EA Session 6 July 12, 2007 Prof. Samar K. Datta Cost Concepts EA Session 6 July 12, 2007 Prof. Samar K. Datta

Overview Cost concepts Economic/opportunity cost vs. accounting cost Fixed vs. sunk cost Notion of opportunity cost elaborated thro’ Classical Trade Theory (from handout)

Costs of Production Implicit Costs Sunk Costs Explicit Costs In general, three cost concepts are often considered when making business strategy or supply decisions. Explicit Costs Implicit Costs Sunk Costs

Costs as Opportunity Costs The firm’s costs include Explicit Costs and Implicit Costs: Explicit Costs: costs that involve a direct money outlay for factors of production. Implicit Costs: costs that do not involve direct money outlay. (e.g. opportunity costs) Both can include opportunity costs.

Costs as Opportunity Costs Economists include all opportunity costs when measuring costs. Accountants measure the explicit costs but often ignore the implicit costs. Gap between accounting & economic costs likely to narrow down with more economic liberalization & opening up / establishment of markets. Accounting Cost means actual expenses plus depreciation charges for capital equipment Opportunity cost is the cost associated with opportunities that are foregone when a firm’s resources are not put to their highest- value use. If a firm owns its own building and therefore pays no rent for office space, does this mean that the cost of office space is zero? Mutual excludability of alternative uses is fundamental to the concept of opportunity cost. When revenues exceed both explicit and implicit costs, the firm earns economic profits.

Costs as Opportunity Costs A third, not so obvious implicit cost includes sunk costs. Sunk costs are costs that have already been committed and cannot be recovered, e.g. cost of developing a software Sunk Costs are . . . Nevertheless an opportunity cost, as some alternatives were foregone in the past; But as it is a matter of history now, it doesn’t influence a firm’s current or future decisions. Fixed Cost Cost paid by a firm that is in business regardless of the level of output e.g. cost of oven to make pizza

Quick Quiz “A farmer has planted corn seeds but has not yet fertilized the field.” Is the cost of seed an opportunity cost or a sunk cost? Is the cost of fertilizer an opportunity cost or a sunk cost? Which of these two costs is more likely to affect the decision to continue ?

Why Division of Labor & Gains from Trade so Fundamental? Economics as theory of choice would fail if each individual with limited means & resources were to produce everything he consumes. Time & resource constraint is overcome Hence there is more choice on what to produce. There is also more choice on what to consume; it is no longer constrained by own production. There are two options: We can be economically Self-Sufficient. We can specialize and trade with others leading to Economic Interdependence.

Interdependence & Trade Why is interdependence the norm? Interdependence occurs because people are better off when they specialize and trade with others. What determines the pattern of production & trade? Patterns of production and trade are based upon differences in opportunity costs.

Interdependence and Trade: “A Parable for the Modern Economy” Imagine... … only two goods (potatoes and meat) … only two people (potato farmer and a cattle rancher) What should each produce? Why should they trade?

Absolute Advantages seen from Absolute Cost Figures Rancher Farmer Potato: 8 hrs. 10 hrs. (1 pound) Meat: 1 hr. 20 hrs. Suppose each has 40 hours at their disposal

Self-Sufficiency: without trade, economic gains are limited. Farmer Rancher 2 40 By ignoring each other: the farmer and rancher will produce a limited amount of meat and potatoes each consumes what they each Produce; each is subject to tradeoffs between meat and potatoes. Meat Meat 1 20 2.5 5 2 4 Potatoes Potatoes 9

Comparative Advantages seen from Opportunity Cost Figures Step 1: Translate figures in terms of productivity (pound of potato/meat per hour) Rancher Farmer 1 hour: 1/8 P 1/10 P 1 hour: 1 M 1/20 M

Comparative Advantages seen from Opportunity Cost Figures Step 2: Calculate opportunity costs from pre-trade exchange rates of each party in isolation Rancher: 1M = 1/8 P i.e., 1P = 8M Farmer: 1/10P = 1/20M i.e., 1P = ½M i.e., 1M = 2P It means the Rancher will sell meat if he gets more than 1/8P per 1M Similarly, the Farmer will sell potato if he gets more than ½M per 1P

Specialization and Trade If the farmer and the rancher were to specialize in producing the product that they were more suited to produce, and then trade with each other, they would be better off. Farmer should produce potatoes. Rancher should produce meat. Farmer and Rancher should trade. 10

Measuring differences in costs of production Absolute advantage describes the productivity of one person, firm, or nation to that of another. - The producer that requires a smaller quantity of inputs to produce a good is said to have an absolute advantage in producing that good (e.g., hours required to produce a standardized unit of output, say, one pound of potatoes) Comparative advantage compares producers of a good according to their opportunity cost. - The producer who has the smaller opportunity cost of producing a good is said to have a comparative advantage in producing that good (opportunity cost is measured by amount of one item sacrificed to obtain another). 12

The Principle of Comparative Advantage Comparative advantage and differences in opportunity costs are the basis for specialized production and trade. Whenever potential trading parties have differences in opportunity costs, they can each benefit from trade. Trade can potentially benefit everyone in a society because it allows people to specialize in activities in which they have a comparative advantage. Example: Michael Jordan mowing his lawn or shooting a commercial? Opportunity Costs. . . Absolute Advantage. . . Gains from trade. . . 16

The Old Ricardian Numerical Example Pre-trade scenario: Country Wine Cloth Total Portugal 80 90 170 England 120 100 220 Post-trade scenario: Portugal 160 - 160 England - 200 200

Issues on classical trade theory and opportunity cost Why is complete specialization taking place in each country in this Ricardian example? Explain why complete specialization may not take place in reality. The Ricardian example prescribes only a range within which post-trade terms of trade should lie if trade is to become a gainful proposition to both the countries. Why can’t the Ricardian example determine the exact post-trade terms of trade? A Marxist writer, Arghiri Emmanuel claims that this Ricardian example gives only a local optimum and not a global optimum for the world as a whole (i.e., it is possible to have a better solution). Critically examine the underlying assumptions of the Ricardian model to determine whether or not you agree with Emmanuel, and if so, how, and under what circumstances?