Simple Explanation of Key Cost Concepts in Economics

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Do you wish to get a simple understanding of such terms as implicit cost, explicit cost, marginal cost, accounting cost, money cost, opportunity cost, overhead cost, social cost, total variable cost and many others as they are used in matters relating to economics and finance?

If your answer is yes then I urge you to continue reading this post.

The purpose of this post is to lay bare, in the simplest terms as possible, the essential meanings of the various terms in economics that relate to cost.

Where are the diagrams?

You will notice that diagrams are missing in these notes. This is a deliberate omission on my part. I’ve left out diagrams because I want you to first get a basic understanding of what these terms actually mean so that when you’re introduced to any diagrams you will be able to follow them easily.

Another point …

You will surely want to understand these concepts as they relate to the theory of cost in Economics first before thinking of committing any definitions to memory. That is why I’ve taken my time to explain them in as simple terms as possible.

So please, do not be in a hurry to memorize. Understand first, and the rest gets really easy.

After going through these simplified explanations of terms such as opportunity cost, money cost, real cost, accounting cost, historical cost, explicit and implicit cost, overhead cost, sunk cost, total cost, marginal cost, fixed cost, average and variable cost you will find it much easier and a lot of fun to follow their illustrations in the form of diagrams and tables.

Opportunity Cost

MEANING: Opportunity cost is the sacrificed next most desired item or items on a scale of preference whose value equals (or is almost the same as) that of the chosen item or items.

Other terms used to refer to opportunity cost are: real cost, alternative cost, alternative forgone, true cost, sacrificed alternative.

Money Cost

MEANING: Money cost is the actual amount of money that is paid in order to obtain the commodity to satisfy the chosen want. Other terms used to refer to money cost are: accounting cost, nominal cost and historical cost

Importance of the Concept of Opportunity Cost to the Individual

1. Awareness of opportunity cost helps the individual consumer to make the right choices among competing wants in order to maximize satisfaction.
2. Knowledge about opportunity cost helps the individual to be prudent in his use of his time and energy to maximize satisfaction.

Importance of the Concept of Opportunity Cost to the Firm

1. Opportunity cost helps the producer to make rational choices as to what to produce in order to maximize profits.
2. An awareness and appreciation of the concept of opportunity cost enable the firm to make the right choices regarding the most efficient method of production among competing methods.
3. Opportunity cost also helps the firm to minimize the cost of production in terms of alternatives to be forgone.

Importance of the Concept of Opportunity Cost to the Government.

1. A proper appreciation of opportunity cost allows the government to make rational choices as to what projects or amenities to provide or what policies to implement and what to forgo.
2. Opportunity cost helps the government to make the best decisions concerning such questions as what type of commodities to import given the scarcity of foreign exchange.

Social Costs

MEANING: Social costs are the inconveniencing experiences the public has to endure as a result of production activity.
An example of social cost is pollution of water bodies or general environmental degradation and its adverse effects as a result of the activities of a mining company in an area.

Private Costs

MEANING: Private costs are the expenses incurred by the firm or producer in the course of production. Private cost could be explicit cost or implicit cost.

Explicit Costs

MEANING: Explicit costs are the ordinary expenses which accountants record as the firm’s cost of production such as wages and salaries, payment for raw materials, fuel, etc. They are usually measured in monetary terms.

Implicit Costs

MEANING: Implicit costs are the costs of personal resources used by the owner for the good of the business.

Example: A proprietor’s own labour or time or other personal assets that he or she freely put at the disposal of the business.

Implicit costs cannot be easily calculated in monetary terms since they are hidden and sometimes intangible and are therefore usually omitted by accountants when calculating the firm’s costs.

To the economist, however, implicit costs are important since the owner incurs some opportunity cost by making his or her personally-owned resources freely available to the firm.

Fixed Costs (FC)

MEANING: Fixed costs are a form of short-run costs that the firm incurs by using fixed inputs or factors of production and which do not change or vary (increase or decrease) as the level of output changes or varies (increases or decreases).

Fixed costs are the costs of the fixed factors of production such as
• rent on land or factory building,
• salaries of administrative staff (other than direct labour),
• interest paid on loans,
• depreciation of machinery,
• property tax etc.

Other terms used for fixed costs are overhead costs, sunk costs, supplementary costs, and indirect costs.

PLEASE NOTE: When output is zero, FC will still be incurred and so will be equal to Total Cost (TC).

* TFC = TC – TVC.

Variable Costs (VC)

MEANING: Variable costs are a form of short-run costs that the firm incurs by using variable inputs or factors of production and which change or vary (increase or decrease) as the level of output changes or varies (increases or decreases).

Variable costs are the costs of the variable factors of production such as electricity, water, fuel, raw materials and direct labour.

Other terms used to refer to Variable Costs are direct costs and prime costs.

PLEASE NOTE: When output is zero, Total Variable Cost (TVC) will also be zero.
*TVC = TC – TFC.

Total Costs (TC)

MEANING: Total costs are the sum total of all the costs incurred by the firm by using both fixed and variable factors of production.

PLEASE NOTE: When output is zero, TC will be equal to TFC.

*TC = TFC + TVC.

Average Cost (AC)

MEANING: Average cost is the cost per unit of output. Average cost is also called unit cost.

* TAC = TC ÷ Quantity (Q). Or: TAC = AFC + AVC.

* AFC = TFC ÷ Q.

* AVC = TVC ÷ Q.

PLEASE NOTE: AC tends to be high at a lower level of output since in this situation FC will be spread over just a small number of units of output.

On the other hand, AC tends to be low at a higher level of output since FC can now be spread over a higher number of units of output.

The behaviour of Average Cost during Production in the Short Run

• Falls initially due to increasing returns to the variable factor of production as more and more units are employed.
• Reaches its minimum when the firm reaches its optimum level of output and experiences constant returns to the variable factor of production.
• Begins to rise finally due to diminishing returns to the variable factor of production.
• SHAPE OF THE AC CURVE is, therefore, U – SHAPED.

Marginal Cost (MC)

MEANING: Marginal cost is the additional cost incurred when an additional unit of output is produced. In other words, marginal cost is the change in TC when one more unit is produced by using an additional unit of the variable input.

*MC = new or current TC MINUS previous or original TC.

i.e. To calculate or obtain MC, you subtract the original or previous TC ( TOTAL COST zero, or one, or two etc. as the case may be) from the new or latest TC ( TOTAL COST one, or two etc. as the case may be).

OR:
MC = new or current VC MINUS previous or original VC.

i.e. To calculate or obtain MC, you subtract the original or previous VC ( VARIABLE COST zero, or one, or two etc. as the case may be) from the new or latest VC ( VARIABLE COST one, or two etc. as the case may be).

PLEASE NOTE: The Variable Cost approach is possible due to the fact that even though TOTAL COST of production is made of only two components, FC and VC, FIXED COSTS, by definition, never change whatever the level of output, therefore, MARGINAL COSTS would just be the same as ADDITIONAL VARIABLE COSTS incurred by producing additional units.

The behaviour of Marginal Cost during Production in the Short Run

• Falls initially due to increasing returns to the variable factor of production as more and more units are employed.
• Reaches its minimum when the firm reaches its optimum level of output and experiences constant returns to the variable factor of production.
• Begins to rise finally due to diminishing returns to the variable factor of production.
• SHAPE OF THE MC CURVE is, therefore, U – SHAPED.

So there you have it …

Let me know if there’s something vital that I’ve left out and/or if you enjoyed this post.

Thank you.

DISCLOSURE: This post contains affiliate links.

Click here to read the full statement of our affiliate disclaimer.

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