Economic Costs
Let’s talk about costs and revenue for a firm. Once again, definitions in economics are a little different than what you’re probably conventionally used to. Explicit or accounting costs involve the expenditure of money. That’s things like rent, wages, materials, and insurance – they’re what you’d typically think of as “costs.” In economics, there are two types of accounting costs: fixed and variable. Fixed costs do not depend on output, variable costs do. That is, the more you produce, the more your variable costs are. For instance, if you were producing bread, the money you’d spend on flour would count as a variable cost – that’s because you’d need to buy more flour if you wanted to increase your bread production. Fixed costs might include the money you spend on rent for your bakery. Implicit costs, another term to know, are basically just opportunity costs; they’re the value of benefits that are forgone. Taking both explicit and implicit costs into account, you get economic cost.
Definitions of cost align with those of profit. Accounting profit is equal to revenue minus explicit costs and depreciation of capital. Again, you’re looking at places where money is directly lost to subtract from revenue. Economic profit is accounting profit minus opportunity costs. The term “normal economic profit” means that there is zero economic profit. Importantly, a firm having non-negative economic profit implies that its resources cannot be more optimally used.
Here’s an example situation: Sahaj works for a law firm, earning $130,000. He leaves his job to
start his own private practice, where he will earn $250,000 per year. He finds an office that rents for $4,000 per month, hires a clerk for $35,000 per year, and estimates operating expenses of his office to be $2,000 per year.
See if you can calculate Sahaj’s accounting and economic profit of his new private practice on your own.
His accounting profit for the year (represented by πA) is 250,000 - (4,000 * 12) - 35,000 - 2,000 = $165,000. The mistake you may have made here was not multiplying the office costs by 12, remembering that profit is generally calculated annually, not monthly. His economic profit (represented by πE) is 165,000 (πA) - 130,000 = $35,000. Looks like Sahaj is using his resources well.
You’ve probably heard the term “long run.” In microeconomics, the long run is the period where all factors of production are variable, meaning a firm can readily adjust its scale of operations. In the short run, that is not the case – there is at least one fixed cost, something that can’t be changed as needed. For instance, if an airline entered into a hangar space rental agreement for one year, the length of the short run would just be one year long.