The economist’s concepts of costs do not necessarily coincide with the cost concepts used by businesses or accountants: for accounting, costs are only incurred where a ledger entry is required because money has been spent; and for economists, the main concept is that of opportunity cost. The cost of any input in the production of any good or service is the alternative it could have produced if used elsewhere, whether valued in monetary terms or not: for example, if financial resources can earn 5% in a bank account, then this is a measure of the opportunity cost of using the funds for some other purpose. However, the alternative use is not always easily identificable or translatable into monetary values. It may also be difficult to attribute alternative values to two inputs that are used together to produce a single product. The simple solution is to use market prices; but, they only fully reflect opportunity costs if all resources are scarce and price is equal to marginal cost. If resources have no alternative use, then their opportunity costs are zero.

Explicit and implicit costs

Another difference between the two approaches is the distinction between explicit and implicit costs. Explicit costs involve expenditure, whereas implicit costs do not. For example, if a retail firm operates two shops, one of which it rents the other it owns, then in terms of costs incurred, rent is paid to the owner of the premises for shop 1, but no rent is paid to itself as owner of shop 2. To make a fair comparison of the cost incurred by the two shops, the implicit cost of the shop owned by the firm should be quantified and imputed into the accounts to reflect alternative uses of the premises. In this case, rental values for other premises in the same street would indicate the implicit value of the resource.

Direct and indirect costs

If costs can be attributed to a particular activity, then they are termed direct costs; if they cannot easily be attributed to a particular activity, then they are termed indirect  or overhead costs. The test for allocation of costs is whether costs are separable and attributable, whereas the economic distinction between ¢xed and variable costs is whether they vary with output.

Replacement and historic costs

Another distinction is made between replacement and historic costs. Historic costs are those paid at the time of purchase, while current or replacement costs reflect the current price or cost of buying or replacing the input now, which, better reflects the opportunity cost of employing equipment or other resources that may have been in stock for some time.

Sunk and non-sunk costs

Sunk costs are those incurred in buying assets, such as plant or machinery, or spending on advertising that cannot subsequently be retrieved by selling the resource or deploying it in another use. Generally, these costs have been incurred in making a previous decision and are not relevant to a decision being currently made. For example, a decision to enter the airline industry will involve buying aeroplanes, setting up support services and advertising new routes. If the venture is unsuccessful, then the aeroplanes can be sold and a substantial part of the initial costs recovered, making only a small portion sunk; but, many of the set-up costs are sunk in that they cannot be retrieved because they were specific to that particular venture. Generally, the more specifc the asset is to a particular use

Incremental cost

those costs incurred by producing an extra unit of output. A related concept used in business is incremental cost, defined as the additional cost relating to any change, not just a unit change, in output: for the incremental costs to the firm of introducing a new product would include capacity and variable costs. Incremental costs are those that will be incurred as the result of a decision and can be thought of as the long-run marginal costs of the decision.

Costs and profits

Costs and profits are also a source of confusion. The concept of profit to an economist differs from that of the accountant. Both consider it to be the difference between revenue and costs, but they regard costs differently. Normal profits are earned in economic analysis when total revenue equals total cost, because total costs are calculated to reflect the opportunity costs of all services provided, including that of the entrepreneur; this is just enough to keep the firm in the industry (i.e., more profit cannot be earned elsewhere). Pure profit is that which arises from the excess of revenue over opportunity costs. Accounting profit has to be adjusted for owned resources, while normal profit needs to be modified to account for the varying degrees of risk involved in different activities.

EMPIRICAL COST ANALYSIS

Identifying the shape and nature of the cost function is important for many decisions. Economists view short-run cost curves as being U-shaped, while accountants see the relevant costs as being constant per unit. The two views are reconciled in the short run by proposing a bath-shaped cost curve with a significant horizontal section to it before diseconomies set in; this is because firms build their plants with flexibility in mind. The plant will have a capacity larger than the ‘‘expected’’ level of sales to meet variations in demand and to accommodate growth. The horizontal portion of the average cost curve has been supported by statistical cost analysis. For long-run costs, the view has emerged that it is more likely to be Lshaped, with average costs declining initially to a point described as the minimum efficient scale (MES); this is the first plant size that minimizes long-run average costs. Thereafter, long-run average costs remain constant, so that there is no relevant point at which diseconomies of scale become operative.