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Notes: Types of Economic Costs
Opportunity Costs -- value of the next best alternative. (Remember production possibilities curve description.)
Explicit Costs -- monetary payments for resources which are external to the firm. i.e. payments for any labor, capital, land and/or entrepreneurial ability which are not owned by the firm.
Implicit Costs -- opportunity costs of self-owned, self-employed resources in their next best alternative use. i.e. If I hire myself to run my own business then the implicit cost for my self-employed labor is the salary that I will forgo in the next best alternative job if I were hired by another employer.
Note: Economists count all explicit and implicit costs prior to reporting a residual or “pure economic profit.” In other words, economists account for wages paid to labor, interest paid to capital, rent paid to land, and a “normal” profit paid to the entrepreneurial to cover risk, etc. Any residual revenue which remains after deducting these four categories of resource payments is the “pure economic profit.” Technically the “normal” profits which are the payment to the entrepreneurial are an implicit cost. Thus, since accountants count only explicit costs prior to determining their “profits,” accountants’ profit figures lump “normal” and “pure” economic profit together.
Note: Production costs are distinguished between short-run and long-run costs. The short-run is defined as a time period too short to allow a firm to alter its plant capacity but long enough to allow for more or less intensive use of existing plant capacity. i.e. In the short-run, the existing plant capacity may be utilized at 60%, 85%, 100%, etc. capacity. In the long-run, new plants can be built. Thus, the long-run time period is long enough to allow for changes in the existing number of plants, and other changes which emerge from technological change.
Production Costs in the Short-Run
In the short-run variable resources can be added to increase production or decrease production. The law of diminishing returns applies to understand the relationship between short-run costs and the physical production process.
Fixed Costs -- costs which do not change as output changes. These costs must be paid even if output is zero. i.e. rent, insurance, salaries to top management, interest. TFC = Total Fixed Cost. (Overhead Cost)
Variable Costs -- costs which increase with levels of output or decrease when output is decreased. i.e. materials, fuel, most labor. TVC = Total Variable Cost. Note: Initially as variable costs increase the rate of change of these variable costs is decreasing. This growth pattern of variable costs can be tracked back to the production function where one will see that MP is increasing which the variable costs are increasing at a decreasing rate. Once the point of diminishing returns is reached, however, variable costs grow at an increasing rate and MP is declining at the same time. The connection between production costs and the production function is critical to understanding decision making by the firm.
Total Costs -- the sum of all fixed and variable costs. Thus, TC = TFC + TVC.
Average, or Per Unit, Costs -- these costs are determined at a particular level of output. They are most useful in quick comparisons.
Average Fixed Costs -- defined as AFC = TFC/Q where Q represents units of output. Note that AFC declines as Q increases. In other words, the fixed cost is spread over more units of output, sometimes referred to as “spreading the overhead.”
Average Variable Costs -- defined as AVC = TVC/Q.
Average Total Costs – defined as ATC = TC/Q.
Marginal Costs -- the extra, or additional, cost of producing one more unit of output. MC = change in TC ÷ change in Q. Note especially, (a) relationship between MP and MC, and (b) relationship between AVC, ATC, and MC. The MC curve cuts the AVC and ATC curves at their minimum points.
Note: Practice calculating these costs by working out the first 8 columns of “Additional Problem 4” Costs.