Production Costs, an Overview of Production Theory


Before we get into the graphical shenanigans, I want to explain the difference between explicit and implicit costs.  Some people may tell you that explicit costs are costs you pay money for and implicit costs are the opportunity costs.  This is half true, because they are all opportunity costs.  The trick is to remember the you pay money for part.  So if you are given a list of costs, how do you determine the difference between the two?  We will use Taco Bell (a Mexican fast food place as an example).

A. Inputs (like taco shells and meat)
B. Economic depreciation of capital goods (tortilla presses)
C. Wages paid to employees
D. Interest paid on loans for equipment (tortilla presses)
E. Rent paid for the building
F. Foregone Salary
G. Electricity costs
H. Lost interest (from money used for the store instead of invested)

Of the following, we would have to pay money/cash for A, C, D, E, and G.  This means that these are explicit costs.  The rest we do not have to pay money for, they are the value of alternatives that we decided not to pursue.  An explanation for B is that we could have sold it instead of using it, and then we would not have lost the depreciated value.  For H we could have not invested in tortilla presses and put it in the stock market instead.  And finally for F, if we quit our job at Taco Bell, we would surely get a job and wage somewhere else.

Another way people talk about the differences between explicit and implicit costs is to relate them to accounting costs.  Generally accounting costs only consider the explicit costs and ignore the implicit.  This is because implicit costs are not used in calculations for tax or shareholder reasons, but are considered in economic reasoning.  We all know that opportunity costs matter, we just can’t deduct them when it comes to our taxes J

To wrap up this segment, I will introduce the different time frames we use when describing costs to producers.  These costs are divided up into the short run and long run.  The trick to remembering the difference between the two is whether or not there are any fixed costs.  This means that if building costs such as rent, or equipment costs, such as ovens or hammers can’t change in your analysis, then you are in the short run.  If the producer can change any of their costs, including getting new buildings, factories, employees, etc. then you are in the long run.

Remember:  short run is not measured in time, it is measured in the ability of a firm to buy or sell new forms of capital.  So if there are any fixed costs, then you are in the short run.

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