Opportunity Costs and Economic Profits

In light of this conflicting advice, what type of cost analysis could guide the firm in determining its profit-maximizing course of action?

Cost analysis is the bedrock on which many managerial decisions are grounded. Reckoning costs accurately is essential to determining a firm’s current level of profitability. Moreover, profit-maximizing decisions depend on projections of costs at other (untried) levels of output. Thus, production managers frequently pose such questions as, What would be the cost of increasing production by 25 percent? What is the impact on cost of rising input prices? What production changes can be made to reduce or at least contain costs? In short, managers must pay close attention to the ways output and costs are interrelated.

In this chapter, we build on Chapter 5’s analysis of production to provide an overview of these crucial cost concepts. In the first section, we discuss the basic principles of relevant costs—considering the concepts of opportunity costs and fixed costs in turn. Next, we examine the relationship between cost and output in the short run and the long run. Then we turn to economies of scale and economies of scope. Finally, we consider the importance of cost analysis for a number of key managerial decisions.

RELEVANT COSTS

A continuing theme of previous chapters is that optimal decision making depends crucially on a comparison of relevant alternatives. Roughly speaking, the manager must consider the relevant pros and cons of one alternative versus another. The precise decision-making principle is as follows:

In deciding among different courses of action, the manager need only consider the differential revenues and costs of the alternatives.

Thus, the only relevant costs are those that differ across alternative courses of action. In many managerial decisions, the pertinent cost differences are readily apparent. In others, issues of relevant cost are more subtle. The notions of opportunity costs and fixed costs are crucial for managerial decisions. We will consider each topic in turn.

Opportunity Costs and Economic Profits

The concept of opportunity cost focuses explicitly on a comparison of relative pros and cons. The opportunity cost associated with choosing a particular decision is measured by the benefits forgone in the next-best

alternative. Typical examples of decisions involving opportunity cost include the following:

• What is the opportunity cost of pursuing an MBA degree? • What is the opportunity cost of using excess factory capacity to supply specialty orders? • What is the opportunity cost that should be imputed to city-owned land that is to be the site of a public parking garage downtown?

As the definition suggests, an estimate of the opportunity cost in each case depends on identifying the next-best alternative to the current decision. Consider the first example. Suppose the MBA aspirant has been working in business for five years. By pursuing an MBA degree full time, what is he giving up? Presumably, it is the income he could have earned from the present job. (This opportunity cost is larger or smaller depending on how remunerative the job is and on the chances for immediate advancement.) Therefore, the total cost of taking an MBA degree is the explicit, out-of-pocket tuition cost plus the implicit (but equally real) opportunity cost.1

Next, consider the case of excess factory space. Assuming this space otherwise would go unused, its opportunity cost is zero! In other words, nothing is given up if the extra space is used to supply the specialty orders. More realistically, perhaps, one would assign a small opportunity cost to the capacity; committing the space to the specialty order might preclude using it for a more profitable “regular” order that might arrive unexpectedly.

Finally, consider the case of the city-owned land. Here the opportunity cost is whatever dollar value the land could bring in its next-best alternative. This might mean a different, more profitable city project. In general, an accurate estimate of the land’s alternative value is simply its current market price. This price reflects what potential buyers are willing to pay for comparable downtown real estate. Unless the city has a better alternative for the land, its next-best option will be to sell the land on the open market.

As the first and third examples illustrate, opportunity costs for goods, services, or inputs often are determined by market prices (assuming such markets exist). For instance, the opportunity cost of the full-time MBA student’s time is his forgone wage (determined, of course, by labor-market conditions). The cost of the city-owned land is its market price. Note that if the city did not own the land, its cost would be explicit; it would have to pay the market price to

1Here are some questions to consider: What is the opportunity cost of pursuing an MBA degree part time at night while holding one’s current job? For a 19-year-old, what is the opportunity cost of pursuing an undergraduate business degree?

obtain it. The fact of ownership doesn’t change this cost; opportunity cost is still determined by the market price.2

The concept of opportunity cost is simply another way of comparing pros and cons. The basic rule for optimal decision making is this:

Undertake a given course of action if and only if its incremental benefits exceed its incremental costs (including opportunity costs).

Thus, pursuing the MBA degree makes sense only if the associated benefits— acquisition of knowledge, career advancement, higher earnings—exceed the total costs. Likewise, the factory space should be used only if the direct increase in cash flows exceeds the opportunity cost. Finally, the garage should be built only if its total benefits exceed its costs.

How would one estimate the full cost to an airline if one of its planes is held over for 24 hours in a western airport for repair?

ECONOMIC PROFIT At a general level, the notion of profit would appear unambiguous: Profit is the difference between revenues and costs. On closer examination, however, one must be careful to distinguish between two definitions of profit. Accounting profit is the difference between revenues obtained and expenses incurred. The profit figures reported by firms almost always are based on accounting profits; it is the job of accountants to keep a careful watch on revenues and explicit expenses. This information is useful for both internal and external purposes: for managers, shareholders, and the government (particularly for tax purposes). With respect to managerial decision making, however, the accounting measure does not present the complete story concerning profitability. In this case, the notion of economic profit is essential. Economic profit is the difference between revenues and all economic costs (explicit and implicit), including opportunity costs. In particular, economic profit involves costs associated with capital and with managerial labor. Here is a simple illustration.

STARTING A BUSINESS After working five years at her current firm, a money manager decides to start her own investment management service. She has

CHECK STATION 1

2Of course, explicit costs and opportunity costs sometimes differ. For example, suppose an individual possesses financial wealth that earns an 8 percent rate of return. If that person were to borrow from a bank, the rate would be no lower than 11 percent. Then the opportunity cost of internally financing payment of MBA tuition is lower than the market cost of obtaining a loan to do so.

developed the following estimates of annual revenues and costs (on average) over the first three years of business:

Management fees $140,000 Miscellaneous revenues 12,000 Office rent 36,000 Other office expenses 18,000 Staff wages (excluding self) 24,000

From this list, the new venture’s accounting profit, the difference between revenues and explicit expenses, would be reckoned at $74,000.

Is going into business on one’s own truly profitable? The correct answer depends on recognizing all relevant opportunity costs. Suppose the money manager expects to tie up $80,000 of her personal wealth in working capital as part of starting the new business. Although she expects to have this money back after the initial three years, a real opportunity cost exists: the interest the funds would earn if they were not tied up. If the interest rate is 8 percent, this capital cost amounts to $6,400 per year. This cost should be included in the manager’s estimate. Furthermore, suppose the manager’s compensation (annual salary plus benefits) in her current position is valued at $56,000. Presumably this current position is her best alternative. Thus, $56,000 is the appropriate cost to assign to her human capital.

After subtracting these two costs, economic profit is reduced to $11,600. This profit measures the projected monetary gain of starting one’s own business. Since the profit is positive, the manager’s best decision is to strike out on her own. Note that the manager’s decision would be very different if her current compensation were greater—say, $80,000. The accounting profit looks attractive in isolation. But $74,000 obviously fails to measure up to the manager’s current compensation ($80,000) even before accounting for the cost of capital.

In general, we say that economic profit is zero if total revenues are exactly matched by total costs, where total costs include a normal return to any capital invested in the decision and other income forgone. Here normal return means the return required to compensate the suppliers of capital for bearing the risk (if any) of the investment; that is, capital market participants demand higher normal rates of return for riskier investments. As a simple example, consider a project that requires a $150,000 capital investment and returns an accounting profit of $9,000. Is this initiative profitable? If the normal return on such an investment (one of comparable risk) is 10 percent, the answer is no. If the firm must pay investors a 10 percent return, its capital cost is $15,000. Therefore, its economic profit is $9,000 $15,000 $6,000. The investment is a losing proposition. Equivalently, the project’s rate of return is