Cost Concepts

Opportunity cost
Opportunity cost is commonly defined as the next best alternative. Also, known as the
alternative cost, it is the loss of gain which could have been gained if another alternative was
chosen. It can also be explained as the loss of benefit due to a change in choice.

Explicit cost
Explicit costs are normal business costs that appear in the general ledger and directly affect
a company's profitability. Explicit costs have clearly defined dollar amounts, which flow through
to the income statement. Examples of explicit costs include wages, lease payments, utilities, raw
materials, and other direct costs.

Explicit costs—also known as accountings costs—are easy to identify and link to a company's
business activities to which the expenses are attributed. They are recorded in a company's
general ledger and flow through to the expenses listed on the income statement. Explicit costs
are the only costs necessary to calculate a profit, as they clearly affect a company's profits.

Expenses relating to advertising, supplies, utilities, inventory, and purchased equipment are
examples of explicit costs.

Implicit cost
An implicit cost is any cost that has already occurred but not necessarily shown or
reported as a separate expense. An implicit cost comes from the use of an asset, rather
than renting or buying it. An implicit cost is a cost that exists without the exchange of cash and
is not recorded for accounting purposes. Implicit costs represent the loss of income but do not
represent a loss of profit. These costs are in contrast to explicit costs, which represent money
exchanged or the use of tangible resources by a company.

Examples of implicit costs include a small business owner who may forgo a salary in the early
stages of operations to increase revenue. Implicit costs are also referred to as imputed, implied,
or notional costs. These costs aren't easy to quantify. That's because businesses don’t necessarily
record implicit costs for accounting purposes as money does not change hands.

These costs represent a loss of potential income, but not of profits. Implicit costs are a type of
opportunity cost, which is the benefit that a company misses out on by choosing one option or
alternative versus another.
Economic cost =Accounting cost (Explicit cost) + Non-Accounting Cost (Implicit cost)

Economic Profit = Total Revenue – Economic Cost

Accounting Profit = Total Revenue – Explicit cost

TR – Accounting Costs = Accounting Profit – Non-Accounting Cost = Economic Profits

Sunk cost
A sunk cost refers to money that has already been spent and cannot be recovered. In
business, the axiom that one has to "spend money to make money" is reflected in the
phenomenon of the sunk cost. A sunk cost differs from future costs that a business may face,
such as decisions about inventory purchase costs or product pricing. Sunk costs are excluded
from future business decisions because they will remain the same regardless of the outcome of a
decision. Sunk costs are in contrast to relevant costs, which are future costs that have yet to be
incurred.

A manufacturing firm, for example, may have a number of sunk costs, such as the cost of
machinery, equipment, and the lease expense on the factory.

Social cost
Social cost is the total cost to society. It includes private costs plus any external costs.

Private cost: The private cost is any cost that a person or firm pays in order to buy or produce
goods and services. This includes the cost of labour, material, machinery and anything else that
the person of firm pays for. The private cost does not take into account any negative effects or
harm caused as a result of the production.

 External cost: An external cost occurs when producing or consuming a good or service
imposes a cost (negative effect) upon a third party. The existence of external costs can
lead to market failure. This is because the free market generally ignores the existence of
external costs. Pollution, health-related problems, Noise pollution are the examples.

 Example of driving to work:

 Costs of paying for petrol (personal cost)
 Costs of increased congestion (external cost)
 Pollution and worse air quality (external cost)
 The social cost includes all the above. (Petrol + congestion + pollution)
  Example of social cost of building airport

Private costs of airport

 Cost of constructing an airport.

 Cost of paying workers to run airport

External costs of airport

 Noise and air pollution to those living nearby.

 Risk of an accident to those living nearby.
 Loss of landscape.

Rational choice theory suggests individuals will only consider their private costs. For example, if
deciding how to travel, we will consider the cost of petrol and time taken to drive. However, we
won’t take into consideration the impact on the environment or congestion levels for other
members in society. Therefore, if social costs significantly vary from private costs then we may
get a socially inefficient outcome in a free market.

Different forms of Market

Perfect competition

Perfect competition is a market structure where many firms offer a homogeneous

product. Because there is freedom of entry and exit and perfect information, firms will make
normal profits and prices will be kept low by competitive pressures.

Features of perfect competition

1. Many firms.
2. Freedom of entry and exit; this will require low sunk costs.
3. All firms produce an identical or homogeneous product.
4. All firms are price takers; therefore the firm’s demand curve is perfectly elastic.
5. There is perfect information and knowledge.
Diagram for perfect competition

 The industry price is determined by the interaction of Supply and Demand, leading to a
price of Pe.
 The individual firm will maximize output where MR = MC at Q1
 In the long run firms will make normal profits.

What happens if supernormal profits are made?

If supernormal profits are made new firms will be attracted into the industry causing
prices to fall. If firms are making a loss then firms will leave the industry causing price to rise
The features of perfect competition are very rare in the real world. However perfect competition
is as important economic model to compare other models. It is often argued that competitive
markets have many benefits which stem from this theoretical model.

Examples of perfect competition

In the real world, it is hard to find examples of industries which fit all the criteria of ‘perfect
knowledge’ and ‘perfect information’. However, some industries are close.
1. Foreign exchange markets. Here currency is all homogeneous. Also, traders will have
access to many different buyers and sellers. There will be good information about relative
prices. When buying currency it is easy to compare prices
2. Agricultural markets. In some cases, there are several farmers selling identical products
to the market, and many buyers. At the market, it is easy to compare prices. Therefore,
agricultural markets often get close to perfect competition.
3. Internet related industries. The internet has made many markets closer to perfect
competition because the internet has made it very easy to compare prices, quickly and
efficiently (perfect information). Also, the internet has made barriers to entry lower. For
example, selling a popular good on the internet through a service like e-bay is close to
 perfect competition. It is easy to compare the prices of books and buy from the cheapest.
The internet has enabled the price of many books to fall in price so that firms selling
books on the internet are only making normal profits.

Monopolistic competition

Monopolistic competition is a market structure which combines elements of

monopoly and competitive markets. Essentially a monopolistic competitive market is one with
freedom of entry and exit, but firms can differentiate their products. Therefore, they have an
inelastic demand curve and so they can set prices. However, because there is freedom of entry,
supernormal profits will encourage more firms to enter the market leading to normal profits in
the long term.

A monopolistic competitive industry has the following features:

 Many firms.
 Freedom of entry and exit.
 Firms produce differentiated products.
 Firms have price inelastic demand; they are price makers because the good is highly
differentiated
 Firms make normal profits in the long run but could make supernormal profits in the
short term
 Firms are allocatively and productively inefficient.
Diagram monopolistic competition short run
In the short run, the diagram for monopolistic competition is the same as for a monopoly.
The firm maximizes profit where MR=MC. This is at output Q1 and price P1, leading to
supernormal profit

Efficiency of firms in monopolistic competition

 Allocative inefficient. The above diagrams show a price set above marginal cost
 Productive inefficiency. The above diagram shows a firm not producing on the lowest
point of AC curve
 Dynamic efficiency. This is possible as firms have profit to invest in research and
development.
 X-efficiency. This is possible as the firm does face competitive pressures to cut cost and
provide better products.
Examples of monopolistic competition

 Restaurants – restaurants compete on quality of food as much as price. Product

differentiation is a key element of the business. There are relatively low barriers to entry
in setting up a new restaurant.
 Hairdressers. A service which will give firms a reputation for the quality of their hair-
cutting.
 Clothing. Designer label clothes are about the brand and product differentiation
 TV programmes – globalisation has increased the diversity of tv programmes from
networks around the world. Consumers can choose between domestic channels but also
imports from other countries and new services, such as Netflix.
Limitations of the model of monopolistic competition
 Some firms will be better at brand differentiation and therefore, in the real world, they
will be able to make supernormal profit.
 New firms will not be seen as a close substitute.
 There is considerable overlap with oligopoly – except the model of monopolistic
competition assumes no barriers to entry. In the real world, there are likely to be at least
some barriers to entry
 If a firm has strong brand loyalty and product differentiation – this it becomes a barrier to
entry. A new firm can’t easily capture the brand loyalty.
 Many industries, we may describe as monopolistically competitive are very profitable, so
the assumption of normal profits is too simplistic.

Imperfect Competition
Imperfect competition exists whenever a market, hypothetical or real, violates the
abstract tenets of neoclassical perfect competition. In this environment, companies sell
different products and services, set their own individual prices, fight for market share, and
are often protected by barriers to entry and exit. Economists generally agree that real-world
 markets rarely meet the assumptions of perfect competition, but disagree as to how much of a
substantial difference this makes for market outcomes.
Imperfect competition creates opportunities to generate more profit, unlike in a perfect
competition environment, where businesses earn just enough to stay afloat.
In an imperfect competition environment, companies sell different products and services, set
their own individual prices, fight for market share, and are often protected by barriers to
entry and exit, making it harder for new companies to challenge them. Imperfect competition is
a market structure in which sellers or buyers have market power over prices, which prevents the
market from operating under perfect competition. Because they have market power, market
participants are often in a position to abuse their power, raise prices, and manipulate the market
to secure higher profits.

Features of Imperfect competition

The characteristics of imperfect competition vary between types of market structures. In this
case, I exclude monopsony and oligopsony markets.
Market power
Sellers have market power and some control over prices, ranging from some power
(monopolistic competition) to absolute (monopoly). Sources of market power can come from a
firm’s ability to differentiate between supply (product differentiation) or influence supply.
Number of sellers
In a monopolistic competitive market, the market consists of many sellers (producers). They
have a small and uniform output size relative to market supply.
The number of sellers is getting fewer when it comes to oligopoly. The fewer the number, the
greater their power to influence market supply. Producer size usually varies, with several firms
dominating the market supply. Apart from changing output, they also have market power
through differentiation.
In an oligopoly market, the market usually creates collusive behavior. Players work together to
increase profits. If it occurs formally, we will call it a cartel.
Furthermore, under a monopoly, the market consists of only one producer. Hence, the firm’s
output represents the market supply. Monopolists can increase its profits by exercising price
discrimination, reducing output and product quality.
Market entry and exit barriers
Entry and exit barriers are low in monopolistic competitive markets. It increases when the
market operates under oligopoly and monopoly.
Barriers to entry prevent the market from becoming highly competitive, thereby reducing market
profits. Conversely, when the barriers to entry are low new players can easily enter. New players
bring additional supply to the market, pushing prices down.
Imperfect information
Under imperfect competition, there is no full disclosure of information about prices and
products. Information asymmetry is present in the market. Few companies are better informed
than their customers or competitors. They can use such information to pursue their own
advantage.
Heterogeneous product
Competing manufacturers offer heterogeneous products. They act as close substitutes rather than
perfect substitutes. Each product has slightly (or even wholly) different features and qualities,
allowing buyers to prefer products from one company over another.
Price maker
Because they have price power, producers act as price makers. They can charge a price that is
higher than the marginal cost. The more significant the difference between the two, the higher
their profit.
On the other hand, under perfect competition, they can only set the selling price equal to
marginal cost. They use the market price as the selling price of the product, making them the
price taker.
 Supply
Supply is the quantity of a good which is offered for sale at a given price at a particular
time. “The amount of a product that firms are able and willing to offer for sale is called the
quantity supplied.”
Supply is a desired flow. It measures how much firms are willing to sell and not how much they
actually sell. It is to be remembered that the firms may not supply the entire amount of a
commodity that they produce per period of time. Supply may exceed or fall short of production.
Supply in a particular year is the total production plus-minus stocks of the commodity.

Determinants of Supply:
Supply of a commodity depends not only on the price of that commodity but also on other
factors.

The supply function may now be expressed as:

Sx = f (Px, Pa… Pc, PL… PO, T, Cr, St, O, G),
Px → own price of good x,
Pa … Pc → prices of related goods,
PL … PO→ prices of inputs,
T → time,
St → the state of technology,
O → objectives of the firm, and
G → taxes, subsidies and regulation.

Now we will explain all these determinants of supply in brief:

(a) Own Price—Sx = f (Px):

Firstly, the most important factor that influences the supply of a commodity is its own price. And
the relationship between supply and own price is a direct one.

(b) Prices of Related Goods—Sx = f (Pa … Pc):

Secondly, supply of any commodity largely depends not only on own price of the commodity but
also on the prices of its substitute and complementary goods.

If market price of wheat rises, the jute farmers would be interested in wheat production so that in
the next season they can increase the supply of wheat. On the other hand, in the case of a joint
product, a rise in the market price of mutton will increase the quantity of leather supplied.
(c) Prices of Inputs—Sx = f (PL … Po):
Thirdly, price of inputs is also an important determinant of supply. If the price of an input (say,
wage bill) rises, the cost of production will surely increase. Consequently, profit will tend to
decline. Seeing an unprofitable situation, a firm will reduce the supply of a commodity and will
try to switch over to the production of another commodity which is still not unprofitable.

(d) Time—Sx = f (T):

Fourthly, in the short run, usually the supply of a commodity (mainly perishable good) is
unresponsive to price change. But, in the long run, the supply of a commodity tends to be more
flexible or fluctuating in response to the changing situation.

For non-reproducible goods, the supply becomes highly inelastic. One can now suggest that the
supply of a commodity also depends on its nature. For instance, the supply of non-perishable
goods responds more than the perishable goods when their prices change.

(e) Technology—Sx = f (St):

Fifthly, the state of art or the technology has an important bearing on the supply of a commodity.
As newer and modern technologies are employed in a concern, production and productivity rise
and average costs of production tend to decline. This result in a change in quantity supplied.

(f) Firm’s Objectives—Sx = f (O):

Sixthly, the nature of a firm’s objectives also affects the supply decisions. Firms can have
different goals. Usually, profit-maximization is the most fundamental objective of a firm.
Modern business firms aim at maximization of sales revenue rather than profit.

Supply of a commodity under these two broad objectives is likely to be different. Thus, the
supply of a commodity depends on the goals or objectives of a firm. Changes in these objectives
of the firms will lead to a change in quantity supplied.

(g) Government Policy—Sx = f (G):

Finally, by imposing taxes on firms, the government can affect the supply of a commodity. The
government may ask business firms to pay taxes for polluting the atmosphere or for meeting
government services on education, health, etc. As these taxes increase costs, firms reduce
supplies. Similarly, subsidies may be given to firms so that they can produce goods needed by
the society.

Often new firms are encouraged to produce some goods (e.g., software) by giving subsidies to
these goods or by reducing taxes. Further, the government may use its regulatory device (e.g.,
industrial licensing) to control the activities of business firms. This affects supply.

Law of Supply
The law of supply is the microeconomic law that states that, all other factors being equal,
as the price of a good or service increases, the quantity of goods or services that suppliers offer
will increase, and vice versa. The law of supply says that as the price of an item goes up,
suppliers will attempt to maximize their profits by increasing the number of items for sale.
The law of supply says that a higher price will induce producers to supply a higher
quantity to the market. Because businesses seek to increase revenue, when they expect to receive
a higher price for something, they will produce more of it. Supply in a market can be depicted as
an upward-sloping supply curve that shows how the quantity supplied will respond to various
prices over a period of time.

The chart below depicts the law of supply using a supply curve, which is upward sloping. A, B,
and C are points on the supply curve. Each point on the curve reflects a direct correlation
between quantity supplied (Q) and price (P). So, at point A, the quantity supplied will be Q1 and
the price will be P1, and so on.

The supply curve is upward sloping because, over time, suppliers can choose how much of their
goods to produce and later bring to market. At any given point in time, however, the supply that
sellers bring to market is fixed, and sellers simply face a decision to either sell or withhold their
stock from a sale; consumer demand sets the price, and sellers can only charge what the market
will bear.

If consumer demand rises over time, the price will rise, and suppliers can choose to devote new
resources to production (or new suppliers can enter the market), which increases the quantity
supplied. Demand ultimately sets the price in a competitive market; supplier response to the
price they can expect to receive sets the quantity supplied.
The law of supply is one of the most fundamental concepts in economics. It works with the law
of demand to explain how market economies allocate resources and determine the prices of
goods and services
 Different Types of pricing

Cost-plus pricing strategy

A cost-plus pricing strategy, or markup pricing strategy, is a simple pricing method
where a fixed percentage is added on top of the production cost for one unit of product (unit
cost). This pricing strategy focuses on internal factors like production cost rather than external
factors like consumer demand and competitor prices. This pricing strategy is commonly used by
retail stores to set prices.
Target Return Pricing
A pricing method in which a formula is used to calculate the price to be set for a
product to return a desired profit or rate of return on investment assuming that a particular
quantity of the product is sold.

Penetration pricing
Penetration pricing is a marketing strategy used by businesses to attract customers to a
new product or service by offering a lower price during its initial offering. The lower price helps
a new product or service penetrate the market and attract customers away from competitors.

Predatory pricing
In a predatory pricing scheme, prices are set low to attempt to drive out competitors
and create a monopoly. Consumers may benefit from lower prices in the short term, but they
suffer if the scheme succeeds in eliminating competition, as this would trigger a rise in prices
and a decline in choice. Prosecutions for predatory pricing have been complicated by the
short-term consumer benefits and the difficulty of proving the intent to create a market
monopoly.

Going-Rate Pricing
The Going-Rate Pricing is a method adopted by the firms wherein the product is priced
as per the rates prevailing in the market especially on par with the competitors.

Price Skimming
Price skimming is a product pricing strategy by which a firm charges the highest
initial price that customers will pay and then lowers it over time. As the demand of the first
customers is satisfied and competition enters the market, the firm lowers the price to attract
another, more price-sensitive segment of the population.1 The skimming strategy gets its name
from "skimming" successive layers of cream, or customer segments, as prices are lowered over
time.