Opportunty Cost and Economic Cost of Firm

The 20 million firms in the United States differs in size and in the scope of' what they do. But they all perform the same basic economic functions. Each firm is a economic institution that hires factors of production and organizes those factors to produce and sell goods and services.

Main Objectives of Firm

If you asked a group of entrepreneurs what they are trying to achieve, you would get many different answers; Some would talk about making a high-quality product, others about business growth, others about market share, and others about the job satisfaction of their work force. All of these goals might be pursued, but they are not the fundamental goal. They are means to a deeper goal.

A firm's goal is to maximize profit, A firm that does not seek to maximize profit is either eliminated or bought out by firms that do seek to maximize profit.

Opportunity Cost

The opportunity cost of any action is the highest-valued alternative forgone. The action that you choose not to take-the highest-valued alternative forgone-is the cost of the action that you choose to take. For a firm, the opportunity cost of production is the value of the firm's best alternative use of its resources.

Opportunity cost is a real alternative forgone, But so that we can compare the cost of one action with that of another action, we express opportunity cost in money units. A firm's opportunity cost includes both explicit costs implicit costs.

Explicit costs are paid in money. The amount paid for a resource could have been spend on something else, so it is the opportunity cost of using the resource. For example, the expenditures on wool, utilities, wages, and bank interest are explicit costs etc. A firm incurs implicit costs when it forgoes an alternative action but does not make a payment. A firm incurs implicit costs when it Uses its own capital or Uses its owner's time or financial resources.

The cost of using its own capital is an implicit cost-and an opportunity cost-because the firm could rent the capital to another firm. The rental income forgone is the firm's opportunity cost of using its own capital. This opportunity cost is called the implicit rental rate of capital.

People rent houses, apartments, cars, and videotapes. And firms rent photo- copiers, earth-moving equipment, satellite-launching services, and so on. If a fir-m rents capital, it incurs an explicit cost. If a firm owns the capital it uses, it incurs an implicit cost. The implicit rental rate of capital is made up of Economic depreciation and Interest forgone.

Economic depreciation is the change in the market value of capital over a given period. It is calculated as the market price of the capital at the beginning of the period minus its market price at the end of the period. The funds used to buy capital could have been used for some other purpose. And in their next best use, they would have yielded a return-an interest income. This forgone interest is part of the opportunity cost of using the capital.

Economic Profit

What is the bottom line-the profit or loss of the firm? A firm's economic profit is equal to its total revenue minus its opportunity cost. The firm's opportunity cost is the sum of its explicit costs and implicit costs. the implicit costs include normal profit. The return to entrepreneurial ability is greater than normal in a firm that makes a positive economic profit, And the return to entrepreneurial ability is less than normal in a firm that makes a negative economic profit-a firm that incurs an economic loss.