*The game referenced in this article is ‘The Tribez‘ offered by Game Insight UAB.
We spoke previously about the Opportunity Costs associated with Trade-offs.
Trade-Offs → the situation where you face an opportunity that includes both benefits and costs. This forces you to choose whether or not to accept the cost in order to gain the benefit.
A Simple Example:
You have a particular love for chocolate chip cookies and your grandmother just brought a lovely batch out of the over. Unfortunately, you know that if you eat a chocolate chip cookie, it brings with it those unwanted calories. Eating a cooking produces a trade-off: to obtain the benefit (deliciousness and joy) you must also accept the cost (calories and possible weight-gain).
In this example, we will focus on the benefits and costs that arise by comparing two different, but exclusive opportunities. You have obtained some rocks and food and wish to use your workers to produce stones. The stone factory is flexible and offers you two contracts:
- Lengthy Deal – The Lengthy Deal will require two hours and two workers.
- Standard Deal – The Standard Deal will require one hour and two workers
Unfortunately, you have limited workers (only 2) and the workers can only fulfill ONE contract at a time. This means that you face a choice – Lengthy Deal or Standard Deal? The choice is difficult because of the trade-offs. . . both contracts have their costs.
In this case, we are comparing the two contracts. Both require two workers, no matter what. . . so let’s disregard the number of workers since that won’t help us make a choice.
The differences arise in terms of the supplies required for each contract (Food and Rocks) and the final result (How much Stone is produced in 2 hours).
Opportunity A (Lengthy Deal)
- Benefits (Pros)
- 1.94 Food per stone (Less)
- Costs (Cons)
- 2.77 Rocks per Stone (More)
- 90 Stone after 2 hours (Less)
Opportunity B (Standard Deal)
- Benefits (Pros)
- Only pay 2.40 Rocks per Stone (Less)
- 100 Stone after 2 hours (More)
- Costs (Cons)
- Have to pay 2 Food per Stone (More)
Lengthy Deal is cheaper in terms of food but more expensive in terms of rocks and hours. It also will give us fewer Stones after 2 hours. Standard Deal is cheaper in terms of rocks and hours, but more expensive in terms of food. It also gives us more Stones after 2 hours.
In this case, your choice will depend on which of the benefits and costs are more important to you. If you have a lot of rocks but little food, you may be inclined to choose the Lengthy Deal. Conversely, if you are in a hurry for stone, you might be inclined towards the Standard Deal.
The important take-away from the concept of trade-offs is that when facing a decision, it is important to identify and examine BOTH the benefits and the costs that will occur from all possible choices. In economics, there is always a trade-off – nothing is perfect in the real world. . . every decision will have some cost attached.
Most resources have more than one possible use. Wood can make firewood or lumber for housing. Labor can produce music or kites. Time can be used for studying or reading.
When a resource is consumed for one use, all alternative uses are then sacrificed. Wood cannot both be burnt in a fire for heat and be used in lumber for construction. You cannot use your energy to both fix a pipe and write a newspaper article simultaneously.
The value of the sacrificed “alternative use” is called an opportunity cost. Opportunity Costs are the possible OTHER uses of a resource that are sacrificed when it is consumed. Basically, it is the cost portion of your Trade-Off.
This can become a massive concept to work with if your resource is widely used. Consider for example time . . . if you choose to spend your time on filing your taxes this Saturday, your opportunity cost would be ALL OTHER POSSIBLE uses for your time on that Saturday. There are probably a million other things you could have done and all of them are now sacrificed.
In economics, calculating such a massive cost is infeasible and impractical. Instead, we limit our consideration and calculations to the value of the second-best alternative use of a consumed resource.
Example A: A teacher has 4 hours of free time on Friday after school.
- She might use that time on grading assignments.
- She might use that time preparing lesson plans for next week.
- She might use that time to clean her classroom.
In reality, she has in making her decision mentally ranked the three alternatives according to what she would actually do first. Our teacher chooses to prepare lesson plans but if she didn’t, she would have been grading assignments (her second most-likely choice). She is least likely to clean the classroom, so we set that choice aside. Instead, we would say that her opportunity cost for calculations and decision-making processes was the opportunity to grade assignments.
Example B: A child is given one hour of recess. He can play on the swings, play on the slides, or play on the monkey bars. Time is his limited resource triggering a decision and thus trade-offs. He likes the monkey-bars least and probably won’t actually choose them. In this example, by choosing to play on the swings, he sacrifices the opportunity to spend the time on slides (opportunity cost).
Example C: A business manager invests $500,000 in Company A with returns of $5,000.00 per year. He later learns he could have had returns of $7,500.00 per year with Company B or $6,500.00 per year with Company C. His opportunity cost is the loss from not choosing Company B (his preferred alternative). Opportunity Cost is calculated as $7,500.00 – $5,000.00 = $2,500.00.
It is important to understand that opportunity costs can be financial or non-financial. Generally, in economics courses, we emphasize the financial costs. But you should remember that time, energy, happiness, convenience, satisfaction, and other intangible or non-monetary sacrifices made can be opportunity costs as well.
Example D: A company spends $75.00 purchasing materials from their supplier. Their financial opportunity cost is $75.00 – the monetary value of whatever they might have bought instead with the same $75.00.
All resources with more than one possible use generate opportunity costs. If you use your water for cola, it cannot be simultaneously used for tea and coffee.
We generally divide business-oriented opportunity costs into two overarching categories:
- Explicit Costs
- Implicit Costs
Explicit Costs are the easiest to calculate and the most emphasized by management and financial officers. Explicit Costs are the cost of resources purchased from external third parties. These resources will be purchased from the global marketplaces – either the market for finished goods and services or the market for factors of production.
The resources purchased are called market-supplied resources and include labor, land, raw materials, factories, taxes, utilities, delivery services, and more. In the modern world, such resources are purchased with money making the value easy to calculate.
Example: Michelle’s company purchases labor for $25,000 in labor; a delivery van for $3,500; and machinery for $7,500. That money could have been used for any number of other purposes, thus opportunity costs of $36,000.00 arise.
Implicit costs are more complex. Explicit costs are costs paid by the company and implicit costs are paid by the owner or investor. Implicit Costs are the value of resources sacrificed by the owner for the sake of the company.
Typically, implicit costs occur when an owner donates or offers resources to the company that have alternative uses. The resources involved are called owner-supplied resources. There are two key differences between explicit and implicit costs:
- Who pays the cost?
- Implicit Costs: Owner Pays
- Explicit Costs: Company Pays
- Kinds of resources involved?
- Implicit Costs: Generally non-monetary
- Explicit Costs: Generally monetary
Consider the following examples of implicit costs:
- Owner works in the company without pay to help with operations. (Time)
- Owner donates some unused land to the company for a new store (Land)
- Owner provides office supplies (pencils, paper, ink) from his home (Materials)
Implicit costs include lost potential profits the owner could have made on his investments or resources had he used them elsewhere.
Example, the owner invests $100,000 into the company for returns of $10,000 annually. An alternative investment would have generated returns of $15,000 annually. This owner has sacrificed $5,000 in potential profits = implicit costs.
Important! The financial investment is not calculated in implicit costs. The other resources we mentioned were sacrificed by the owner immediately upon giving them to the company. Money doesn’t work the same way – money invested into a company is still technically recorded on the balance sheet as owner’s equity (resources belonging to the owners). The money will cease being the owner’s when it is spent by the company into the market.
To avoid counting costs twice (once when the owner gives it to the company and once when the company uses it to buy something), original investments into the company are only counted as explicit costs and are recorded as a cost when the company consumes the money.
Example: Michelle is investing $50,000 in her restaurant, in return for $17,000 in annual returns. There was an alternative investment that would have generated $18,000 in annual returns that she passed up. Michelle also donated 250 apples from her farm valued at $300 in the marketplace.
The implicit costs include both actualized costs + lost potential profits but not the financial investment.
It is possible for the company itself to face lost potential profits (opportunity costs). Examples include money lost on investments, in market selection, in project management, etc.
Example: A company invests $100,000 in a new land development that generates $150,000 returns. They could have invested the $100,000 in a different opportunity for $170,000 in returns but choose against it.
There is a $20,000.00 opportunity cost in lost potential profits from using their money in this way. To calculate lost potential profits = (Opportunity Benefit – Opportunity Cost) = ($150,000 – $170,0000).
These lost potential profits are generally only relevant in project or investment opportunity analysis and are normally estimated. Consequently, they are often NOT calculated in Explicit Costs by the company’s financial papers (Balance Sheets, Income Statements, Cash Flow Statements). They would theoretically be a form of Implicit Cost in that it is money the owner should have received but did not (lost potential profits for the owners).
Total Economic Costs
How companies assess and calculate costs depends on the situation.
If trying to identify actual financial costs spent by a company over the year, consider Actualized Explicit Costs.
When considering the value of an upcoming project or new company investment, consider both Explicit Costs and relevant Implicit Costs
When a company is considering the total costs (actualized and lost potential profits) from their operations, they identify the Total Economic Cost = Explicit Costs + Implicit Costs. This figure is very significant to owners and investors as it reflects not only the company’s costs, but the separate owner’s losses as well.
Because there are different ways to calculate costs – there are different ways to calculate profits as well.
The difference lies in whether costs include implicit costs or not.
Accounting Profit only takes into consideration money spent by the company (Explicit Costs). This figure, while not all-encompassing does focus on the most valuable resource the company has – it’s money. Financial and accounting officers are responsible for monitory the accounting profit and ensuring the company is both increasing in profits and generating sufficient money for operations to continue. This is the figure seen on Balance Sheets, Annual Reports, and Income Statements.
Economic Profit is of greater significant to owners and investors, taking into calculation both Implicit and Explicit Costs. This figure is less reliable (often including estimates) but does give a better understanding of what resources the company is draining in operations.
|Opportunity Cost||Those things that motivate one to choose Option A. Formally defined as the value of the second-best alternative use of a consumed resource|
|Trade-Off||The costs associated with making a decision, occurring where a choice has a resulting sacrifice required.|
|Profits||Revenue – Cost = Profit|
The money the owners make from a transaction in the end.
|Explicit Costs||The cost of resources spent in external markets.|
|Market Supplied Resources||Resources purchased from external markets in exchange for explicit costs.|
|Implicit Costs||The cost of resources sacrificed by the owner specifically for the sake of the company.|
|Owner Supplied Resources||Resources received from owners, generating implicit costs|
|Total Economic Cost||Explicit Costs + Implicit Costs|
The total cost of the business for the owners and investors.
|Accounting Profit||Revenue – Explicit Cost|
The financial profit
|Economic Profit||Revenue – Total Economic Cost|
The overall profit