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An introduction to the concept of costs in economics, distinguishing between explicit and implicit costs, and discussing the differences between accounting and economic costs. The text also covers opportunity costs, sunk and nonsunk costs, and their relevance to a firm's decision-making process.
Typology: Lecture notes
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I (^) In the last chapter - look at process by which a firm produces output. I (^) In this chapter - look at how a firm produces a given quantity at the minimum cost I (^) Introduce the cost function I (^) Determine how the firm chooses the input mix (how much K and L to use) to produce a given quantity
Not all costs require spending money. I (^) Explicit Costs - involve a direct monetary outlay I (^) Airlines pay for jet fuel I (^) Roxie’s Tacos has to pay a lease, wages, inventory costs I (^) Implicit Costs - do not involve an outlay of cash I (^) Teaching this class costs me time on my research paper on the migratory e↵ects of the A↵ordable Care Act. I (^) When I stay up late watching TV, I am not getting a good night’s sleep.
The di↵erence between accounting costs and economics costs Question: If you were not in class, what would you be doing? What would your next best alternative be? What is the opportunity cost of being in class?
Firms ask the same question I (^) What is the next best alternative or opportunity cost of using machinery to produce, say, aluminum? I (^) The owner of a business, often, does not get paid a salary but gets the profits and losses from the business. The opportunity cost is the salary he or she could be making elsewhere.
To Accountant: Expenditure on labor is a current expense. So, it is a cost of production. Use the hourly wage rate as the expense. To Economist: Labor is an explicit cost C that involves a direct monetary outlay.
To Accountant: To calculate capital costs using the historical price of the machine, apply some kind of de- preciation factor and determine how much of the machine’s original cost to include in the current costs To Economist: View historical cost of the machine as a sunk cost. The historical cost is irrelevant to a de- cision being made today.
To economists the opportunity costs di↵er depending on the decision(s) being made For example, opportunity cost of steel I (^) A firm purchased $1 million worth of steel 2 months ago. Since then, the price of steel has gone up and it is now worth $1.2 million. Usually, this firm produces cars with the steel. What is the opportunity cost of manufacturing the cars? I (^) $1.2 million (economic cost) I (^) $1 million (accounting cost)
Sunk Costs: costs that have already been incurred and can- not be recovered Nonsunk Costs: costs that are incurred only if a particular de- cision is made Let’s go through some examples. You are spending too much money (story of my life) and are looking at your finances to see what you can change for next month. Let’s determine what are sunk costs and what are nonsunk costs.
Sporting good firm produces bowling balls I (^) Factory costs $5 million to build I (^) Once built, the factory is so specialized that nothing else can be made with it. I (^) If factory shuts down, nothing else can be produced with it The type of cost (sunk vs. nonsunk) depends on the decision being made I (^) In deciding whether to build the factory
Sporting good firm produces bowling balls I (^) Factory costs $5 million to build I (^) Once built, the factory is so specialized that nothing else can be made with it. I (^) If factory shuts down, nothing else can be produced with it The type of cost (sunk vs. nonsunk) depends on the decision being made I (^) In deciding whether to build the factory: $5 million is a nonsunk cost (they can avoid it)
Sporting good firm produces bowling balls I (^) Factory costs $5 million to build I (^) Once built, the factory is so specialized that nothing else can be made with it. I (^) If factory shuts down, nothing else can be produced with it The type of cost (sunk vs. nonsunk) depends on the decision being made I (^) In deciding whether to build the factory: $5 million is a nonsunk cost (they can avoid it) I (^) After the factory is built: $5 million is a sunk cost. If a firm is deciding whether or not to shut the factory down, should the firm consider the $5 million?
Sporting good firm produces bowling balls I (^) Factory costs $5 million to build I (^) Once built, the factory is so specialized that nothing else can be made with it. I (^) If factory shuts down, nothing else can be produced with it The type of cost (sunk vs. nonsunk) depends on the decision being made I (^) In deciding whether to build the factory: $5 million is a nonsunk cost (they can avoid it) I (^) After the factory is built: $5 million is a sunk cost. If a firm is deciding whether or not to shut the factory down, should the firm consider the $5 million? I (^) No! They don’t say, “shoot I spend $5 million so I need to make sure I get my money’s worth and produce.” The sporting good firm - in this case - should ignore the cost because it is sunk (their decision doesn’t change the fact they already spent the money)
Assumptions: 1) Only 2 inputs L - measured in labor-hours K - measured in machine-hours
If we have two inputs into the production function - labor (L) and capital (K ) - what is the total cost of production?
