Costs

Microeconomics
In economics, the value of resources used (including opportunity cost) to produce a good, service, or outcome.
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Costs are the value of the resources used to achieve an outcome. In economics, that includes not only cash payments (like wages or rent) but also opportunity cost: the value of the best alternative you give up.

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Economic Cost vs. Accounting Cost

Economists usually separate:

  • Explicit costs: direct out-of-pocket payments (wages, materials, rent, interest).
  • Implicit costs: non-cash costs of using your own resources (owner time, using owned capital, using owned land).
  • Opportunity cost: the value of the next-best alternative (often includes implicit costs).

This is why an activity can be “profitable” in an accounting sense but still have negative economic profit if the opportunity cost of resources is high.

Key Cost Measures In Production

In microeconomics, costs are often described as functions of output \(Q\):

\[ TC(Q) = FC + VC(Q) \]

From total cost \(TC\), we define:

  • Average cost: \(AC(Q) = TC(Q)/Q\)
  • Marginal cost: \(MC(Q) = \Delta TC / \Delta Q\) (or the derivative when costs are smooth)

Two core ideas follow:

  • Marginal decisions depend on marginal cost. Firms compare the extra cost of producing one more unit to the extra revenue from selling it.
  • Average costs summarize “cost per unit” but are not the decision margin for whether to expand output by one more unit.

Decision Rules (Why Cost Definitions Matter)

Three common rules show up again and again:

  • Ignore sunk costs. If a cost cannot be recovered, it should not affect the optimal choice going forward; only future marginal benefits and costs matter.
  • Short-run shutdown (competitive intuition): a firm may keep producing in the short run if price covers average variable cost (it can pay variable inputs and contribute something to fixed costs).
  • Long-run entry/exit: in the long run, fixed costs are avoidable; staying in the market requires covering all relevant opportunity costs.

Private Cost vs. Social Cost

Some costs fall on people other than the decision maker:

  • Private cost: borne by the producer/consumer making the decision.
  • External cost: imposed on others (pollution is the classic example).
  • Social cost: private cost plus external cost.

This distinction matters for policy because private incentives can diverge from what is efficient for society.

Knowledge Check

### In economics, why is opportunity cost part of “cost” even when no money is paid? - [x] Because using a resource for one purpose means giving up its best alternative use - [ ] Because costs are defined only as accounting expenses - [ ] Because taxes always create opportunity costs - [ ] Because prices never change > **Explanation:** Economic cost is about trade-offs. The real cost of a choice includes what you must forgo by making it. ### Why should sunk costs not affect a forward-looking decision? - [x] Because they cannot be recovered, so they do not change the marginal cost/benefit of the next choice - [ ] Because sunk costs are always equal to fixed costs - [ ] Because sunk costs are paid by someone else - [ ] Because sunk costs occur only in the long run > **Explanation:** Optimal choices depend on future consequences. If a past cost is unrecoverable, it is the same across all future options. ### If marginal cost (MC) is below average cost (AC), what typically happens to AC as output increases? - [x] AC tends to fall - [ ] AC tends to rise - [ ] AC stays constant by definition - [ ] AC becomes negative > **Explanation:** The average is “pulled down” by adding units that cost less than the current average; it is “pulled up” by adding units that cost more than the current average.
Council for Mutual Economic Assistance
Cost, Insurance, and Freight (c.i.f.)