Chapter 11: Problem 3

What are implicit costs? How are they different from explicit costs?

Short Answer

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Implicit costs are opportunity costs that do not involve direct monetary payment while explicit costs are clear, obvious cash outflows that reduce a business's profitability. Explicit costs are actual cash outflows and therefore recorded in books of accounts, whereas implicit costs, as opportunity costs, are not recorded because no actual cash outflow occurs.

Step by step solution

Define Implicit Costs

Implicit costs, also referred to as imputed, implied, or notional costs, are the opportunity cost equal to what a firm must give up in order to use factors of production for which it already owns and thus does not pay rent. These are costs that are not normally accounted for in cash outflow but are related to the company's use of resources. For example, if the owner of a firm uses his own car for the firm's operations, he gives up the opportunity to rent his car to another firm and thus incurs an implicit cost.

Define Explicit Costs

Explicit costs are the direct cost of operating a business, which can easily be identified and measured in money term. These costs represent clear, obvious cash outflows from a business that reduces its bottom-line profitability. This includes items such as wages, rent, and material costs. Explicit costs are recorded in the books of accounts.

Difference between Implicit and Explicit Costs

The main difference between the two types of costs lies in their treatment in the accounting of the firm. Explicit costs are actual cash outflows from the firm and therefore, they are recorded in the books of accounts, whereas implicit costs are the opportunity costs which are not recorded in the books of accounts, because no actual cash outflow occurs. In business decision making, both implicit and explicit costs are important, even though only the explicit costs form part of the accounting system.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Understanding Opportunity Cost in Economics

Opportunity cost is a fundamental concept in economics that refers to the value of the next best alternative that is forgone when a decision is made to pursue a certain action. In simpler terms, it's the benefit you could have received by taking a different action.

For example, if a student decides to spend time working on a hobby instead of studying, the opportunity cost is the lower grades or learning that might result from not studying. Likewise, in a business context, if a company decides to allocate funds to one project over another, the opportunity cost is the potential profit that the second project could have generated.

Understanding opportunity costs is critical for efficient resource allocation as it helps individuals and businesses to make more informed decisions by considering the potential benefits they're missing out on when choosing one alternative over another.

Accounting for Production Costs in Business

Properly accounting for production costs is essential for businesses to evaluate their financial health and to make strategic decisions. Production costs include both explicit and implicit costs.

Explicit costs are out-of-pocket expenses, such as salaries, rent, and materials, which are directly paid out and recorded in the financial statements. They are critical for calculating profit in the traditional sense, as they are subtracted from revenue.

However, implicit costs represent the opportunity costs of using resources owned by the company. For example, the use of a company-owned building for operations represents an implicit cost equal to the potential rental income that could be earned if the building was leased to another business. Although implicit costs do not represent cash outflows, they are crucial for calculating economic profit, which provides a more comprehensive view of a company's profitability by including these non-expensed resources.

The Role of Costs in Business Decision Making

When it comes to business decision making, both explicit and implicit costs play significant roles. Decision makers need to consider the full scope of costs involved in operations to assess the true profitability and practicality of business ventures.

Explicit costs, being direct payments, are routinely factored into budgets and financial projections. They help in assessing the company's short-term financial obligations and performance.

Implicit costs, while not as apparent, relate to long-term strategic planning and the evaluation of opportunity costs. They can significantly affect a business's decisions. For example, a business owner might decide against pursuing a new project upon realizing that the implicit cost of reallocating resources could outweigh the project's potential revenue.

In sum, considering both explicit and implicit costs allows for a more accurate assessment of potential investments and strategic initiatives. Informed decision-making requires that both types of costs be considered to ensure that all resources—cash, time, and assets—are used to their greatest potential.