Managerial Economics

Explicit and implicit costs and accounting and economic profit

Key points
Privately owned firms are motivated to earn profits. Profit is the difference between revenues
and costs.
Private enterprise is the ownership of businesses by private individuals.
Production is the process of combining inputs to produce outputs, ideally of a value greater than
the value of the inputs.
Revenue is income from selling a firm’s product; defined as price times quantity sold.
Accounting profit is the total revenues minus explicit costs, including depreciation.
Economic profit is total revenues minus total costs—explicit plus implicit costs.
Explicit costs are out-of-pocket costs for a firm—for example, payments for wages and salaries,
rent, or materials.
Implicit costs are a specific type of opportunity cost: the cost of resources already owned by the
firm that could have been put to some other use. For example, an entrepreneur who owns a
business could use her labor to earn income at a job.
Explicit and implicit costs and accounting and economic Profit
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Private enterprise—the ownership of businesses by private individuals—is a hallmark of the US
economy. When people think of businesses, often giants like Wal-Mart, Microsoft, or General
Motors come to mind. Each of these businesses, regardless of size or complexity, tries to earn a
profit.
Profit = Total revenue – Total cost
Total revenue is the income brought into a firm from selling its products. It is calculated by
multiplying the price of the product times the quantity of output sold:
Total revenue = Price × Quantity
We can distinguish between two types of cost: explicit and implicit. Explicit costs are out-of-
pocket costs—payments that are actually made. Wages that a firm pays its employees or rent that
a firm pays for its office are explicit costs.
Implicit costs are more subtle but just as important. They represent the opportunity cost of using
resources already owned by the firm. Often for small businesses, they are resources contributed
by the owners—for example, working in the business while not getting a formal salary or using
the ground floor of a home as a retail store. Implicit costs also allow for depreciation of goods,
materials, and equipment that are necessary for a company to operate.

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These two definitions of cost are important for distinguishing between two conceptions of profit
—accounting profit and economic profit. Accounting profit is a cash concept. It means total
revenue minus explicit costs—the difference between dollars brought in and dollars paid
out. Economic profit is total revenue minus total cost, which includes both explicit and implicit
costs.
The difference is important. Even though a business pays income taxes based on its accounting
profit, whether or not it is economically successful depends on its economic profit.

Calculating implicit costs

Let's take a look at an example in order to understand better how to calculate implicit costs.
Fred currently works for a corporate law firm. He is considering opening his own legal practice,
where he expects to earn $200,000 per year once he gets established. To run his own firm, he
would need an office and a law clerk. He has found the perfect office, which rents for $50,000
per year. A law clerk could be hired for $35,000 per year. If these figures are accurate, would
Fred’s legal practice be profitable?
Step 1. First we'll calculate the costs. We'll use what we know about explicit costs:
Explicit costs = Office rental - Law clerk's salary
2 Explicit costs = $50,000 + $35,000
Explicit costs =$85,000
Step 2. Subtracting the explicit costs from the revenue gives you the accounting profit.
Accounting profit = Revenues - Explicit costs
Accounting profit = $200,000 - $85,000
Accounting profit = $115,000
But these calculations consider only the explicit costs. To open his own practice, Fred would
have to quit his current job, where he is earning an annual salary of $125,000. This would be an
implicit cost of opening his own firm.
Step 3. You need to subtract both the explicit and implicit costs to determine the true economic
profit:
Economic profit =Total revenues - Explicit costs - Implicit costs Economic profit =$200,000 -
$85,000 - $125,000
Economic profit = - $10,000\

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Fred would be losing $10,000 per year. That does not mean he would not want to open his own
business, but it does mean he would be earning $10,000 less than if he worked for the corporate
firm.
Implicit costs can include other things as well. Maybe Fred values his leisure time, and starting
his own firm would require him to put in more hours than at the corporate firm. In this case, the
lost leisure would also be an implicit cost that would subtract from economic profits.
Implicit costs are the opportunity cost of resources already owned by the firm and used in
business—for example, expanding a factory onto land already owned.

Self-check questions

A firm had sales revenue of $1 million last year. It spent $600,000 on labor,
$150,000 on capital, and $200,000 on materials. What was the firm’s
accounting profit?

Accounting profit = Total revenues - Explicit costs

3 Accounting profit = $1,000,000 - (\600,000 + $150,000 + $200,000)

Accounting profit= $50,000

Definition of Opportunity Cost in Economics

In modern economic analysis, the factors of production are scarce as compared to the wants.

Therefore, when society uses a certain factor in the production of a specific commodity, then it
forgoes other commodities for which it could use the same factor. This led to the idea of an
opportunity cost (OC).Let’s say that a certain kind of steel is needed to manufacture weapons for
war. Therefore, society has to give up the number of utensils that it could produce using the same
amount of steel.

Hence, the opportunity cost of producing weapons for war is the number of utensils forgone.

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In other words, opportunity costs are the costs of the next best alternative forgone. Therefore, we
can deduce two important aspects:

1. The opportunity costs of a product are only the best alternative forgone and not any other
alternative.

2. These costs are viewed as the next-best alternative goods that we can produce with the
same value of factors which are more or less the same.

How to Calculate Opportunity Cost

4 Formula of Opportunity cost = Return of Investment from the best option available – Return of
investment from the chosen option.

Examples of Opportunity Cost

Let’s understand these costs with the help of an illustration.

Let’s say that a farmer has a piece of land on which he can grow wheat or rice.

Therefore, if he chooses to grow wheat, then he cannot grow rice and vice-versa.

Hence, the opportunity cost for rice is the wheat crop that he forgoes. The following diagram
explains this:

Opportunity Cost Graph –

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Let’s assume that the farmer can produce either 50 quintals of rice (ON) or 40 quintals of wheat
(OM) using this land. Now, if he produces rice, then he cannot produce wheat.Therefore, the OC of
50 quintals of rice (ON) is 40 quintals of wheat (OM).

Further, the farmer can choose to produce any combination of the two crops along the curve MN
(production possibility curve). Let’s say that he chooses the point A as shown above.

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Therefore, he produces OD amount of rice and OC amount of wheat. Subsequently, he decides to
shift to point B. Now, he has to reduce the production of wheat from OC to OE in order to increase
the production of rice from OD to OF.

Therefore, the OC of DF amount of rice is CE amount of wheat.

Applications of Opportunity Cost

 Determining factor prices

 Determining economic rent

 Consumption pattern decisions

 Determining factor prices

 Product plan decisions

 Decisions about national priorities

Determining factor prices

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The factors for production need a price equal to or greater than what they command for alternative
uses. If the factor price is less than the factor’s opportunity cost, then the said factor moves to the
better-paying alternative.

Determining economic rent

Many modern economists use this concept for determining economic rent. As per them, economic
rent = The factor’s actual earning – Its opportunity cost or transfer earning

Consumption pattern decisions

According to this concept, if with a given amount of money a consumer chooses to have more of
one thing, then he needs to have less of the other.

Further, he cannot increase the consumption of all the goods at the same time. Therefore, he decides
his consumption pattern using the concept of opportunity cost.

Product plan decisions

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Let’s say that a producer has fixed resources and technology. If he wants to produce a greater
amount of one commodity, then he must sacrifice the quantity of another commodity.

Therefore, he uses this concept to make decisions about his production plan.

Decisions about national priorities

Every country has certain resources at its command and needs to plan the production of a wide
range of commodities. This decision depends on the national priorities which are based on
opportunity costs.

For example, if a country is at war, then it will use its resources to produce more war-related goods
as compared to civilian goods.

This concept helps the country in making these decisions.

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What is the Difference between Sunk Cost and Opportunity Cost?

The sunk cost can be defined as the financial cost which is already invested and now it cannot be
incurred or money you cannot get back.

For example, if a company purchases 1000s of laptops for $1000000, then that money is sunk i.e.
the company cannot get the money back for those laptops. To get that money back we need to get
the amount higher than the purchase price.

Opportunity cost is how much less return of investment a company received because of investing
capital somewhere else.

Types of Opportunity Cost in Production

 Explicit Cost

 Implicit Cost

 Marginal Opportunity Cost

What is Explicit Cost?
Explicit costs are the cost which includes the monetary payment from the producers. For example,
7 if the company is paying $1000 per month in food by providing free lunch and breakfast, then its
explicit OC is $1000. The expenditure on food could have been used somewhere else.

What is Implicit Cost?

Implicit cost aka notional cost can be defined as the OC which a company used in order to produce
something. For example, a company purchased small electronic devices to produce mobile phones,
laptops, etc. This cost is used to produce something, the electronic devices are not sold or rented.

What is Marginal Opportunity Cost?

Marginal opportunity cost is a cost required to produce something extra. For example, currently a
company is producing 1000 burgers per day, but due to heavy demand, they are running out of the
burgers. So, the company decided to hire more people and cook more burgers.

Now marginal opportunity cost will include – payment of new employees, cost required for
ingredients required to cook more burgers,  profit company was missing before and many other
extra costs required for producing additional burgers.

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