You probably know the law of supply that says businesses will increase the supply of a good when the price of the good increases. But did you know that the price of a good and the quantity supplied are also affected by the economic cost a firm faces during production? All businesses, from United Airlines to your local store, face economic costs. These economic costs determine the company's profit and how long it can stay in business. Why don't you read on and find out all there is to know about economic costs?
Concept of Cost in Economics
The concept of cost in economics refers to the total expenditure a firm incurs when utilizing economic resources to produce goods and services. Resources in the economy are scarce, and the allocation of them in an efficient manner is an essential step toward maximizing the firm's profit.
Profit is the difference between a firm's revenue and its total cost
Although a firm might experience high revenues, if the cost of production is high, it will shrink the firm's profit. As a result, firms are concerned about what the expenses will most likely be in the future, as well as the ways in which the company may be able to reorganize its resources to reduce its costs and increase its profitability.
The economic cost is the total expenditure a firm faces when using economic resources to produce goods and services.
Economic cost involves all the expenses a firm faces, those it can manage, and those beyond the company's control. Some of these economic costs include capital, labor, and raw materials. However, the company may use other resources, some of which have expenses that are not as readily apparent but are still significant.
Economic Cost Formula
Economic cost formula takes into account explicit cost and implicit cost.
Explicit costs refer to the money a firm spends on input costs.
Some examples of explicit costs include salaries, rent payments, raw materials, etc.
Implicit costs refer to the costs that do not require an explicit outflow of money.
For example, a company that owns a factory and doesn't pay rent faces the implicit cost of not renting out the factory but using it for production purposes instead.
The formula of economic cost is as follows:
\(\hbox{Economic cost}=\hbox{Explicit cost}+\hbox{Implicit cost}\)
Explicit and implicit cost is the main difference between accounting cost and economic cost. While economic cost takes into account explicit and implicit costs, accounting cost only considers actual expenses and capital depreciation.
To learn more about the difference between the two,check out our detailed explanation:- Economic profit vs accounting profit.
Types of Economic Costs
There are many types of economic costs that a firm should take into account during the decision-making process. Some of the most important types of costs in economics include opportunity costs, sunk costs, fixed and variable costs, and marginal cost and average cost as seen in Figure 1.
Opportunity cost
One of the main types of costs in economics is opportunity cost. Opportunity cost refers to the benefits a business or an individual loses when choosing to pursue one alternative over the other. These benefits that are missed due to choosing one option over the other are a type of cost.
Opportunity cost is the cost an individual or business incurs from choosing one alternative over the other.
Opportunity costs arise when a company does not put its resources to the greatest possible alternative use.
For example, consider a company that uses land in its production. The company does not pay for the land because it owns the land. This would suggest that the company does not incur an expense for renting land. However, according to the opportunity cost, there is a cost associated with using the land for production purposes. The company could rent out the land and receive monthly income from it.
The opportunity cost for this company would be equal to the rental income forgone due to using the land rather than renting it.
Sunk Cost
Another type of economic cost is sunk cost.
Sunk cost is the expenditure that a company has already made and can't recover.
Sunk cost is ignored when making future economic decisions. That's because it is an expenditure that has already occurred, and the firm can't recover its money.
Sunk costs usually include equipment bought by businesses and used only for one purpose. That is to say that the equipment can't be put toward an alternative use after a certain time.
Additionally, it includes salaries paid to workers, the cost of installing a software product for the company, facilities expenses, etc.
A health company spends $2 million on research and development to develop a new drug that will slow down aging. At some point, the company finds out that the new drug has serious side effects and needs to stop producing it. The $2 million is part of the company's sunk cost.
Dive into our article - Sunk Costs to learn more!
Fixed Cost and Variable Cost
Fixed costs and variable costs are also important types of economic costs. They play an important role when a firm decides how to allocate its resources so that it can maximize its profit.
Fixed cost (FC) is a company's expense regardless of its production level.
A firm is required to make payments toward expenditures known as fixed costs, regardless of the particular commercial activity it engages in. Fixed costs do not change as a firm's output level changes. That is to say; it doesn't matter whether a firm produces zero units, ten units, or 1,000 units of goods; it still has to pay this cost.
Examples of fixed costs include maintenance expenses, heat and electricity bills, insurance, etc.
Fixed cost is only eliminated when a firm completely shuts down its activity.
Variable cost is a company's expense that varies as output varies.
When the volume of a firm's production or sales changes, the variable costs of that company also change. Variable costs go up when the amount of production goes up, and they go down when the production volume goes down.
Some examples of variable costs include raw materials, production supplies, labor, etc.
We have an entire explanation covering - Fixed vs Variable Costs!Feel free to check it out!
Fixed and variable costs comprise a very important economic cost, the total cost.
Total cost is the total economic cost of production, which consists of fixed and variable costs.
The formula to calculate the total cost is as follows:
\( TC = FC + VC \)
Marginal Cost and Average Cost
Marginal cost and average cost are two other important costs in economics.
Marginal costs refer to the increase in cost as a result of increasing production by one unit.
In other words, the marginal costs are measured by how much costs increase when a company decides to increase its output by one unit.
Fig. 2 - Marginal cost curve
Figure 2 above shows the marginal cost curve. The marginal cost initially decreases with each unit produced. However, after some point, the marginal cost of producing an additional unit begins to increase.
The formula to calculate MC is as follows.
\(\hbox{Marginal Cost}=\frac{\hbox{$\Delta$ Total cost}}{\hbox{$\Delta$ Quantity}}\)
We have an entire explanation on Marginal Cost! Don't miss it!
The average total cost is a firm's total cost divided by the quantity of total output produced.
The formula to calculate the average cost is:
\(\hbox{Average Total Cost}=\frac{\hbox{ Total Cost}}{\hbox{ Quantity}}\)
Fig. 3 - Average total cost curve
Figure 3 above shows the average total cost curve. Notice that initially the average total cost a firm experiences drops. However, at some point, it begins to increase.
To find out more about the shape of the average cost curve and all there is about average costs, check out our explanation!
Economic Costs Examples
There are multiple economic costs examples. We'll consider some examples pertaining to different types of costs in economics.
Let's consider Anna, who is a math tutor. Anna lives on her farm and tutors other students remotely. Anna charges her students \(\$25\) an hour per class she tutors. One day Anna decided to plant seeds that would, later on, sell for \(\$150\). To plant the seeds, Anna needs \(10\) hours.
What's the opportunity cost that Anna faces? Well, if Anna decided to use the ten hours for tutoring instead of planting the seeds, Anna would make \( \$25\times10 = \$250 \). However, as she spends those ten hours planting \(\$150\) worth of seeds, she misses on earning an extra \( \$250-\$150 = \$100 \). So Anna's opportunity cost in terms of her time is \(\$100\).
Now assume that Anna's farm has expanded. Anna buys a piece of machinery that milks the cows she has on her farm. Anna buys the machinery for $20,000, and the machinery is capable of milking ten cows in 2 hours. During the first year Anna buys the machinery, the amount of milk her farm is capable of producing grows, and she can sell more milk.
However, some years later, the milking machinery wears out and isn't capable of milking cows anymore. Anna can't sell the machinery or recover any of the $20,000 she has spent on it. Therefore, the machinery is a sunk cost that Anna's farm incurs.
Now assume that Anna wants to expand her farm further and rents some land from the nearby neighborhoods. The amount of expenses that go toward paying the rent of the extra land is an example of a fixed cost.
Theory of Cost in Economics
The theory of cost in economics revolves around the idea that the costs that a firm faces significantly impact the firm's supply of goods and services and the price for which it sells its products.
According to the theory of cost in economics, the costs a firm faces determine how much money they charge for a product or service and the amount supplied.
A firm's cost function adjusts itself according to several factors, such as the scale of the operation, the quantity of the output, the cost of production, and several other factors.
The economic theory of costs incorporates the notion of economies of scale, which asserts that an increase in output leads to a decrease in the cost incurred per unit of production.
- Economies of scale, which are impacted by a firm's cost function, play an important role in the firm's productivity and the amount of output it can produce. When a firm is experiencing economies of scale, it can produce more output at a lower cost, enabling more supply and lower prices.
- On the other hand, if a firm is not experiencing economies of scale, it faces higher costs per output, lowering supply and raising prices.
The returns to scale will first increase, then remain stable for a time, and then start a downward trend.
Economic Cost - Key takeaways
- The economic cost is the total expenditure a firm faces when using economic resources to produce goods and services.
- Explicit costs refer to the money a firm spends on input costs.Implicit costs refer to the costs that do not require an explicit outflow of money.
- Some of the most important types of costs in economics include opportunity cost, sunk cost, fixed and variable cost, and marginal cost and average cost.
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