided by owners

• Terry Brady’s coaching job at Mattoon High paid $45,000 of annual salary and benefits.
• To get the sporting goods store opened, Brady used $50,000 of his personal savings, which was earning a
guaranteed 12 percent annual rate of return. ( implied cost #1)
• Brady opened his store in a building that he owned in Terre Haute. Prior to opening his store, the building was
rented for $24,000 per year.
3. The total implicit cost of using owner-supplied resources in 2007 is $____________.

Remember:
Implicit Costs - No monetary payments or opportunity costs of using owner-supplied resources
 2. Opportunity cost of using land or capital owned by the firm
 3. Opportunity cost of owner’s time spent managing or working for the firm

• Terry Brady’s coaching job at Mattoon High paid $45,000 of annual salary and benefits. (implied cost # 3)
• To get the sporting goods store opened, Brady used $50,000 of his personal savings, which was earning a
guaranteed 12 percent annual rate of return. (implied cost #1)
• Brady opened his store in a building that he owned in Terre Haute. Prior to opening his store, the building was
rented for $24,000 per year. (implied cost #2)

Note: This is the amount of profit that Brady would have earned if he stayed as a coach.
4. The total opportunity cost of resources used by Brady Advantage in 2007 is
$_______________. The total economic cost in 2007 is $_______________.

Note: Total economic cost is defined as the opportunity cost of all resources used by the firm.)
5. The accounting profit for Brady Advantage in 2007 is $_______________.
6. Based on his profit in 2007, did Terry Brady increase his wealth by quitting his
job at Mattoon High and opening Brady Advantage? Explain your answer
carefully. [Hint: Compute economic profit in 2007].
 Did Terry Brady increase his wealth by quitting his job at Mattoon High
and opening Brady Advantage?
1. Terry Brady’s wealth decreased in 2007 because economic profit is –$3,000.
2. Only when the owners of businesses earn positive economic profits do they experience an increase in their wealth.
3. Remember, the value of their firm, which is part (or perhaps all) of their wealth, depends on the future stream of
economic profit earned by the firm.
 A year in which profit is zero adds nothing to owner’s wealth.
 A year in which profit is negative reduces owners' wealth.

4. The value of economic profit, –$3,000, indicates Brady would have been $3,000 better off had he NOT owned and
operated Brady Advantage in 2007 but instead collected
 an annual salary as high school coach of $45,000,
 an annual interest of $6,000,
 and annual rent of $24,000 (which totals $75,000).
 As you can see, accounting profit of $72,000 in this example must exceed $75,000 of implied opportunity cost in order
for Brady to break even.