Opportunity Cost & Profit
While for convenience one usually measures opportunity cost in dollars
involves real alternatives foregone. Thus for a firm, the opportunity cost of producing
(OCP) a good (and therefore opportunity
cost of employing factors of production) is the next best alternative action.
There are two components to a firm’s OCP : explicit and implicit costs
Explicit costs are paid directly in money; implicit costs or opportunities foregone
are not paid directly in money (even though
measured that way).
Explicit costs include direct payment for factors of
production, e.g. in the case of labour,
money cost or wages are generally equal to their OC. Implicit costs include
the implicit cost of physical capital, inventories and the owner’s resources. (MKM Figure 13.1)
i - Capital
form of implicit cost faced by a firm is the opportunity cost of its physical
capital. The OC of capital plant and equipment are usually implicit because
they are generally
, There are two forms of implicit costs
associated with physical capital: depreciation and interest:
a) economic depreciation is the change in market price of capital asset over a
given time period. Depreciation occurs for various reasons such as: older equipment has
shorter life than new equipment and requires
more maintenance. It is, however, important to distinguish between technical
and functional obsolescence. Equipment becomes technically obsolete when
newer equipment can do the job more efficiently, e.g. the Pentium CPU made the
486 and 386 technically obsolete. Functional obsolescence occurs when old
equipment can simply not do the job;
b) interest could have been earned on capital used to purchase
equipment. If a firm borrows money to buy it then it pays the explicit cost as interest on
the borrowed money but if uses its own cash it foregoes interest earned e.g. in bank deposit
and becomes an implicit cost.
The combination of depreciation and interest constitutes the 'implicit rental
rate' of physical capital. All thing being equal, market forces should bring about
the equality of
implicit and explicit rental rates for given type of capital equipment
It is important to realize that accounting measures of depreciation
differ from economic depreciation. In accounting one often uses
some form of straight line
depreciation, for example, over 20 yrs for buildings or 3 years for cars and
computers. In economics depreciation continues until there is no resale value and interest
to be earned as an opportunity cost no matter generally
accepted accounting principles (GAAP), i.e., 'vintage' equipment
with zero book value may be a productive asset especially if the cost of other
factors of production can be reduced, e.g., worker coop purchase of mills
and mines usually involve a drop in wages & salaries or Third World countries
with 'vintage' plant & equipment but low wage labour. This stage can be associated with
technical obsolescence, i.e., it can continue to do the job but is not at
minimum optimum scale and lowest cost per unit. All usefulness must be exhausted and
then the shell simply thrown away or sold as junk. This is the final stage
called functional obsolescence, i.e., it can no longer perform the job it
was designed to do.
There are some costs, however, that are not treated as economic costs. For
example, sunk cost or past economic depreciation are not counted as an economic
cost. Once capital equipment has been bought any alternative opportunity
is foregone and cannot be retrieved except by selling. Similarly, once equipment has
been depreciated the cost is sunk and cannot be recovered.
second type of implicit cost faced by a firm is the stock of raw materials, semi-finished goods and unsold finished goods,
i.e. inventories. The opportunity cost of inventories can be calculated in
a number of ways including estimating their current market price using the
'first-in-first out' (FIFO) or 'last-in-first out' (LIFO) methods.
iii - Owner’s Resources
form of implicit cost faced by a firm is the opportunity cost of the owner's
resources. This includes the time and effort the owner could have made
employed elsewhere earning a wage or salary. The OC of entrepreneurship is
called ‘normal profit’.
General, Technical and Economic
In general, efficiency refers to the ratio of outputs to
inputs. To measure efficiency one must therefore be able to calculate
both inputs and outputs. This is most easily done in the production of
goods rather than services, especially in manufacturing, e.g.
cars produced per worker.
Technical efficiency is achieved when it is
not possible to increase output without increasing inputs. Economic efficiency occurs when the cost of production
for a given output is as low as possible. A secondary
consideration is that such output is sold at a price sufficient to
compensate all factors of production at their
normal rates, i.e., no excess or
economic profit or rents are earned. Thus all
economically efficient solutions are technically efficient but not all
technically efficient solutions are economically efficient, that is,
something may be technically possible but uneconomic. It can not pay
its own way, e.g., space exploration and the military.
Why the Firm and not the Market?
Markets are also institutions that can coordinate economic decisions
The firm is an institution that hires factors of production to produce goods and
Why should some economic activities take place in the one or the other?
The answer is 'cost'.
Firms internalize economic activity because of a number of factors
including: transaction costs, economies or diseconomies of scale and economies of
team production (specialization).
Transaction cost include: the costs of finding
someone with whom to do business; the costs of reaching agreement on exchange;
and, the costs of ensuring such agreements are fulfilled.
Markets require that buyers and sellers find each
other, get together and negotiate. They also usually require lawyers
to draw up contracts. Rather than buying a good or service on a market, firm can reduce
such cost by internalizing their production.
It is important to note, however, that while at any given point in time may be cheaper to buy on
a market rather than produce
within the firm (out-sourcing), at another point in time cost may change and it
becomes cheaper to internalize production of necessary factors of production.
ii - Economies & Diseconomies of Scale
Economies of scale exist when the
cost per unit output falls as output rises.
Economies of scale are due to specialization and division of
labour. A firm will tend to internalize an economic activity if its scale
of production allows it to enjoy such economies of scale.
On the other hand, diseconomies of scale occur
the cost per unit output increases as output rises. Diseconomies of scale
can occur as
a firm grows in size and complexity. Some things are more cheaply
done at a smaller scale of production, e.g. due to congestion. In
fact, some entire industries are based on 'small scale', e.g. creative products like art,
advertising and R&D. These activities are often more efficiently conducted in small rather than
large firms. In entertainment and advertising the same result can
sometimes be achieved by creating special small scale production units while the
main administration of the enterprise handles marketing and other activities
that benefits from economies of scale.
iii - Team Production
Another factor leading firms to internalize certain activities is specialization
in mutually supportive tasks or team production. Putting a designer
together with an engineer and other specialists within the firm may be
cheaper than trying to buy such services on the market and then try and
coordinate their various outputs.
Technological Change (MKM C4/78;
In the Standard Model
technological change refers to the impact of new knowledge
on the production function of the firm. The nature of
that knowledge whether from the Natural & Engineering
Sciences (NES), Humanities & Social Sciences (HSS) or the
Arts is not identified only its mathematical impact.
Such new knowledge may be endogenous, i.e., a result of the
profit seeking activities of firms. Or it may be
exogneous, i.e., the result of the curiosity of
inventors and the search for knowledge-for-knowledge-sake,
i.e, pure research usually conducted in universities.
For those interested in a fuller description of
technological change please see
Observation #7: Technological Change.