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
