Author: John Bouman

Nominal and Real Interest Rates The interest rate is the price that people pay for borrowing money. It is also the price that businesses or people receive for lending money. The nominal interest rate is the interest rate that banks list as their lending rate. The real interest rate is the nominal rate minus the inflation rate. If a bank charges an interest rate of 10%, and the inflation rate is 8%, then the bank generates interest of 2% in real terms. Interest Rate Determination In a free market, interest rates are determined the same way as prices of goods and services. In the graph below, the demand and supply of loanable funds (loans) intersect at an equilibrium interest rate of 8% and an equilibrium quantity of loanable funds of 200. If the demand for loanable funds increases, interest rates increase, and vice versa. If the supply of loanable funds increases, interest rates decrease, and vice versa. The graph below illustrates the effect of an increase in loanable funds demand on the equilibrium interest rate. In free market economies, general interest rates vary with changes in supply and demand. The interest rate on a specific loan also varies based on the risk and the cost of making the loan. If a lender has evidence that the borrower is very likely to pay back the loan, then the interest rate...

What’s in This Chapter? One of a firm’s objectives is to be cost efficient in order to increase its profits. This unit analyzes a firm’s costs of production. A firm’s fixed costs include its expenses on fixed inputs, such as land and large pieces of machinery. Variable costs include expenses on variable inputs, such as labor, inexpensive supplies, and materials. Total costs equals total fixed costs plus total variable costs. Cost can also be expressed per unit: average fixed cost, average variable cost, average total cost, and marginal cost. As quantity produced increases, average variable, average total, and marginal cost eventually increase in the short run, because of diminishing returns. Long-run average cost for a typical firm decreases as output increases, due to economies of scale. But due to diseconomies of scale, average cost may then increase as output continues to increase. We also distinguish between explicit costs and implicit costs. The calculations of all these costs are explained in this...

The Difference Between Explicit and Implicit Costs Economists distinguish between explicit and implicit costs. Explicit costs, also called accounting costs, are out-of-pocket costs, such as expenses on labor, raw materials, and rent. Implicit costs are costs a business incurs without actually spending money. They are estimates of the value of alternative activities you have sacrificed. A person who invests $100,000 of her/his own money in a business does not have to pay any finance charges to a bank for using this money. Thus, there is no explicit cost for using this money. However, the implicit cost is the earnings the owner sacrifices by not using the $100,000 in an alternate activity, such as investing in stocks or bonds. What are the Explicit Costs and Implicit Costs of Attending College? Explicit costs of attending college include tuition, lodging, fees, books, and transportation. Implicit costs include sacrificed job earnings, the value of other time sacrificed, and sacrificed interest earnings. Let’s say that your annual costs on tuition and fees, lodging, books, and transportation are $25,000. In addition, you estimate that your annual implicit costs are $30,000 because this is the additional income you could have earned had you not attended college. Your total annual cost of attending college is now $55,000 ($25,000 plus $30,000). Therefore, your total cost of attending four years of college equals 4 times $55,000, or $220,000. If...

Economic Costs and Accounting Costs Below are definitions of economic costs and accounting costs. Economic costs = implicit costs + explicit costs Accounting costs = explicit costs Economic Profit and Accounting Profit Below are definitions of economic profit and accounting profit. Economic profit = total revenue – economic costs. Accounting profit = total revenue – explicit costs. Examples of Economic and Accounting Profit Calculations Example 1 Problem: Let’s say that a firm’s total revenue is $180,000. Using the explicit and implicit costs from the business example at the bottom of section 1, what are the firm’s accounting and economic profits? Solution: Economic profits equal total revenue minus economic costs. Total revenue is $180,000. Economic costs are $172,000. Thus, economic profits equal $180,000 – $172,000 = $8,000. Accounting profits equal total revenue minus explicit costs. Thus, accounting profits equal $180,000 – $120,000 = $60,000. Example 2 Problem: Let’s say that a firm’s total revenue is $80,000 and its explicit costs and implicit costs are $50,000 and $25,000, respectively. What are the firm’s economic and accounting profits? Solution: Economic Profits are: $80,000 – $75,000 = $5,000. Accounting Profits are: $80,000 – $50,000 = $30,000 Example 3 Problem: Let’s say that a firm’s total revenue is $80,000 and its explicit costs and implicit costs are $70,000 and $25,000, respectively. What are the firm’s economic and accounting profits? Solution: Economic Profits are: $80,000...

Economic Costs There are seven important economic costs: Total Variable Cost (TVC). This is the cost of all variable inputs. Examples include the cost of temporary workers and hourly labor, the cost of materials, office supplies, energy, and taxes. Total Fixed Cost (TFC). This is the cost of all fixed inputs. Examples include the cost of the building, large pieces of machinery, certain fixed taxes (property tax), and salaried employees on long-term contracts. Total Cost (TC). This is the sum of TVC and TFC. Average Variable Cost (AVC). This is variable cost per product, or total variable cost divided by output. Average Fixed Cost (AFC). This is fixed cost per product, or total fixed cost divided by output. Average Total Cost (ATC). This is cost per product, or total cost divided by output. Marginal Cost (MC). This is the per product cost of producing an additional unit of the product, or the change in total cost divided by the change in output.   All of the above costs are economic costs. Therefore, they include both implicit and explicit expenses. From now on when we refer to total cost, we mean total economic cost. For example, if explicit costs are $7,000 and implicit costs are $2,000, then total cost equals...