Meaning of Cost in Economics

In economics, we use the term cost to refer to both explicit as well as implicit costs.

Explicit costs refer to the payment made to others for resources owned by them.

Implicit costs refer to the opportunity cost of self-employed resources - the value of resources in their next best alternative use.

So when we speak of the additional cost of producing an additional unit, we are referring to both the additional explicit as well as implicit costs of producing that unit.

Example (Explicit and Implicit costs)

Suppose Sarah enrolls into a one-year graduate program and to do so sacrifices a job offer, which would pay her $80,000 a year.

Typical costs of going to a college, such as tuition and expenditure on textbooks are examples of explicit costs.

The salary that she sacrifices to enroll in college, $80,000, is an example of an implicit cost of her degree.

Example (Explicit and Implicit costs)

Suppose you have two investment alternatives: invest $1000 in a mutual fund with load fees of 1%, or invest in a one-year risk-free CD with an interest rate of 2%.

Then, ignoring any risk associated with the mutual fund investment, its explicit cost is $10 (from load fees). The implicit cost is the $20 you lose as interest from your next best alternative (the CD investment).

The total explicit and implicit costs (again, ignoring any risk) of the mutual fund investment are $30.

Accounting Costs and Economic Costs

Explicit costs are also referred to as Accounting costs

In Economics, whenever we talk about costs, we mean both Explicit Costs and Implicit Costs. That is,

Economic Costs = Explicit Costs + Implicit Costs.

Economic Profit vs Accounting Profit

Profit is defined as: Total Revenue - Total Cost

Depending on which measure of cost we use (accounting or economic measure) we obtain the corresponding profit.

Accounting Profit = Total Revenue - Accounting Costs

or,
Accounting Profit = Total Revenue - Explicit Costs

Economic Profit = Total Revenue - Economic Costs

or,
Economic Profit = Total Revenue - Explicit Costs - Implicit costs