TOTAL FACTOR COST, PERFECT COMPETITION: The opportunity cost incurred by a perfectly competitive firm when using a given factor of production to produce a good or service. This is the total cost associated with the use of a particular resource or factor of production--it is the total cost of the factor. For a perfectly competitive firm, the price paid is constant and total factor cost increases at a constant rate. Total factor cost is predominately used in the analysis of the factor market. Two derivative factor cost measures are average factor cost and marginal factor cost.
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An opportunity cost that involves a monetary payment or some other form of compensation. The monetary payment is generally made to compensate the person who initially foregoes the satisfaction. This payment, in effect, transfers the burden of the opportunity cost from the original person to the one making payment. Explicit cost is also commonly termed out-of-pocket or accounting cost, and occasionally explicit opportunity cost. Opportunity cost is the value of the best foregone alternative. In some cases the opportunity cost involves a monetary payment or compensation. In other cases there is no compensation, monetary or otherwise. This distinction gives rise to two types of opportunity cost--explicit and implicit.
A Transfer of CostAn explicit cost is characterized by a monetary payment or some other form of compensation to the person who initially foregoes the satisfaction. The person foregoing the satisfaction then, at the very worst, breaks even, while the opportunity cost is transferred to the person making the payment. The person receiving the payment can purchase other satisfaction, while the person making payment foregoes satisfaction that could have been purchased with the money.
Here is an example.
- The Activity: Suppose that Chip Merthington, a typical fun-loving Shady Valley teenager, is hired as a part-time employee at the CD Music Emporium in the Shady Valley Sprawling Hills Shopping Mall. Chip spends four hours each afternoon stocking CD's and assisting customers.
- The Opportunity Cost: The four hours Chip spends at the CD Music Emporium is time that cannot be spent pursuing other activities. Chip's best, most satisfying alternative, would be playing video games with his friends at Alicia Hyfield's house. The opportunity cost of working at CD Music Emporium is this foregone satisfaction.
- The Payment: Fortunately, Chip receives $5 for each hour of work at the CD Music Emporium. This payment compensates Chip for his foregone satisfaction. If not, then he would probably choose not to work. Chip then uses this compensation to purchase other consumer satisfying goods, such as evenings spent eating pizza and watching movies with Alicia Hyfield. Chip, at worst, breaks even.
- The Transfer: The opportunity cost of foregone satisfaction is effectively transferred to the CD Music Emporium through the monetary payment of Chip's wage. In particular, the owners of CD Music Emporium now have less money (profit) that can be used to purchase consumer satisfying goods. As such, the CD Music Emporium owners are now incurring the opportunity cost of foregone satisfaction resulting from Chip's employment.
Out-of-Pocket PaymentThe key to an explicit cost is that an explicit transaction occurs, money trades hands. This, more often than not, results in a record of the transaction, the type of record used by business firms to track expenses. For this reason, explicit cost forms the basis for what is called accounting cost.
A word or two about accounting cost seems in order:
- First, not all accounting cost is opportunity cost. That is, in some cases an explicit payment is made by a firm but not in compensation of foregone satisfaction. It might be recorded by a firm as accounting cost, but it is actually economic profit. For example, CD Music Emporium also employs Randy Goodluck, who happens to be the nephew of the head of the company. Randy never shows up for work and does not actually do anything productive. Randy's $5 "wage" is recorded as an accounting cost, but it is really part of the company's profit, not compensation for opportunity cost.
- Second, accounting cost does not necessarily reflect all opportunity cost incurred by a business firm for production. The official, out-of-pocket, accounting cost might not fully compensate for the opportunity cost. For example, Suzanne Haberstone is also employed by CD Music Emporium making the same $5 hourly wage as Chip and Randy. Suzanne is a licensed massage therapist and charges $50 per hour for her services. Each hour spent working at CD Music Emporium means Suzanne is foregoing $50 of massage therapy. Her wage is also an accounting cost, but it does not fully reflect the opportunity cost she incurs.
An Implicit AlternativeThe counterpart of explicit cost is implicit cost. Implicit cost is an opportunity cost that does not involve a monetary payment or any form of compensation. If, for example, Chip Merthington worked for the CD Music Emporium without receiving a wage, that is, he worked for "free," then the opportunity cost of his foregone satisfaction would be uncompensated and hence an implicit cost.
EXPLICIT COST, AmosWEB Encyclonomic WEB*pedia, http://www.AmosWEB.com, AmosWEB LLC, 2000-2024. [Accessed: February 27, 2024].
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