Economic Costs and Profit.
Computing the firm’s cost.
We have already learned (twice) that the firm’s cost is
determined by the cost formula:
Cost = (x×P
) + (y×P
) + (z×P
) + .
x, y, z, etc., represent the quantities of different inputs that the firm consumes.
suppose that a manager wants to know the cost of producing 10,000 pairs of jeans.
might include labor, sewing machinery, denim, thread, dye, etc.
If she knows the price of each
input, then she can use the production function to figure out how much of each input she needs
to produce 10,000 jeans efficiently (as we learned in Chapter 5).
Then she can substitute all of
these prices and quantities into the cost formula and compute the total cost of producing the
A complication: using the correct prices for inputs.
One problem in calculating the cost
of production is that the true “prices” of inputs are sometimes unclear.
The next section
discusses this issue, which affects many practical business decisions.
A. Opportunity cost and sunk cost.
The cost of using inputs that are already owned.
If production would use up a resource
that the firm already owns, then it may be unclear what is the true current “cost” of using up that
It may be quite different from whatever price the firm originally paid for that resource.
It is important to evaluate such costs rationally, because they have an important effect on
production decisions and on the firm’s profitability.
Valuing inputs correctly can even change
the firm’s shutdown decision. (In reality, “shutting down” does not necessarily mean shutting
down the whole firm; it might mean dropping one product, or closing one plant.)
To determine the cost of using inputs that the firm already owns,
economists use the concept of
The opportunity cost of an already-owned input,
for producing some good “G,” is
the value that the firm could get from that input in its next best
use, if it did not produce G
The “next best use” of an input might be using it to produce some
alternative good (not G), or to return it to the original supplier, or to sell it in the open market.
Among all of these choices, the
next best use
is whichever alternative gets the most value from
the unused input.
By using the input to produce G, the firm loses the opportunity to get value
from the input in its next best use; that is why we call this value the
The best way to explain opportunity cost is through examples.
Example 1: The hours that a businessman spends working for himself.
No one has to pay
for his or her own labor -- since he or she is born with it -- but it still has value.
businessman uses his own labor to run his store, he loses the opportunity to use that valuable
labor in a different activity.
of using his labor in his store is whatever he
could earn from his labor in its next best use. That might be working for himself in a different