Question

Unit 6 DQ1: Opportunity Costs

Explain in detail:

Implicit costs are defined by economists as nonmonetary opportunity costs. Why is it important for a firm to take these costs into consideration when evaluating a potential activity, when they don’t involve any monetary expense?

Answer 1

Solution:

Implicit costs (or) imputed costs are nothing but the opportunity costs.As we already know,opportunity cost is the cost of foregone alternative.Implicit costs are defined as non-monetary opportunity costs by economists as they are not the actual costs that are incurred.Implicit costs are used only when we want to calculate economic profit which is different from normal profit ( i.e.,accounting profit).Explicit costs (also called out-of-pocket costs) are actual costs which we incur.

It is importance for a firm to take these costs into consideration

Example: You have 2 choices (say); going to a movie and other watching television at your home.Normally we say we spent $20 on purchasing the ticket & $10 for travelling for the movie.So actual cost (explicit cost ) is $20 which we spent.Implicit Costs would be the sum of $20 and also the opportunity (i.e.,enjoyment / time) which you have missed by not watching television at home.

So for this reason,it is difficult tocompute as it has a judgemental component in it.

Why it is important for a firm to take these costs into consideration when evaluating a potential activity ?

A business should opt for choice which has the lowest opportunity cost associated with it.

A company should not always choose the potential activity just because it is the most profitable one but also evaluate the opportunity costs (which can be brand value foregone by selecting this activity instead of another activity,etc.,).After considering opportunity cost you may have to opt for the other activity which is more profitable but having the least opportunity cost associated with it.

Total economic cost = Explicit cost + Implicit Cost

So economic profit is always lesser than normal profit.

Explicit costs can be same for different companies but the opportunity costs will be different.