Identifying the Characteristics of Perfect Competition

122 Part II: Considering Which Side You’re On in the Decision-Making Process

Determining the Cost of Everything: Opportunity Costs

Everything!? To produce goods, you must decide how to use scarce resources. Using those resources for one thing means they can’t be used for something else. Economists define production costs in terms of what’s forgone or given-up. Therefore, the cost of using resources to produce one good is based upon the value of the next best alternative for those resources. This is the concept of opportunity cost.

The importance of opportunity costs is emphasized in the distinction between explicit and implicit costs:

✓ Explicit costs represent the costs of using resources contributed by non-owners of the firm. Explicit costs include the wages and salaries paid to workers, the interest paid on debt, and payments made to suppliers. Typically, these costs require a direct cash expenditure. ✓ Implicit costs are the opportunity costs of resources contributed by the firm’s owners. Implicit costs include the value of your time, the opportunity cost of the financial resources you contribute to the firm, and depreciation on the firm’s machinery, equipment, and factories.

Often no immediate direct cash outlay is associated with the implicit costs.

Accountants and business owners normally don’t include implicit costs. When determining whether or not your business is profitable, you need to include the opportunity costs of the time you contributed. You also must include the opportunity costs of the money you invested. At the very least, you could have invested that money and earned interest. Be very careful that you include every cost associated with production, regardless of whether or not it involves an immediate cash outlay.

Purchasing Inputs

Because your goal is profit, inputs — and the goods produced with those inputs — are simply a means to your goal. But just like you’ve heard about your health — you are what you eat — what you produce and its cost are determined by the inputs you use. The product you produce reflects the inputs you choose.

Changing inputs in response to changing market conditions is influenced by the timeframe you have to adjust. An increased demand for your product may lead you to immediately hire additional workers. Over a longer period of time, you may decide to expand by building a new facility or renovating an existing facility to produce more. When examining production costs, recognize that some inputs aren’t easily changed due to the timeframe available.