Difficulty: Introductory to Intermediate | Prerequisites: Demand, Elasticity, and Price Controls study notes
This material covers three connected areas: how economists think about costs (including costs you never write a cheque for), how the structure of a market shapes firm behaviour and pricing, and what happens when governments intervene in the labour market through minimum wage laws. Understanding opportunity cost and the explicit/implicit cost distinction is essential groundwork. Market structures (particularly perfect competition) show how those costs interact with revenue to determine profit. The minimum wage discussion applies price-floor logic from the demand and supply notes to a specific market: the market for labour. If you have not yet reviewed demand, supply, and price controls, do that first.
Opportunity cost is what you give up when you choose one option over another, and it includes both the money you spend (explicit costs) and the income you forgo (implicit costs). Perfect competition describes a market where no single firm has pricing power. Minimum wage increases raise pay for some workers but can reduce employment for others, with mixed effects on inequality.
Opportunity cost
The value of the best alternative forgone when a decision is made. This is not just the money spent; it includes the next-best use of your time, resources, or capital.
In simple terms, this means: what you gave up by choosing this option instead of the next-best one.
Explicit costs
The direct, out-of-pocket monetary payments a firm makes: wages paid to workers, rent on premises, raw materials purchased, utility bills. These appear in the firm's accounting records.
In simple terms, this means: costs you can point to on a bank statement.
Implicit costs
The opportunity costs of using resources the firm already owns, for which no direct payment is made. These do not appear in accounting records but are real economic costs.
Think of it as: the income you sacrifice by using your own resources instead of renting them out or deploying them elsewhere. If you use your own building for your business, the implicit cost is the rent you could have earned by leasing it to someone else.
Economic profit
Total revenue minus all costs, both explicit and implicit. Economic profit can be zero even when accounting profit is positive, because accounting profit ignores implicit costs.
Think of it as: the profit left over after you account for everything you gave up.
Accounting profit
Total revenue minus explicit costs only. This is the profit figure on a firm's income statement, but it overstates true profitability because it ignores implicit costs.
Perfect competition
A market structure with many buyers and many sellers, where no single participant can influence the market price. Products are identical (homogeneous), firms are price takers, and there are no barriers to entry or exit.
In simple terms, this means: a market where every seller is so small relative to the whole that they just accept whatever price the market sets.
Monopoly
A market structure with a single seller and no close substitutes. The monopolist has significant pricing power.
Oligopoly
A market structure with a small number of large firms, where each firm's decisions affect the others. Strategic behaviour (game theory) becomes important here.
Monopsony
A market structure with a single buyer (rather than a single seller). The monopsonist has power over the price it pays, which is relevant in labour markets where one employer dominates a region.
Minimum wage
A government-mandated price floor on labour. When set above the equilibrium wage, it is a binding floor that can raise wages for those who remain employed but reduce the number of jobs available.
Every decision has an opportunity cost, even when no money changes hands
Example: attending university full-time has an explicit cost (tuition fees) and an implicit cost (the salary you could have earned working full-time instead)
Economists care about economic profit, not just accounting profit, because implicit costs represent real sacrifices
A firm earning zero economic profit is still covering all its explicit and implicit costs. The owner is earning exactly what they would in their next-best occupation. This is the "normal profit" condition in perfect competition
Explicit costs: wages, rent, materials, interest on loans, any payment recorded in the books
Implicit costs: foregone rent on an owner-occupied building, foregone salary the owner could earn elsewhere, foregone interest on the owner's capital invested in the firm
The distinction matters for decision-making. A business that shows positive accounting profit may be earning negative economic profit if the owner's time and capital would be worth more elsewhere
Example: a shop owner pays £30,000 in rent and materials (explicit) but could earn £50,000 working for someone else (implicit). If revenue is £70,000, accounting profit is £40,000 but economic profit is negative £10,000
Perfect competition: many firms, identical products, no pricing power, no barriers to entry. Firms are price takers. In long-run equilibrium, economic profit is zero
Monopoly: one firm, unique product, high barriers to entry. The firm is a price maker and restricts output to raise price
Oligopoly: few firms, products may be identical or differentiated, significant barriers to entry. Firms are interdependent and may collude or compete strategically
Monopsony: one buyer (often relevant in labour markets). The single buyer can push the price it pays below the competitive level
The labour market follows supply-and-demand logic: workers supply labour, firms demand it
A minimum wage is a price floor on labour. When set above the equilibrium wage, it is binding
Effects of a minimum wage increase:
Wages rise for workers who keep their jobs, benefiting low-income earners
Employment may fall, particularly for low-skilled workers, as firms cut back hiring or reduce hours to manage higher labour costs
Some firms pass increased costs to consumers through higher prices, which can contribute to inflation
The net effect on income inequality is ambiguous: the wage increase narrows the gap for those still employed, but job losses among the lowest-skilled workers can widen it in a different dimension
The empirical evidence on minimum wage effects is more nuanced than the simple supply-and-demand model suggests. Some studies find minimal employment effects at moderate increases; larger increases tend to show clearer disemployment effects
Opportunity cost explains why highly paid professionals hire cleaners rather than cleaning their own houses: the implicit cost of their time exceeds the explicit cost of paying someone else. The explicit/implicit cost distinction is central to business valuation, because a buyer needs to know the true economic profit, not just the accounting figure. Minimum wage debates appear in policy discussions in virtually every country; understanding the trade-off between higher pay and potential job losses is essential for evaluating those arguments.
Students often think opportunity cost is the same as the monetary price. It is broader: it includes the value of the best alternative you did not choose, whether or not money was involved.
Students frequently forget implicit costs when calculating profit. If an exam asks for "economic profit," you must subtract both explicit and implicit costs from revenue.
A perfectly competitive market does not mean there is only one buyer. It has many buyers and many sellers. A market with many sellers and one buyer is a monopsony.
Students sometimes assume a minimum wage increase always reduces employment. The real-world effect depends on the size of the increase, the elasticity of labour demand, and local market conditions.
⚠️ "What is opportunity cost?" is among the most commonly tested definitions in introductory micro. The answer is the value of the best alternative forgone, not the monetary cost and not the total cost of production.
⚠️ Expect a question asking you to distinguish explicit costs from implicit costs with an example. The owner-occupied building scenario is the standard one.
⚠️ Know the four market structures (perfect competition, monopoly, oligopoly, monopsony) and their defining features. Perfect competition is the one with many buyers and sellers where no one has pricing power.
⚠️ The minimum wage essay question is a classic. Structure your answer around three effects: wages (up for those employed), employment (potentially down for low-skilled workers), and income inequality (ambiguous, because the two effects pull in opposite directions).
Fill in the blank: Opportunity cost is the value of the ______ forgone.
Answer: best alternative
True or False: A perfectly competitive market has many sellers, but only one buyer.
Answer: False. It has many buyers and many sellers.
True or False: Implicit costs appear in a firm's accounting records.
Answer: False. Only explicit costs appear in accounting records.
Fill in the blank: Economic profit equals total revenue minus ______ costs minus ______ costs.
Answer: explicit, implicit
True or False: A minimum wage set below the equilibrium wage has no effect on the market.
Answer: True. A non-binding price floor does not alter the market outcome.
Q: What is the opportunity cost of a decision?
A: The value of the best alternative forgone. If you choose to attend university, the opportunity cost includes the salary you could have earned working full-time during those years, plus any other benefits of the next-best option you gave up.
Q: Describe the difference between explicit costs and implicit costs in microeconomics.
A: Explicit costs are the direct monetary payments a firm makes, such as wages and rent. Implicit costs are the opportunity costs of using resources the firm already owns, for which no cash payment is made. For example, if an owner uses their own building for the business, the implicit cost is the rent they could have received by leasing it to someone else.
Q: What is the term for a market structure with many buyers and sellers, where no single buyer or seller can influence the market price?
A: Perfect competition. Firms in a perfectly competitive market are price takers: they accept the market price as given and cannot raise their own price without losing all their customers.
Q: Discuss the impact of a minimum wage increase on the labour market, including effects on employment, wages, and income inequality.
A: A minimum wage increase raises wages for low-income workers who remain employed, directly improving their earnings. However, it can reduce employment opportunities, especially for low-skilled workers, because firms may cut back hiring to offset higher labour costs. Some businesses pass increased costs to consumers through higher prices. The effect on income inequality is mixed: the higher wage narrows the income gap for those still working, but job losses among the most vulnerable workers can widen inequality in another way. The net outcome depends on the size of the increase and the elasticity of labour demand in the affected sectors.
Opportunity cost underpins nearly every decision model in economics, from consumer choice theory to the production possibilities frontier. The explicit/implicit cost distinction feeds directly into the theory of the firm and the conditions for long-run equilibrium in competitive markets. Market structures connect forward to topics on pricing strategy, game theory (oligopoly), and regulation (monopoly). The minimum wage discussion links back to price controls (it is a price floor) and forward to labour economics, welfare analysis, and policy evaluation.
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