ECON101: Principles of Microeconomics (2021.A.01)

The economic cost is based on the cost of the alternative chosen and the benefit that the best alternative would have provided if chosen.

LEARNING OBJECTIVES

Break down the components of a firm's economic costs

KEY TAKEAWAYS

Key Points

• Economic cost takes into account costs attributed to the alternative chosen and costs specific to the forgone opportunity.
• Components of economic cost include total cost, variable cost, fixed cost, average cost, and marginal cost.
• Cost curves – a graph of the costs of production as a function of total quantity produced. In a free market economy, firms use cost curves to find the optimal point of production (to minimize cost). Maximizing firms use the curves to decide output quantities to achieve production goals.
• Average cost (AC) – total costs divided by output (AC = TFC/q + TVC/q).
• Marginal cost (MC) – the change in the total cost when the quantity produced changes by one unit.
• Cost curves – a graph of the costs of production as a function of total quantity produced. In a free market economy, firms use cost curves to find the optimal point of production (to minimize cost). Maximizing firms use the curves to decide output quantities to achieve production goals.

Key Terms

• economic cost: The accounting cost plus opportunity cost.
• cost: A negative consequence or loss that occurs or is required to occur.
• Opportunity cost: The cost of any activity measured in terms of the value of the next best alternative forgone (that is not chosen).

Economic Cost

Throughout the production of a good or service, a firm must make decisions based on economic cost. The economic cost of a decision is based on both the cost of the alternative chosen and the benefit that the best alternative would have provided if chosen. Economic cost includes opportunity cost when analyzing economic decisions.

An example of economic cost would be the cost of attending college. The accounting cost includes all charges such as tuition, books, food, housing, and other expenditures. The opportunity cost includes the salary or wage the individual could be earning if he was employed during his college years instead of being in school. So, the economic cost of college is the accounting cost plus the opportunity cost.

Components of Economic Costs

Economic cost takes into account costs attributed to the alternative chosen and costs specific to the forgone opportunity. Before making economic decisions, there are a series of components of economic costs that a firm will take into consideration. These components include:

• Total cost (TC): total cost equals total fixed cost plus total variable costs (TC = TFC + TVC).
• Variable cost (VC): the cost paid to the variable input. Inputs include labor, capital, materials, power, land, and buildings. Variable input is traditionally assumed to be labor.
• Total variable cost (TVC): same as variable costs.
• Fixed cost (FC): the costs of the fixed assets (those that do not vary with production).
• Total fixed cost (TFC): same as fixed cost.
• Average cost (AC): total costs divided by output (AC = TFC/q + TVC/q).
• Average fixed cost (AFC): the fixed costs divided by output (AFC = TFC/q). The average fixed cost function continuously declines as production increases.
• Average variable cost (AVC): variable costs divided by output (AVC = TVC/q). The average variable cost curve is normally U-shaped. It lies below the average cost curve, starting to the right of the y axis.
• Marginal cost (MC): the change in the total cost when the quantity produced changes by one unit.
• Cost curves: a graph of the costs of production as a function of total quantity produced. In a free market economy, firms use cost curves to find the optimal point of production (to minimize cost). Maximizing firms use the curves to decide output quantities to achieve production goals.