Source: Strickland, Chapter 7, Texas A&M University
Tags: economic cost, accounting cost, opportunity cost, economic profit, accounting profit, explicit cost, implicit cost, fixed cost, variable cost, total cost, sunk cost, sunk cost fallacy, ECON 323, microeconomic theory, cost of production
A firm's costs split into explicit (out-of-pocket) and implicit (opportunity costs), and the gap between accounting profit and economic profit comes down to whether you count opportunity costs. Costs also split by behaviour: fixed costs stay constant regardless of output, variable costs change with output, and total cost is their sum. Sunk costs are already spent and should be irrelevant to forward-looking decisions, though people routinely let them influence choices anyway.
Accounting profit
Total revenue minus accounting (explicit) costs only. This is the profit figure that appears on financial statements.
Economic profit
Total revenue minus economic cost (which includes both explicit and implicit costs). Economic profit can be zero or negative even when accounting profit is positive.
Accounting cost (explicit cost)
The direct, out-of-pocket payments a firm makes for inputs: wages, rent, materials, utilities. These show up in the books.
Implicit cost (opportunity cost of owned resources)
The value of the next-best alternative use of resources the owner supplies, such as the salary the owner could earn elsewhere. These do not appear in accounting records but are real economic costs.
Economic cost
Accounting cost plus opportunity cost. Put differently: explicit costs plus implicit costs.
Fixed cost (FC)
A cost that does not change with the level of the firm's output. Examples include building rent, insurance premiums, and loan repayments. In the short run, at least one input is fixed, so its cost is fixed.
Variable cost (VC)
A cost that changes as the firm changes its level of output. Examples include raw materials, hourly labour, and energy used in production.
Total cost (TC)
The sum of fixed costs and variable costs: TC = FC + VC.
Sunk cost
A cost that has already been incurred and cannot be recovered regardless of any future decision. Sunk costs should be irrelevant to rational decision-making.
Sunk cost fallacy
The error of allowing unrecoverable past expenditures to influence current decisions. The rational approach is to ignore sunk costs and decide based only on future costs and benefits.
Accounting profit = Total Revenue − Accounting Cost (explicit costs only)
Economic profit = Total Revenue − Economic Cost (explicit + implicit costs)
Economic cost = Accounting Cost + Opportunity Cost
Because economic cost is larger than accounting cost, economic profit is always less than or equal to accounting profit
A firm can show a healthy accounting profit while earning zero or negative economic profit. That means the owner's resources would be better deployed elsewhere.
Suppose a business has the following explicit costs:
Lumber supplies: $80,000
Building rent: $40,000
Utilities and insurance: $20,000
Employee salaries: $150,000
Owner's salary: $110,000
Revenue: $400,000
The owner could alternatively earn $115,000 per year as a store manager elsewhere. That forgone salary is the implicit (opportunity) cost.
Step-by-step:
Explicit costs = $80,000 + $40,000 + $20,000 + $150,000 + $110,000 = $400,000
Implicit cost = $115,000 (the salary she gives up)
Economic cost = $400,000 + $115,000 = $515,000
Wait, but the answer key says $405,000. Let me reconsider. The implicit cost is the difference between what she could earn ($115,000) and what she pays herself ($110,000)? No. The standard approach: economic cost includes the opportunity cost of the owner's time. The owner already pays herself $110,000 from the business, but the true cost of her time is $115,000. So the additional implicit cost beyond what is already counted is $5,000.
Economic cost = $400,000 (explicit) + $5,000 (additional opportunity cost) = $405,000
Economic profit = $400,000 − $405,000 = −$5,000
The answer is C: economic cost of $405,000 and economic profit of −$5,000.
The key insight: Lilly's salary of $110,000 is already in the explicit costs. The opportunity cost adds only the gap between what she could earn elsewhere ($115,000) and what she already pays herself ($110,000).
True statements to know:
Accounting profit = Total revenue − Accounting cost ✓
Economic cost = Accounting cost + Opportunity cost ✗ (This is a common trap. Economic cost equals accounting cost minus the owner's salary already counted, plus the full opportunity cost. More precisely: economic cost = explicit costs + implicit costs, where the implicit cost is the full forgone alternative, but you must avoid double-counting.)
Economic profit = Total revenue − Economic cost ✓
Economic profit = Accounting profit − Opportunity cost ✓
The exam tests whether you can identify which of these relationships hold. Statements I and IV from the exam (accounting profit = TR − accounting cost; economic profit = TR − economic cost) are reliably true.
A fixed cost does not change with the level of the firm's output
Fixed costs are associated with fixed inputs (in the short run, at least one input cannot be adjusted)
Variable costs rise as output increases, because producing more requires more variable inputs (labour, materials)
TC = FC + VC at every output level
At zero output, variable cost is zero, so TC = FC.
In the short run, at least one input is fixed (e.g. factory size, machinery), so its cost is fixed
In the long run, all inputs are variable, so all costs become variable
Longer time horizons mean fewer fixed costs, because the firm has more flexibility to adjust every input
Factors that lead to fewer fixed costs:
Longer time horizons (more inputs become adjustable)
Reliable resale markets (capital equipment can be sold, converting a sunk fixed cost into a recoverable one)
Factors that lead to more fixed costs:
Greater capital requirements for production
Short planning horizons
The firm's total cost is the sum of its fixed and variable costs (true)
Over the long term, the costs of the firm's inputs tend to become fixed (false, they become variable)
In the long run, the firm can adjust the use of all of its inputs (true)
A sunk cost is spent and gone. Rational decisions ignore it entirely.
Examples of the sunk cost fallacy:
"I'm not going to allow the sacrifice of 2,527 troops who have died in Iraq to be in vain by pulling out before the job is done." Past losses cannot be recovered; they should not determine whether to continue.
Examples that are NOT the sunk cost fallacy:
Giving away a sweater that does not fit (the $85 is sunk, but the decision to give it away is forward-looking and rational)
Waiting for a sale before buying (this is just price sensitivity, no sunk cost is involved)
Buying a replacement bag of popcorn because the first is burnt (the ruined popcorn is sunk, but buying a new one is a fresh cost-benefit decision that happens to be rational)
On a standard cost-curves graph:
The FC curve is horizontal (flat), because fixed costs do not change with output
The VC curve starts at zero and rises, typically with increasing steepness (reflecting diminishing returns)
The TC curve is the vertical sum of FC and VC at each output level, so TC starts at the FC level (when Q = 0) and rises parallel to VC
To read values at a given quantity:
Find the quantity on the horizontal axis, go up to the relevant curve, then read across to the vertical axis
The vertical gap between TC and VC at any output level equals FC
At 6 units of output (from the exam figure): FC = $200, VC = $250, so TC = $450.
At 7 units of output: TC = $500 (read from the TC curve directly, answer D).
Given a table with partial data (Q, FC, VC, TC), fill in the blanks using TC = FC + VC:
Q | FC | VC | TC |
|---|---|---|---|
0 | 100 | 0 | 100 |
1 | 100 | 50 | 150 |
2 | 100 | 100 | 200 |
3 | 100 | 150 | 250 |
Then match to the panel where:
FC is a flat line at 100
VC starts at 0 and rises through (1, 50), (2, 100), (3, 150)
TC starts at 100 and rises through (1, 150), (2, 200), (3, 250)
The correct panel shows linear cost curves with FC = 100 (panel a).
Profit formulas:
Accounting Profit = TR − Explicit Costs
Economic Profit = TR − (Explicit Costs + Implicit Costs)
Economic Profit = Accounting Profit − Implicit Costs
Cost identity:
TC = FC + VC
At Q = 0: VC = 0, so TC = FC
⚠️ The distinction between accounting profit and economic profit is a perennial exam favourite. Remember that economic profit subtracts opportunity costs that accounting profit ignores.
⚠️ When calculating economic cost for an owner-operator, watch for double-counting. If the owner's salary is already listed as an explicit cost, the implicit cost is only the difference between the outside option and the salary already drawn.
⚠️ Fixed cost does not mean "unchangeable forever." It means unchangeable in the short run. In the long run, all costs are variable.
⚠️ The sunk cost fallacy question tests whether you can tell the difference between someone irrationally clinging to past spending and someone making a normal forward-looking decision.
⚠️ On graph-reading questions, the vertical distance between TC and VC is always FC. If the question asks for FC at any output level, just subtract VC from TC (or note the level of the flat FC line).
Q: What is the relationship between economic profit and accounting profit?
A: Economic profit = Accounting profit minus implicit (opportunity) costs. Economic profit is always less than or equal to accounting profit.
Q: A business owner has explicit costs of $400,000, pays herself $110,000 (included in explicit costs), and could earn $115,000 elsewhere. Revenue is $400,000. What is her economic profit?
A: Economic cost = $400,000 + $5,000 (the gap between outside option and salary already drawn) = $405,000. Economic profit = $400,000 − $405,000 = −$5,000.
Q: What is the defining characteristic of a fixed cost?
A: It does not change with the level of the firm's output.
Q: Are all costs fixed in the long run?
A: No. In the long run, all costs are variable because the firm can adjust every input.
Q: Someone says, "We've already spent $2 million on this project, so we can't stop now." What fallacy is this?
A: The sunk cost fallacy. The $2 million is already spent and unrecoverable, so it should not affect the decision to continue or stop.
Q: On a cost-curves graph, how do you find fixed cost at any output level?
A: FC is the vertical distance between the TC curve and the VC curve, or simply the height of the horizontal FC line.
economic cost, accounting cost, opportunity cost, explicit cost, implicit cost, economic profit, accounting profit, normal profit, sunk cost, sunk cost fallacy, fixed cost, variable cost, total cost, short run, long run, cost curves, TC, FC, VC, Strickland, ECON 323, Chapter 7, microeconomic theory, cost of production, Texas A&M