Cost (economics)
Overview
In economics, the term "cost" refers to the value of the resources used to produce a good or service. This value is often measured in terms of the opportunity cost, which is the value of the next best alternative that must be given up to undertake an activity. The concept of cost is fundamental to economic analysis, underpinning theories of supply, production, and market structure.
Types of Costs
There are several types of costs in economics, each with its own characteristics and implications for economic decision-making.
Explicit and Implicit Costs
Explicit costs are out-of-pocket expenses for inputs to production, such as wages, rent, and materials. These costs are easily identifiable and measurable. On the other hand, implicit costs, also known as imputed costs, are not paid out directly but represent the opportunity cost of using resources in one way rather than their next best alternative.
Fixed and Variable Costs
Fixed costs are costs that do not change with the level of output. They are incurred even if production is zero. Examples include rent and salaries of permanent staff. Variable costs, on the other hand, change with the level of output. Examples include costs of raw materials and hourly wages.
Average and Marginal Costs
Average cost is the total cost divided by the quantity of output. It falls as output increases due to economies of scale, and rises as output increases due to diseconomies of scale. Marginal cost is the additional cost of producing one more unit of output. It is a key concept in the theory of the firm and in profit maximization.
Cost Functions
A cost function represents the relationship between the cost of production and the quantity of output. It is derived from the production function, which describes the technological relationship between inputs and output. The shape of the cost function reflects the nature of costs in the short run and the long run.
Short-Run Cost Function
In the short run, at least one input to production is fixed. The short-run cost function thus includes both fixed and variable costs. The law of diminishing marginal returns applies, which means that beyond a certain level of output, additional units of output require increasingly larger amounts of variable inputs, leading to rising marginal and average costs.
Long-Run Cost Function
In the long run, all inputs to production are variable. The long-run cost function is derived by considering all possible combinations of inputs to find the least-cost method of producing each level of output. Economies and diseconomies of scale are reflected in the shape of the long-run average cost curve.
Cost in Market Structures
The concept of cost is crucial in understanding different market structures, including perfect competition, monopoly, monopolistic competition, and oligopoly.
Perfect Competition
In perfect competition, firms are price takers and aim to maximize profits by producing where price equals marginal cost. In the long run, firms earn zero economic profit as price equals minimum average total cost.
Monopoly
A monopoly is a single seller in a market. A monopolist maximizes profit by producing where marginal cost equals marginal revenue, which is less than the price. The difference between price and average cost represents monopoly profit.
Monopolistic Competition and Oligopoly
In monopolistic competition and oligopoly, firms have some market power, which they can use to influence price. Cost considerations, along with demand and strategic interactions with other firms, determine price and output decisions.
Cost and Economic Efficiency
Cost plays a key role in determining economic efficiency. Efficiency in production occurs when a firm produces a given level of output at minimum cost. Efficiency in allocation occurs when goods and services are distributed in a way that maximizes the total benefit to society. The concept of cost, particularly opportunity cost, is central to both these notions of efficiency.