Foundationsmicroeconomics
Costs in Economics: A Complete Overview
Overview
Before the individual cost curves, this lesson maps the territory: what economists mean by cost, how explicit and implicit costs combine into opportunity cost, and why economic profit - the profit that matters for decisions - subtracts both. You will also see how the short-run and long-run cost families fit together as a roadmap for the lessons ahead.
Learning objectives
- Define opportunity cost and apply it to production decisions.
- Distinguish explicit from implicit costs with examples.
- Explain the difference between accounting profit and economic profit.
- Outline how the short-run and long-run cost curves relate.
Cost Means Opportunity Cost
In economics, the cost of any choice is the value of the best alternative forgone - the opportunity cost. Producing 100 chairs costs not just the wood and wages but the tables that wood and labor could have made instead. Market prices usually measure opportunity cost well, because the price of lumber reflects what others would pay for it; the exceptions, where prices mislead, are exactly what implicit costs capture.
Explicit vs Implicit Costs
Explicit costs are out-of-pocket payments: wages, rent, materials, interest on loans. Implicit costs are forgone opportunities without a cash transaction: the salary the owner could have earned elsewhere, the interest the invested savings could have earned, the rent the owned building could have fetched. Total economic cost = explicit + implicit costs.
A founder who works 60-hour weeks for free still incurs a real cost: the market wage she forgoes. Ignoring it makes the business look more profitable than it truly is - a classic small-business accounting illusion.
Accounting Profit vs Economic Profit
Accounting profit = revenue minus explicit costs - the number on financial statements. Economic profit = revenue minus all opportunity costs (explicit + implicit). A shop with 150,000 explicit costs, and 50,000 accounting profit but -$10,000 economic profit: the owner would do better taking the job. Decisions follow economic profit.
Zero economic profit means the firm covers all its opportunity costs, including a normal return on the owner's time and capital. The resources have no better alternative - that is success, not failure, in economic terms.
Normal Profit: The Cost of Staying
Normal profit is the minimum return needed to keep resources in their current use - it is an implicit cost, part of total cost. When economists say long-run competitive equilibrium yields zero economic profit, they mean firms earn exactly normal profit: enough to stay, not enough to attract entry. Anything above normal profit is pure (supernormal) economic profit.
The Cost Roadmap: Short Run and Long Run
Short-run analysis splits cost into fixed and variable, producing the TFC/TVC/TC and AFC/AVC/ATC/MC family with their U-shapes. Long-run analysis treats all inputs as variable, asking which plant size minimizes cost at each output - the envelope LRAC curve with its economies and diseconomies of scale. The coming lessons walk this map curve by curve.
Why Getting Cost Right Matters
Cost misconceptions drive real mistakes: counting sunk costs that should be ignored, ignoring implicit costs that should be counted, and confusing average with marginal cost in pricing. Every supply curve in microeconomics is derived from marginal cost, so the entire theory of how markets respond to prices rests on measuring cost the economic way.
Key points
- Economic cost is opportunity cost: the value of the best forgone alternative.
- Total cost = explicit (out-of-pocket) costs + implicit (forgone-opportunity) costs.
- Accounting profit subtracts only explicit costs; economic profit subtracts all opportunity costs.
- Normal profit is the implicit cost of keeping resources in their current use.
- Zero economic profit means covering all opportunity costs - not business failure.
- Short-run costs split fixed/variable; long-run costs treat all inputs as variable.
Common misconceptions
✓ Truth: Accounting profit ignores implicit costs like the owner's forgone salary and the forgone return on invested capital. A firm can show accounting profit while earning negative economic profit - its resources would do better elsewhere.
✓ Truth: Normal profit is part of cost: the minimum payment needed to retain the owner's resources. Economic models include it in total cost, which is why zero economic profit still leaves the firm viable.
✓ Truth: It drives real decisions: whether to attend college (forgone earnings), whether to keep a loss-making product line (forgone input uses), and how antitrust authorities assess predatory pricing.
Practice questions
Q1. A bakery has revenue of $300,000, explicit costs of $220,000, and the owner forgoes a $50,000 salary. Economic profit is:
- $80,000
- $30,000
- -$20,000
- $0
Accounting profit = 300,000 - 220,000 = 50,000 salary too: 300,000 - 220,000 - 50,000 = $30,000.
Q2. Which of the following is an implicit cost of running a firm?
- Wages paid to employees.
- The rental income forgone by using a self-owned building.
- Electricity bills.
- Raw material purchases.
Forgone rent is an opportunity cost with no cash transaction - the building could have earned rent elsewhere. Wages, electricity, and materials are explicit out-of-pocket costs.
Q3. Zero economic profit in long-run competitive equilibrium means firms:
- are going bankrupt.
- cover all opportunity costs including normal profit, with no incentive to enter or exit.
- earn zero accounting profit.
- pay no wages.
Zero economic profit means revenue exactly covers explicit plus implicit costs - owners earn normal profit, the return needed to keep resources in place. There is no pure profit to attract entrants and no loss driving exits.
Q4. A firm must decide whether to keep a machine or sell it for $40,000. The relevant cost concept for the decision is:
- the machine's historical purchase price.
- the $40,000 forgone by keeping it - its opportunity cost.
- last year's depreciation charge.
- the average cost of all machines.
The purchase price is sunk and depreciation is backward-looking; the decision turns on what is forgone now. Keeping the machine costs the $40,000 sale proceeds given up.
Click a question to reveal the answer and explanation.
Frequently asked questions
How do I estimate implicit costs in practice?
Ask what each owner-supplied resource would earn in its best alternative: the wage for the owner's labor, the market rent for an owned building, the safe interest rate for invested funds. These market benchmarks approximate the forgone opportunities without needing perfect data.
Why do economists insist on including costs nobody pays?
Because decisions respond to real alternatives, not cash flows. A farmer deciding whether to keep farming weighs the city job she gives up; excluding it would predict she farms forever even when the job pays more.
Is depreciation an explicit or implicit cost?
Accounting depreciation of owned equipment is a non-cash charge reflecting wear - economists treat the forgone resale value and replacement need as part of the opportunity cost of using the equipment. Either way, using up capital is a real cost.
Do nonprofits and governments face opportunity costs too?
Yes. A charity's volunteer hours could have produced value elsewhere, and a government project's funds have alternative public uses. Opportunity cost applies to every allocation of scarce resources, market or not.