What It Means
Every economic decision carries a cost, a price that must be paid in order to acquire or produce anything. Costs can come in terms of money, time, labor, or even the trouble it takes. For instance, nearly every action a person makes uses up money, time, or both; that money or time could have been used for other things that that person values. In economics, cost is often viewed in terms of the opportunity that is given up when a decision is made; this is called opportunity cost. In a simple example, if Maria chooses to go to college full-time, she chooses not to spend that time on working and earning a full-time salary at a job. Therefore, the cost of attending college is not just the money Maria spends on school; it also includes the value of her next-best alternative, the job she has given up to attend college.
The opportunity cost of a choice includes both explicit and implicit costs. The explicit cost is easily identifiable because it is a measurement of the money sacrificed through actual payments for a particular choice. In Maria’s case, the explicit cost of going to college is the amount she spends on tuition and books (but not food and clothing, because she would have to purchase those regardless). The explicit costs a business might typically have include a wage paid out to an employee, rent paid for use of a building, and payments for new materials. The explicit, or direct money, cost may only be a part—and sometimes just a small part—of the opportunity cost of a choice.
The implicit cost is the value of anything other than direct payment that is sacrificed. Time is usually the biggest type of implicit cost, because time can often be spent earning money. When Maria chooses to attend college full-time, one implicit cost of that decision is the time she could have spent earning money at a full-time job. Because implicit costs are largely intangible, they can be hard to assess. For a business, use of its facilities and equipment and even the time that the owner spends on the business are all considered implicit costs.
When Did It Begin
The concepts of opportunity cost and explicit and implicit costs developed along with modern forms of business. In the decades after World War II (1939–45), business in the United States grew rapidly. With that growth came a greater understanding of economic profit and the various types of costs that a business takes on in order to achieve profitability.
Additionally, the population increase of the last half-century has meant that all resources, including land and money, have been growing increasingly scarce. The scarcities of resources such as land, money, and time have contributed to greater competition and, for some members of society, have created more wealth. A talented entrepreneur, for example, can earn hundreds of dollars for an hour of work. Therefore, each activity that such a person undertakes carries a high opportunity cost.
Greater population pressure on land in many U.S. cities means that officials making real estate decisions there have to consider opportunity costs carefully. For instance, if a city is choosing between constructing a stadium and a convention center, it needs to determine as fully as possible the costs of giving up either option.
More Detailed Information
With many choices, the largest part of the opportunity cost is the money sacrificed. For instance, if a person spends $18 on a new compact disc, he has to part with $18, which is money he could have spent on something else. Other than this sacrifice, there is little additional cost involved. For other choices, money may be a small part of what is given up. Sometimes there is no money sacrificed. If you decide to spend an hour watering your plants instead of working out at the gym, you have given up time but no money.
Economists tend to attach monetary values to costs that do not involve money, although individuals rarely do. By giving a monetary value to sacrifices, it is easier to understand costs in terms of a number, even if the number is an estimate. This makes it easier to compare the cost of a choice with its benefits, which are often represented in dollars (or whatever the local currency is). The person who chooses to attend college full-time instead of working full-time can develop an estimation of the many explicit costs of her choice (by adding up the payments she makes to go to college). She could also estimate the implicit cost, the amount of income she would be able to make if she were to work full-time instead of attending college. Added together, these explicit and implicit costs would give her the total opportunity cost of a year in college, which is significantly greater than the price of school tuition.
The information gathered from the analysis of costs must be weighed against information about the advantages of attending college. In addition to its substantial cost, a college education has substantial benefits, including financial ones. Over the course of 40 years in the workplace, the average college graduate makes significantly more money and may enjoy greater job security than the average high school graduate. This benefit is easier to quantify than the enjoyment and satisfaction that some students can derive from attending college. Although such benefits might be difficult to measure, they are important factors in analyzing the costs and benefits of attending college.
The same distinctions about opportunity costs and explicit and implicit costs apply to business firms. In business an explicit cost is the money spent on inputs (any resources used in the processes of production, such as new equipment or the wages paid to an employee). Sometimes explicit costs are referred to as outlay costs. Technically speaking, outlay costs are any concrete costs that can be identified in the past, present, or future.
For businesses an implicit cost is the cost of inputs for which there is no direct money payment, such as the time that the business owner spends working. In other words, the implicit costs of a business decision are the opportunity costs of using the business’ self-owned, self-employed resources. The number attached to these costs is the amount of money that those resources could have made in their best alternative use. For example, if the business were trying to determine the implicit cost of its owner’s time, it would consider the best possible financial compensation its owner could receive if she was employed elsewhere.
Operators of business firms today are able to determine costs for virtually all decisions they need to make in the course of running a business. For example, suppose an entrepreneur who owns a business that produces greeting cards brings in $40,000 in total revenue in a year. The owner would carefully consider the other products he might be able to make with the business’s available production resources. He estimates that, by producing children’s notebooks instead of cards, he could generate $50,000 in a year. Therefore, he is able to recognize that the implicit cost of producing cards is $50,000 and that to continue to do so for another year would mean sacrificing the $10,000 difference.
This example, however, is the simplest possible scenario: the opportunity cost only involves the $10,000 in revenue that the business sacrifices to make cards instead of notebooks. There are usually many more factors involved, making it much more complicated to calculate opportunity costs. For instance, in the above example, card production would probably carry different business expenses than notebook production (perhaps the raw materials for one of the products would cost less). The entrepreneur would have to take these expenses into account. Other factors might include different ways that the business could be cutting its expenses (such as adopting different production techniques and finding ways to pay less business tax) and different ways it could spend the money it usually puts into the business (for instance, by investing some of it). Companies have increasingly been employing business analysts with specific training in determining opportunity costs.