9.3 Cost and Profit

(A) A Firm’s objective: Production and sale of goods is a commercial activity; it is a profit motivated activity or behavior. A firm will produce a particular quantity of output and will sell it at a particular price which will help maximize profit. Profit is the difference between Total Revenue (TR) and Total Cost (TC) of the firm. By revenue we mean money value of the output at market price. Similarly total cost is in money units at the market price of inputs.

Profit = (TR TC)max

A firm attempts to maximize the difference between TR and TC by maximizing the value of TR or minimizing the value of TC or by doing both.

(B) Explicit and Implicit Costs: In the act of production a variety of inputs are used and a variety of services employed. Inputs such as labor, land, building premises, raw material, transport charges etc. are paid their remuneration by way of wages, rent, profits, interest etc. All these costs incurred are of explicit nature. Actual payments are made from time to time out of the revenue or capital of the firm.

There are certain inputs or services utilized in the act of production which are not paid or are not adequately remunerated. These are the implicit costs of the firm. Consider the case of a small producer carrying out productive activity: he may provide tea and snacks to the workers; or the owner-manager of a firm may carry goods to the market in his own motor car; or the owner may visit the factory even on Sundays and holidays and may work for extra hours. All these contributions are unpaid cost items in the act of production. These are implicit costs of production. Explicit inputs are obvious and receive full cash compensation; implicit inputs are not obvious and do not receive full value for their contribution.

(C) Profits - Accounting, Economic, Normal: A firm intends to maximize profits by maintaining as large a difference between total revenue and total cost as possible. The profits of a firm may appear in different forms.

i) Accounting Profits: First there are accounting profits. These are the profits calculated as the difference between total revenue and total explicit costs of a firm. Only such costs are deducted from the revenue which have been fully paid out.

Accounting Profits = Total Revenue - Explicit Costs

ii) Economic Profits: These are smaller in value. In determining economic profit, explicit as well as implicit costs are deducted from total revenue. Economic profits are therefore smaller in value than accounting profits.

Economic profits = Total Revenue - (Explicit + Implicit Costs)

iii) Normal Profits: The concept of normal profit is of analytical or theoretical nature. Ordinarily it can be stated that a normal profit condition is one in which economic profits are zero. Such a situation will arise when total revenue of a firm is equal to its total cost. Marshall has stated that normal profit is that rate of minimum profit which a firm must earn in order to survive in the market. Depending upon actual market conditions a firm may earn Super Normal (more than normal), Normal (Just normal), or Sub Normal (less than normal) profits. By way of an example, consider a firm which expects a minimum profit of 8 percent over the costs of production. If the actual profit it earns is 10 percent then the firm makes Super normal profit. If the firm earns exactly 8 percent then it is said to be making normal profit. However, if the actual profit of a firm is only 6 percent then it is suffering sub normal profit (loss). In a competitive market, super normal profits are competed with and eliminated. Firms suffering subnormal profits may have to close down in the long run. The competitive rule permits only normal profits to all the firms in the long run.

Profit = TR - TC

When TR = 100 and TC = 80 Profit = 100 - 80 = 20 Super Normal
When TR = 100 and TC = 100 Profit = 100 -100 = 0 Normal
When TR = 100 and TC = 120 Profit = 100 -120 = -20 Sub Normal

Normal profit rate is governed by the general expectations of a firm. It is usually equal to current market rate of interest. In that sense it is an opportunity cost of capital resources.