EXPLICIT AND IMPLICIT COSTS

Date: 2015-10-07; view: 368.

Reading

Pre-reading task

Vocabulary

Use your dictionary to look up any new word.

1. Write the following words in the correct column.

cost(2) resources produce owner use(2) explicit

implicit monetary purchase(2) incur frequently

return(2) typically identical exception rent(2)

equipment sacrifice(2) reason earn amount(2)

Nouns (12)1 Verbs (10)1 Adjectives (4) 1 Adverbs (2)

Work in small groups.

Now you are going to read about explicit and implicit costs. What do you think they are

based on?

1.Read text 30. Were your ideas about explicit and implicit costs correct?

TEXT 30

The cost of using resources to produce a good or service is the opportunity costto the owners of the firm using those resources. The opportunity cost to the firm's owners of using a resource is what the owners must give up to use the resource. All costs of production are opportunity costs, and for decision-making purposes, it is opportunity costs that matter.

The opportunity cost of using an input or a resource is classified as either an explicit cost or an implicit cost. Explicit costsare what most people mean when they think of the cost of something. An explicit cost is the monetary payment made by a firm for the use of an input owned or controlled by other individuals. Explicit costs are also referred to as accounting costs. For example, if a firm purchases 40 hours of unskilled labour services for $8 per hour, an explicit (accounting) cost of $320 is incurred by the firm. The $320 payment is the amount the firm's owners give up to use the 40 hours of labour. Other types of explicit costs include the costs of purchasing raw materials, leasing a building, purchasing advertising, and leasing a plot of land.

Firms frequently use some resources that do not involve explicit monetary payments. Even though the firm does not make an explicit monetary payment for the use of such an input, the opportunity cost of using this input is not zero. These nonmonetary opportunity costs are called implicit costs.An implicit cost is the opportunity cost of using resources that are owned or controlled by the owners of the firm. The implicit cost is the foregone return the owners of the firm could have received had they used their own resources in their best alternative use rather than using the resources for their own firm's production. Implicit costs typically take two forms: (1) the opportunity cost of using land or capital owned by the firm, (2) the opportunity cost of the owner's time spent managing the firm or working for the firm in some other capacity. These implicit costs are just as real and important in decision making as the firm's out-of-pocket explicit costs.

To illustrate the implicit cost of using capital owned by the firm, suppose Alpha Corporation and Beta Corporation are two manufacturing firms that produce a particular good and are in every way identical, with one exception. The owner of Alpha Corporation rents the building in which the good is produced. The owner of Beta Corporation inherited the building the firm uses and therefore pays no rent. Which firm has the higher cost of production? The costs are the same, even though Beta makes no explicit payment for rent. The reason the cost are the same is that using the building to produce good cost the owner of Beta the amount of income that could have been earned had the building been leased at the prevailing rent. Since these two buildings are the same, presumably the market rentals would be the same. In other words, Alpha incurred an explicit cost for the use of its building, whereas Beta incurred an implicit cost for the use of its building. Regardless of whether the payment is explicit or implicit, the opportunity cost of using the building resource is the same for both firms.

The opportunity cost or implicit cost of using capital equipment or land that is owned by the firm (that is, owned by the firm's owners) is the return that could have been received if this resource had not been used by the firm but instead employed in its best alternative use. This sacrificed return can be measured in one of two ways. As in the above example, the sacrificed return is what could have been earned from leasing or renting the resource to some other firm. Alternatively, the sacrificed return can be measured as the amount the owner could earn if the resource, such as the building, were sold and the payment invested at the market rate of interest. The sacrificed interest is the implicit cost. These two measures of implicit cost are frequently the same, but if they are not equal, the true opportunity cost is the best alternative return.

2. Comprehension check.

Read the text more carefully. Are the following statements true or false? Correct the false ones.

a) The opportunity cost is what the firm's owners give up to use a resource, the sum of explicit and implicit costs.

b) Explicit cost is an out-of-pocket monetary payment for the use of a resource.

c) The costs of purchasing raw materials, leasing a building, purchasing advertisement are not referred to explicit costs.

d) Explicit costs are considered to be accounting costs.

e) Implicit cost is the foregone return the firm's owners could have received had they used their own resources in the best alternative use.