Welcome, friends to an incredible world of Economics!
On the following pages, we will be discussing COST THEORY: A surprisingly exciting topic in this fantastic world of Economics!
We will also try to show you how certain theories can be put into practice and give you a couple of real life evidence.
Even though this topic might make you want to fall asleep, we will do our best to entertain you. We will help you use your imagination and common sense to better understand this topic.
Before we start allow us to review a couple basic economic assumptions:
With these assumptions in mind, let’s begin to explore the topic…
Imagine you opened a firm called BeOne Incorporated and you want to produce very cool, expensive cars. Go on... imagine it. Beautiful isn’t it? Now imagine how many costs you will have. Ugly!
In the following pages we will go step-by-step through short run and long run costs that exist while you produce your flashy cars. Additionally, we will attempt to help you understand when it is not worth it to produce. We will also demonstrate how there are costs that will never appear on your balance sheets or income statements (see page two). These costs can have a large economic effect even if they do not appear to have an accounting effect. You will also learn how to deal with a fisherman (curious? – see page four), and have a chance to watch some interesting YouTube videos.
But, before we go into detail about short run and long run analysis (and the fisherman), here is some important information that you need to know about costs.
Cost concepts for economists do not necessarily coincide with those of accountants. Accounting costs are those which are recorded in a ledger entry as they have actually been incurred, while economic costs also include the concept of opportunity costs (Boddunun.com).
Opportunity Cost:
Lets say you decided to open that car factory that we mentioned earlier in the heart of London. Obviously, that’s going to require a lot of money. What was your next best alternative? Opening a factory in Timbuktu or Calcutta instead of London? Or, could you have decided to travel the world instead of starting a company? All of these alternatives have opportunity costs attached to them.
The next section outlines some key differences between accounting costs and economic costs and the way they are defined.
We will also try to show you how certain theories can be put into practice and give you a couple of real life evidence.
Even though this topic might make you want to fall asleep, we will do our best to entertain you. We will help you use your imagination and common sense to better understand this topic.
Before we start allow us to review a couple basic economic assumptions:
- People always try to maximize their outcome. In other words, if you are a manager, you will try to maximize your profits given the information that you have and the resources that you possess (saving the planet comes second in terms of Economics).
- We will be using the principle of Ceteris Paribus. This roughly translates to “all other things being equal.” In economics and finance, the term is used as shorthand for illustrating the effects of one economic variable on another, holding constant all other variables that may affect the second variable (Investopedia.com). This concept allows us to simplify our very complex world. Thus, you might think at certain points in our webpage, “This is impossible!” or, “I am not sure that this reflects what I have seen!” But, always keep in mind these key assumptions we are making because we are trying to explain some complex information using a simple approach.
With these assumptions in mind, let’s begin to explore the topic…
Imagine you opened a firm called BeOne Incorporated and you want to produce very cool, expensive cars. Go on... imagine it. Beautiful isn’t it? Now imagine how many costs you will have. Ugly!
In the following pages we will go step-by-step through short run and long run costs that exist while you produce your flashy cars. Additionally, we will attempt to help you understand when it is not worth it to produce. We will also demonstrate how there are costs that will never appear on your balance sheets or income statements (see page two). These costs can have a large economic effect even if they do not appear to have an accounting effect. You will also learn how to deal with a fisherman (curious? – see page four), and have a chance to watch some interesting YouTube videos.
But, before we go into detail about short run and long run analysis (and the fisherman), here is some important information that you need to know about costs.
Cost concepts for economists do not necessarily coincide with those of accountants. Accounting costs are those which are recorded in a ledger entry as they have actually been incurred, while economic costs also include the concept of opportunity costs (Boddunun.com).
Opportunity Cost:
- “Opportunity cost is the value of the next best alternative that is forgone when another alternative is chosen” (Econ.yal.edu).
Lets say you decided to open that car factory that we mentioned earlier in the heart of London. Obviously, that’s going to require a lot of money. What was your next best alternative? Opening a factory in Timbuktu or Calcutta instead of London? Or, could you have decided to travel the world instead of starting a company? All of these alternatives have opportunity costs attached to them.
- Opportunity cost includes both implicit and explicit costs
- Implicit (or indirect) costs are costs that do not involve a direct payment of money to a third party. For example, when a firm already owns 'factors' (e.g. machinery), it does not have to pay money to use them. Nevertheless, implicit costs involve a sacrifice of an alternative (Sloman and Wride pg 126). For example, when you open that firm to create cars, you have costs that are not directly related to money. One such cost is stress. Stress (among other other implicit costs) can occur in several ways but will never show up in a balance sheet. How could you include this cost? It is impossible because it is intangible.
- Explicit (or direct) costs are the opportunity costs of using factors not already owned by the firm. They involve direct payment of money by firms. For example, bills paid for electricity, rent, salaries to workers, etc. (Sloman and Wride pg 126). To link it to our example, the wages that you give to your engineers (after all, you can’t do everything by yourself!) could have been invested in additional machinery.
The next section outlines some key differences between accounting costs and economic costs and the way they are defined.
Accounting Costs Vs. Economic Costs (Econ.yale.edu):
Accounting Costs
1. Take into account only explicit costs
2. Appear on the financial statements of a firm 3. Are backward-looking 4. Are objectively verifiable as they show the firm’s position to outsiders and are used to make tax payments |
Economic Costs
1. Are a sum of explicit and implicit costs
2. Are not taken into account on paper but they are relevant for decision making 3. Are forward-looking 4. Are not usually objectively verifiable as they are estimates of the cost of alternatives sacrificed. |
Let’s use to some numbers to illustrate these differences:
Consider that after graduating from Cass Business School, you worked for a while as a consultant at YouHaveNoPersonalLife Plc and earned a salary of £38,000 annually. You also received money from renting your garage - £1,000 annually. You decide to quit your job and evict your tenant and use the garage for setting up your own business of producing cars.
- Your accounting statement for the year would look like this:
Total revenue earned from your new business £130,000
Subtract costs (explicit costs):
Cost of cars (£90,000)
Advertising (£5,000)
Employees’ wages (£20,000) (£115,000)
Total accounting profit: £15,000
But an economist would not stop here. He/she would take into consideration the opportunity costs (the costs of the alternative opportunity that you passed up in order to undertake the business).
- Your economic profit/loss would be:
Total revenue earned from business £130,000
Explicit costs (£115,000)
Implicit costs:
Salary of previous job (£38,000)
Previous rent received (£1,000) (£154,000)
Therefore, economic profit (loss) (£24,000)
Although economists and accountants define profits and losses similarly, economic profits and accounting profits often differ (Unc.edu). The difference between the two (as shown above) is the opportunity cost. It is possible to make an ‘accounting profit’ while making an 'economic loss' at the same time. This is possible because economists include the costs of lost opportunities (i.e. the salary that you would have received if you had not quit your job to start a new business).
Historic costs
Historic costs are simply the costs that are paid at the time of purchase of a fixed asset. For example, the historic cost of machinery purchased in the past is always going to be equal to the cost of the machinery that you paid at that time. (Boddunan.com).
Sunk Costs
Sunk costs are monies that have been spent and cannot be recovered. They should not be taken into account when making financial decision and they must never affect your future decisions! (Mcafee, R, et al. pg 1) For example, if you spent £100,000 on constructing a self-made assembly line that failed to work, this should not affect your decision in terms of trying to save this money from other operations. You should act as if you never lost this money.
Works Cited for this page
Boddunan.com - Information Creates Wealth (2010) Economics versus Accounting cost concepts - Boddunan. [online] Available at: http://www.boddunan.com/articles/business-finance/6-other/13594-economics-versus-accounting-cost-concepts.html [Accessed: 19 Dec 2012].
Econ.yale.edu (2013) The Cost of Production. [online] Available at: http://www.econ.yale.edu/~gjh9/econ115b/slides8_4perpage.pdf [Accessed: 20 Dec 2013].
Investopedia.com (2012) Investopedia – Educating the world about finance. [online] Available at: http://investopedia.com [Accessed: 17 Dec 2012].
Mcafee, R. et al. (2007) Do Sunk Costs Matter? . [online] Available at: http://vita.mcafee.cc/PDF/SunkCostFolly.pdf [Accessed: 30 Dec 2012].
Sloman, J. and Wride, A. (2009) Economics. 7th ed. England: Pearson Prentice Hall.
Unc.edu (2011) Economics Interactive. [online] Available at: http://www.unc.edu/depts/econ/byrns_web/Economicae/Essays/Actg_V_Econ.htm [Accessed: 19 Dec 2012].
Econ.yale.edu (2013) The Cost of Production. [online] Available at: http://www.econ.yale.edu/~gjh9/econ115b/slides8_4perpage.pdf [Accessed: 20 Dec 2013].
Investopedia.com (2012) Investopedia – Educating the world about finance. [online] Available at: http://investopedia.com [Accessed: 17 Dec 2012].
Mcafee, R. et al. (2007) Do Sunk Costs Matter? . [online] Available at: http://vita.mcafee.cc/PDF/SunkCostFolly.pdf [Accessed: 30 Dec 2012].
Sloman, J. and Wride, A. (2009) Economics. 7th ed. England: Pearson Prentice Hall.
Unc.edu (2011) Economics Interactive. [online] Available at: http://www.unc.edu/depts/econ/byrns_web/Economicae/Essays/Actg_V_Econ.htm [Accessed: 19 Dec 2012].