CFA Level 1

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Microeconomics - Opportunity Costs

Explicit Costs
Explicit costs reflect monetary payments made to resource owners. Examples include wages, lease payments and interest payments.

Implicit Costs
Implicit costs are those associated with resources used by the firm, but with no direct monetary payment. For example, there may not be an explicit monetary payment associated with the work efforts of a sole proprietor; however, there is an implicit cost associated with those work efforts as the sole proprietor could earn wages elsewhere. For a firm's capital, there is an implicit cost involved as the firm could be getting interest or earning a rate of return elsewhere. The implicit cost associated with the highest-valued alternative opportunity is referred to as the opportunity cost.

On the reverse side, particularly for an individual, there may be forms of implicit ("psychic") revenues; for example, a person may particularly enjoy "being his own boss".

Economic Profit
Economic profit is equal to total revenues less both implicit and explicit costs. For a firm to stay in business, both implicit and explicit costs must be covered. If firms are receiving a negative economic profit in a market, they will leave that market. A normal profitrate exactly covers wage costs and the competitive rate of return on capital.

Accounting Profits
Accounting profits are generally higher than economic profits, as they omit certain costs, such as the value of owner-provided labor and the firm's equity capital.

When calculating "economic profit", explicit and opportunity costs are taken into account.

Example:
Suppose someone owns and runs a candy store that grosses $20,000 per month and has operating expenses of $14,000 per month. The store owner particularly enjoys socializing with the customers; this aspect of the business provides a comfort to the owner which is worth $2,000 a month to her. The owner could receive $3,000 a month in interest with the capital that is tied up in the store's inventory. She could earn $5,000 a month at a different job.

An income statement would show an accounting profit of $6,000 a month:

Explicit Revenues $20,000

Explicit Costs $14,000
----------
Accounting Profit $ 6,000

Answer:
The economic profit, which should determine the economic decision, would be calculated as follows:

Explicit Revenues $20,000

Implicit Revenue
(value of socialization) $ 2,000
- - - - - -
Economic Revenues $22,000
Explicit Costs $14,000

Implicit Costs:
Value of owner's labor $5,000
Required rate of return on
inventory investment $3,000
- - - - - -
Economic Profit ($2,000)

From an economic viewpoint, keeping the candy store open does not make sense. The implicit value of enjoying being with the customers is not of sufficient value in comparison to the fact that the store owner could make more money by working elsewhere and employing the capital elsewhere.

Achieving Economic & Technological Efficiency

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