Page 573 - Krugmans Economics for AP Text Book_Neat

of an activity is quite substantial—indeed, sometimes it is much larger than the ex-
The accounting profit of a business is
plicit cost.
the business’s total revenue minus the
Table 52.1 gives a breakdown of hypothetical explicit and implicit costs associated explicit cost and depreciation.
with spending a year in college instead of taking a job. The explicit cost consists of tu-
ition, books, supplies, and a computer for doing assignments—all of which require you
to spend money. The implicit cost is the salary you would have earned if you had taken
a job instead. As you can see, the forgone salary is $35,000 and the explicit cost is
$19,500, making the implicit cost more than the explicit cost in this example. So ignor-
ing the implicit cost of an action can lead to a seriously misguided decision.

table 52.1 Section 10 Behind the Supply Curve: Profit, Production, and Costs

Opportunity Cost of an Additional Year of School
Explicit cost Implicit cost
Tuition $17,000 Forgone salary $35,000
Books and supplies 1,000
Computer 1,500
Total explicit cost 19,500 Total implicit cost 35,000
Total opportunity cost = Total explicit cost + Total implicit cost = $54,500

A slightly different way of looking at the implicit cost in this example can deepen
our understanding of opportunity cost. The forgone salary is the cost of using your
own resources—your time—in going to college rather than working. The use of your
time for more education, despite the fact that you don’t have to spend any money, is
still costly to you. This illustrates an important aspect of opportunity cost: in consider-
ing the cost of an activity, you should include the cost of using any of your own re-
sources for that activity. You can calculate the cost of using your own resources by
determining what they would have earned in their next best alternative use.

Accounting Profit versus Economic Profit
As the example of going to college suggests, taking account of implicit as
well as explicit costs can be very important when making decisions.
This is true whether the decisions affect individuals, groups, gov-
ernments, or businesses.
Consider the case of Babette’s Cajun Café, a small restaurant
in New Orleans. This year Babette brought in $100,000 in rev-
enue. Out of that revenue, she paid her expenses: the cost of food
ingredients and other supplies, the cost of wages for her employ-
ees, and the rent for her restaurant space. This year her expenses were $60,000.
We assume that Babette owns her restaurant equipment—items such as appli-
ances and furnishings. The question is: Is Babette’s restaurant profitable?
At first it might seem that the answer is obviously yes: she receives $100,000
from her customers and has expenses of only $60,000. Doesn’t this mean that
she has a profit of $40,000? Not according to her accountant, who reduces the
number by $5,000 for the yearly depreciation (reduction in value) of the restau-
rant equipment. Depreciation occurs because equipment wears out over time.
As a consequence, every few years Babette must replace her appliances and fur-
nishings. The yearly depreciation amount reflects what an accountant esti-
mates to be the reduction in the value of the machines due to wear and tear that
year. This leaves $35,000, which is the business’s accounting profit. That is, Alamy

module 52 Defining Profit 531