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Cost
and the firm’s budget constraint. Although largely the domain of accountants, the concept of cost to an economist carries a somewhat different connotation. As already discussed in Chapter 1, economists generally are concerned with any and all costs that are relevant to the production process. These costs are referred to as total economic costs. Relevant costs are all costs that pertain to the decision by management to produce a particular good or service. Total economic costs include the explicit costs associated with the dayto-day operations of a firm, but also implicit (indirect) costs. All costs, both explicit and implicit, are opportunity costs. They are the value of the next best alternative use of a resource. What distinguishes explicit costs from implicit costs is their “visibility” to the manager. Explicit costs are sometimes referred to as “out-of-pocket” costs. Explicit costs are visible expenditures associated with the procurement of the services of a factor of production. Wages paid to workers are an example of an explicit cost. By contrast, implicit costs are, in a sense, invisible: the manager will not receive an invoice for resources supplied or for services rendered. To understand the distinction, consider the situation of a programmer who is weighing the potential monetary gains from leaving a job at a computer software company to start a consulting business. The programmer must consider not only the potential revenues and out-of-pocket expenses (explicit costs) but also the salary forgone by leaving the computer company. The programmer will receive no bill for the services he or she brings to the consulting company, but the forgone salary is just as real a cost of running a consulting business as the rent paid for office space. As with any opportunity cost, implicit costs represent the value of the factor’s next best alternative use and must therefore be taken into account. As a practical matter, implicit costs are easily made explicit. In the scenario just outlines, the programmer can make the forgone salary explicit by putting himself or herself “on the books” as a salaried employee of the consulting firm.
SHORT-RUN COST The theory of cost is closely related to the underlying production technology. We will begin by assuming that the firm’s short-run total cost (TC) of production is given by the expression TC = f (Q)
(6.1)
As we discussed in Chapter 5, the short run in production is defined as that period of time during which at least one factor of production is held at some fixed level. Assuming only two factors of production, capital (K) and labor (L), and assuming that capital is the fixed factor (K0), then Equation (6.1) may be written
