Economic cost

Transcription

Sometimes, people need to readjust their thinking as to what costs mean in economic analysis. From an accounting standpoint, costs refer to direct, or out-of-pocket, or explicit costs. What do I, the business owner, pay for the resources that I use to produce my product? Accounting costs are explicit costs. This means that, from an accounting standpoint, profit is total revenue minus explicit costs, where total revenue can be found by taking the number of units sold times the price charged for each unit. An economist, however, would tell you that you're omitting a critical component: what about the value of the resources you already own, that could be used elsewhere? For example, your own labor goes into your business, but you could sell their labor elsewhere, couldn’t you? We have a name for these implicit, or indirect, costs -- opportunity costs. Economic costs do, of course, include the explicit, or accounting costs, but also the implicit, or opportunity, cost. So economic costs are both the explicit and the implicit costs. From an economic standpoint, then, profit is going to be the total revenue minus the explicit costs, but then also subtracting the implicit costs. The question you might have is: does this distinction really matter? The answer is yes; failure to consider the implicit or opportunity costs could lead you to a faulty conclusion in considering choices. Consider this: a small farmer grows wheat. He manages to grow 20 bushels of wheat, which he can sell for $5 per bushel. This means, of course, that his total revenue is $5 times the 20 bushels, or $100. The farmer’s explicit costs of production are $40. Remember the explicit costs are the direct costs of purchasing resources. What might this $40 represent? Maybe seeds? Irrigation? Machinery? Or workers? What's the farmers accounting profit, then? Accounting profit is the total revenue minus the explicit cost. So in this case you have $60 of profit. Pretty good, right? The farmer is happy when his accountant tells him that he's earning $60 of profit. But then an economist that he knows tells him that he's forgotten something: what about his opportunity cost? Suppose that the farmer could be working in town at the local burger joint for $5 an hour. For every hour he spends farming, he sacrifices $5 salary elsewhere. So if, for example farming took 3 8-hour long days, for a total of 24 hours, his implicit cost would be $5 an hour, times the 24 hours it took him to grow the wheat, or $120. What's the farmer’s economic profit then? Economic profit was the total revenue minus both the explicit and the implicit costs. He’s actually losing $60. From the economic standpoint, the farmer is losing money and therefore, assuming as we are that all producers are interested in maximizing profits, he'd be better off working at the local burger joint. One last note: $0 economic profit is also known as a normal accounting profit. If you find that a business owner is making a zero economic profit, it doesn't mean that he or she earns nothing; it means that revenues are enough to cover all of your costs, even the value of the owner's time. NEXT TIME: Fixed versus variable costs. TRANSCRIPT (MICRO) EPISODE 21: ACCOUNTING VS. ECONOMIC COSTS