After you have worked through this section of the learning unit, you should be able to:
- distinguish between explicit and implicit costs
The total cost of production will have an important impact on a firm’s profit because profit is equal to total revenue minus total cost. The concept of total cost might seem straightforward. If you ask an accountant, he or she will tell you that it is all the payments that are actually made to produce the goods or services, and includes things such as wages, rent, equipment costs and administration costs. This is referred to as explicit costs.
Economists, however, have a more subtle if not complicated view of cost since we are interested in the opportunity cost of things. What economists are interested in is not only the actually cost that the firm incurs, but what the cost is to society of producing goods and services. Moreover, the reason we are interested in opportunity cost is because our resources are scarce and we would like to see that they are used in the best possible way to satisfy as many needs and wants as possible. Economists will therefore include the opportunity cost of making use of all self-owned resources into account and not only actual payments as accountants do. This is referred to as implicit costs.
Example: Explicit and implicit costs
Take the following as an example of the different ways an accountant and an economist would calculate costs:
Thabo currently works for a corporate law firm. He is considering opening his own legal practice. To run his own firm, he would need an office and a law clerk. He decides to use his own home as an office. He is also able to find a law clerk whom he hires for R120 000 per year. He estimates his administration costs to be R80 000.
An accountant would do the following cost calculation:
| Salary for law clerk:
Administration costs: |
R120 000
R80 000 |
| Total cost: | R200 000 |
Before an economist can do the cost calculation, he or she would need to know the cost of the self-owned resources (implicit cost). This would require the following information:
How much would he have to pay to rent an office? This then is the opportunity cost of using his own home as an office. Let's assume the rent would have been R60 000.
How much did he earn when he worked for the law firm? This is the opportunity cost for working for himself. Let’s assume that he earned R450 000 per year. This reflects his opportunity cost of working for himself.
Let's see how the economist would calculate cost:
Based on the above example, what would be the explicit cost for Thabo?
It is R200 000 and is calculated as follows:
Salary for law clerk: R120 000
Administration costs: R80 000
Total explicit cost: R200 000
What would be the implicit cost?
It is R510 000 and it is calculated as follows:
It consists of the opportunity cost of self-owned resources, which includes the opportunity cost of using his own home, which is the rent of R60 000 he would have paid, as well as his salary of R450 000.
Rent: R 60 000
Forgone salary: R450 000
Total implicit cost: R510 000
Based on the above example, what would be the total cost according to an economist?
It is R710 000.
An economist’s calculation is explicit cost + implicit cost = R200 000 + R510 000 = R710 000.
To summarise:
Based on the example of Thabo, this is how an accountant and an economist would calculate total cost:
| An accountant uses only explicit costs | An economist uses both explicit and implicit costs | |||
| Salary for law clerk: R120 000
Administration costs: R80 000 |
Salary for law clerk: R120 000
Administration costs: R80 000 |
|||
| Total explicit cost: R200 000 | Total explicit cost: R200 000 | |||
|
Explicit cost is the actual payments that are made towards the production of goods and services, while implicit cost is the opportunity cost of the use of self-owned resources in the production of goods and services. Accounting cost only includes explicit costs, while economic costs include both explicit and implicit costs.