Pannell Discussions

No. 45, 28 March 2005

Thinking like an economist 13: What is the cost?

Economists treat costs somewhat differently to the way that accountants do. This article explains why and how.

You run a business producing, say, furniture, or maybe wheat. What does it cost you to produce a unit of output? It is a question of some importance to a prudent business manager.

Perhaps it sounds simple. Couldn't you just add up all of your expenditures and divide the total by the number of units of output? That would give you a measure of the average cost, but not necessarily the most useful or valid one.

Economists tend to look at things through a decision making lens, and as a business manager, one of your key decisions is how much output to produce. Curly questions about costs that you need to address to make this decision include:

(a) How should you deal with the fact that some costs are fixed while others vary with the level of output?

(b) Are input costs the only relevant costs?

(c) What if you produce more than one product? How should you apportion costs when an input is used to jointly produce two or more outputs? (e.g. crops and livestock from the same farm paddock within a year).

Economists have answers, and they are a bit different from the answers you would get from an accountant. The economists' answers are tailored to making decisions that maximise the overall benefits.

(a) Fixed costs are almost (but not quite) irrelevant to decisions about production levels. Economists focus on "marginal costs": the cost of making one additional unit of production, or in other words, the variable costs at the margin. Because fixed costs don't vary with the production level, they don't appear in the calculation of marginal costs. Marginal cost generally varies unit by unit as production changes, and the manager needs to know about that (so that he or she can compare it to marginal benefits) to choose the best level of production.

(b) Input costs are not the the whole story. Economists use a much broader concept called the opportunity cost. The opportunity cost does includes input costs: the financial cost of acquiring and transforming the necessary resources into a unit of production. But it also includes the cost of not using the resources in their best alternative use. If you didn't use your land to grow wheat, the best alternative land use might be barley. The barley profits you have to give up to grow wheat are, in a real sense, part of the cost of growing wheat. The opportunity cost, that is. Barley is the opportunity. Not grasping that opportunity results in a cost, in the sense of missed profits.

(c) You don't have to make arbitrary divisions of costs amongst joint products. You just need to watch overall benefits and overall costs. In practice, as the quantity of any one product is increased, the most profitable quantities of production of other products will vary too (probably down, but not necessarily). The opportunity costs (or benefits) of these other changes have to be factored in during the calculation of opportunity cost for the current product, and they already account for any changes in input costs associated with the other product(s). You don't actually have to allocate costs among the various outputs to make the best decision. By focusing on the marginal opportunity cost for any one , the problem of allocating costs among outputs becomes irrelevant. 

In this framework, you can only look at the cost of one product at a time. If a firm produces several products, the marginal opportunity cost of producing any one of them will already factor in the benefits and costs of producing any or all of the others.

Obviously, then, there is no easy conversion from accounting measures of costs to economic costs. However, if you are working with an accounting style model (e.g. a budgeting model) it is possible account for the above curly issues if you approach it properly.

(a) You can look at average (or total) costs and benefits, but only if you recalculate the averages (or totals) for each possible level of output, and choose the one with the highest net benefit.

(b) You can't easily calculate opportunity costs in a budgeting model, but you can achieve the same effect by comparing results for all possible strategies or options. All you are really doing when you calculate opportunity costs is comparing the current option with the best alternative. Compare net benefits for all options, and you have it.

(c) When you are doing (a) and (b), focus on total profits for the whole business enterprise, rather than trying to calculate average costs for individual outputs.

Do all that and you'll be like a human economic optimising machine. In practice, computer-based optimisation models of firms or industries built by economists often do exactly that. They are structured somewhat like an accounting model, but are set up to process the data and produce results in a way that is consistent with the sort of economic model you see in an economics text book.

David Pannell, The University of Western Australia,

Pannell Discussions are brief pieces on issues and ideas in economics, science, the environment, natural resource management, politics, agriculture and whatever else.

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