Cost

Let us now consider a basic economic term that is often misunderstood - the idea of cost. When an economist uses the word “cost,” a layman, or beginning student, often assumes he means the financial cost - the cost hi terms of money. However, when the word “cost” is used in a discussion among economists, it does not even occur to them that it means only the financial cost. For cost is a very broad idea in economics: depending on the situation, the cost of a given action may include money, time, emotional stress, discomfort, the risk of physical injury or criminal prosecution, or other undesirable consequences.

In general, the cost of an action is the value of the best opportunity that is lost by taking that action. In other words, it is the value of the best alternative to the action being considered. Suppose Bill, a college student, is trying to decide what to do with his life. He is considering several alternative occupations: law, dentistry, accounting, and becoming a high-school cross-country coach. Among these alternatives, the two he finds most appealing are law and becoming a cross-country coach. In this case the cost of choosing law is that he will not be able to coach cross-country. His decision whether to enter law school should turn only on whether law is more attractive to him than coaching cross-country. The other alternatives to law are irrelevant to his decision because they are dominated by the option of coaching cross-country.

The cost of going to college, rather than going to work immediately after high school, includes not only the out-of-pocket expenses for tuition, books, and the like, but also the loss of earnings one could have had by working fiill-time instead of attending classes. There is also a psychic cost, namely the effort involved in studying and learning new and often difficult material. High school graduates go to college because the benefits they expect from college, in terms of increased earnings and greater knowledge, exceed these expected costs.

As the preceding example suggests, an important component of the cost of an action is the time it takes. Businesses whose workers must frequently wash their hands, like those involved in food preparation and health care, must decide whether their employees will use paper towels or electric hand driers to dry their hands. Manufacturers of hand driers contend that they cost less than paper towels, but then calculation does not consider the value of the tune an employee requires to dry his hands. If the services of the average employee are worth $30 an hour to the employer, and the use of an electric hand drier takes a minute longer than paper towels, this represents an additional cost of 1/60 x $30 = S.50 each time an employee dries his hands. When this additional cost is considered, paper towels may be less expensive to an employer than electric hand driers.²

Sometimes one hears the expression “sunk cost.” A sunk cost is a cost that has already been incurred and cannot be recovered. The key thing to know about a “sunk cost” is that it is not a cost at all. The cost of an action, or decision, is the opportunities that are sacrificed, or the resources that are consumed, by taking that action or making that decision. One should act if the benefits of the action being considered exceed its costs. If. on the other hand, the costs of the proposed action exceed its benefits, one should not do it. If an expenditure has already been made, and would not be increased or reduced by an action being considered, it is not a cost of that action, and is not at all relevant to whether that action should be taken. Suppose your father was a physician, and for as long as you can remember, everyone in your family expected that you would also become a physician. After college you entered medical school (mostly because everyone expected you to do so), and your family eventually paid $200,000 for your medical school education. However, after graduating, you realized that what you really wanted to do, or at least consider seriously, is to become a writer. How should you decide what to do - whether to become a writer or pursue a career in medicine? In particular, should the $200,000 your family paid for your medical education be a consideration? In fact it should not be. The $200,000 is gone and cannot be recovered; in economic terms, it is a sunk cost.

We may also note that economists use the terms “cost” and “revenue” in ways that are sometimes different from the way those words are used by others, such as accountants and tax lawyers. This is illustrated in the example below.

The economist’s definitions of cost and revenue

The following example illustrates the difference between the definitions of cost and revenue used by the economist and the accountant, and the meaning of opportunity cost. Suppose Mr. X buys a parcel of land for $20,000 because he suspects there is oil under the property. To finance his oil exploration venture, he borrows $300,000 from a bank at an interest rate of 5 percent per year. He then buys oil drilling machinery for $200,000, and spends $50,000 more on materials and supplies, all of winch are consumed during the year. He also hu es two workers at a salary of $25,000 each.

Dining the year he discovers reserves of oil on the property, which increases its market value to SI million. However, he does not sell the property. At the end of the year, the oil drilling machinery is worth $140,000 because of depreciation and ordinary u^rear and tear. Although Mr. X works fiill-time in the oil chilling venture and owns the business, he does not receive any salary. Mr. X is framed as an engineer. If he were not working fiill-time in this

oil drilling business, he could earn $50,000 a year working for a corporation. The question is, what is his profit (or loss) for the year?

An accountant would say that Mr. X has a loss, determined as follows:

Total revenue = SO

• - 50,000 (cost of labor)
• - 60,000 (depreciation of oil drilling machinery)
• - 50,000 (cost of materials and supplies)
• - 15,000 (interest)

= ($175,000)

i.e., a loss. An economist, on the other hand, would say that Mr. X has a profit, determined as follows:

Total revenue = S980,000 (the gain from appreciation of the land, S1,000,000 - S20,000)

• - 50,000 (cost of labor)
• - 60,000 (depreciation of oil drilling machinery)
• - 50,000 (cost of materials and supplies)
• - 15,000 (interest)

- 50,000 (the value of the tune of Mr. X)

= $755,000

i.e. a substantial profit.

Note that there are two differences between the calculation of profit made by the accountant and the economist. Unlike the economist, the accountant does not treat the appreciation in value of the land as a gain, because there has been no sale of the land. Also, unlike the accoimtant. the economist treats the value of the time of Mr. X - the income he sacrifices by working in the oil business - as a cost.

Now suppose instead that Mr. X was able to start his business without borrowing any money, because his grandmother had left him a trust fund, from which he withdrew the $300,000 required to finance the oil drilling project. Should we then eliminate the deduction of $15,000 for the cost of interest? We should not. Even though Mr. X does not have to borrow the money, by investing it in his business he has foregone the opportunity of investing it in a bond that would earn interest at 5 percent per year.³ Since this opportunity that is sacrificed is a real economic cost, it is still appropriate to subtract the $15,000 to reflect the cost of using these funds.

In discussions of firm costs one often encounters references to “economies of scale.” Below we consider economies of scale, and two related ideas: economies of scope, and leaming-by-doing.

Table 1.1 Economies and diseconomies of scale

Economies of scale

There are economies of scale when the long-run average cost of production declines with the amount produced. In Table 1.1 average cost declines in the range from 0 to 50 units, but increases over the range from 50 to 100 units. We would say there are diseconomies of scale over the range from 50 to 100 units.

There are a number of different reasons for economies of scale:

• 1. One important factor is specialization and division of labor. In a famous passage in the Wealth of Nations, Adam Smith explained how “the important business of making a pin is ... divided into about eighteen distmct operations which, in some manufacturies, are all performed by distinct hands.” If one worker tried to do all these operations himself, he would produce much less efficiently, since he would continually have to put down the tools required for one task, to pick up another set of tools required for another task. Also he would probably do each operation less skillfully than he could if he did the same operation repeatedly. Consequently eighteen workers dividing the labor of making phis would produce far more than eighteen times the number of pins that could be made by a single worker.
• 2. There are indivisibilities of certain factors of production or, putting it differently, certain inputs may have unavoidable “excess capacity.” A photocopying machine suitable for a firm of twenty lawyers does not cost ten times as much as a photocopier purchased for a firm of two lawyers; it may cost less than twice as much. Moreover the photocopier purchased for the larger film probably will not require ten times as much space, nor require ten times as much labor to maintain it, nor use ten times as much electricity. Perhaps the two-lawyer firm could have then photocopying done by an outside firm like Kinko’s, but this would involve a transaction cost not borne by the film with its own photocopier.
• 3. Inputs are generally less expensive when purchased in large quantities. The purchaser of 10,000 envelopes will pay less per envelope than one who buys 100 envelopes, since the cost of the transaction - making the purchase - can be spread, or as the economist would say, amortized, over a larger number of envelopes.
• 4. Some economies of scale are a result of the statistical law of large numbers. Loosely speaking, the weak law of large numbers states that the average value of a sample of objects chosen randomly from some population is likely to be closer to the true mean of the population, the larger the size of the sample. For example, there is much less variation in the death rate of a large population like the United States - i.e., the number of deaths per year divided by the population - than in the death rate of a small town. The current death rate of the U.S. population is about eight per thousand per year, and does not change much from year to year. In a small town with a population of 500, however, there may be only one death in one year, but seven in the following year, and four the year after that, etc. (a small town is a very small sample of the U.S. population). Because of the law of large numbers, there is less variation in the demand for milk by the customers of a large supermarket than by the customers of a local convenience store. Therefore if, for example, the supermarket sells on average ten times as much milk as the convenience store, it does not have to stock its shelves with ten times as much milk. The convenience store must cany' more inventory relative to its sales since there is far more variation in the demand of its customers.⁴

Diseconomies of scale

Table 1.1 shows that there are diseconomies of scale over the range from 50 to 100 units. In general, there are diseconomies of scale if it takes more than twice the inputs to double the film’s output. What would explain diseconomies of scale? Students often think they would result from efforts to produce more than a plant’s capacity, but this is incorrect, since in the long run we assume the film is using a plant of optimal size for the level of output being considered. Some economists argue that once a firm reaches a certain size, it becomes difficult (costly) for managers to obtain good information about the firm’s operations, or monitor the work of employees, or to organize and coordinate activities.

Diseconomies of scale may also arise because of unions. Unions are more likely to attempt to organize the workers of a large firm than a small firm; the reason is that for the union there are economies of scale in organizing workers. The costs of a firm whose workers join a union will generally increase as the union seeks higher wages and fringe benefits for its members; moreover, a union can call a strike, and cause the legal expenses of a firm to increase for various reasons.

George Stigler noted that very large films do not do well in industries where rapid changes are required by changes in style or fashion, like women’s apparel, women’s shoes, or novelty toys. Walter Oi pointed out that entrepreneurial ability is subject to the law of eventually diminishing marginal product. If there is one fixed factor (entrepreneurial ability), the marginal product of other factors such as land, labor and capital, must eventually decline as more of these factors are hired. If only one executive can be in charge of the firm, he will become less informed and less effective when the film continues to grow beyond a certain size.

Economies of scope, economies of scale and learning-by-doing

There are economies of scope when two different products can be produced at lower cost by one finn than by two films, each producing one product. Since films in the beef industry obtain the hides of steers as a by-product, they may be able to produce beef and leather at lower cost than two firms, each producing one of these goods, assuming the same inputs are used in each production arrangement. A single oil refinery can produce heating oil, gasoline and jet fuel at a lower cost than three films making these products separately. Conversely in some situations there are diseconomies of scope. Kim (1987) found that it cost 41 percent more for a railroad to transport both passengers and freight than if these tasks were done separately by two railroads.

Economies of scale and economies of scope refer to conditions in effect at a particular time, with a given technology. For example, there are economies of scale in the automobile industry, because today the average cost of an automobile is lower for a firm that produces one million vehicles than for a film that produces only ten of them. This comparison involves only a change in output, not a change that occurs over tune; we are considering a movement along a long-run average cost curve, rather than a shift of the curve.

We can also consider changes that occur over time. “Learning by doing” refers to a downward shift of the long-run average cost curve that occurs when workers leam from experience how to produce goods more efficiently. A lawyer who has done three or four house closings (the investigation, negotiations and paperwork required to complete the sale of a house) can do another one much more efficiently than a lawyer doing his first closing. Long- run average cost curves also move downward because of technological change. It costs less to manufacture an automobile today than it did thirty years ago at any level of production, because of technical advances such as computer programs, lasers and robots.