Difficulty: Intermediate | Prerequisites: Basic understanding of production functions (Chapter 6), familiarity with the concepts of inputs, outputs and the distinction between the short run and the long run.
Before a firm can figure out how much to produce or what price to charge, it needs to know what things cost. This section sits at the foundation of the entire cost analysis in the course: without a clear way to measure costs, every later decision (output levels, pricing, market entry) is built on sand. You need to understand why economists and accountants measure costs differently, and why the economist's approach, which counts opportunity costs, is the one that leads to sound business decisions. If you are coming in cold, just know that Chapter 6 covered production functions and inputs; this chapter is where those inputs get price tags.
Economists measure costs by counting both explicit (out-of-pocket) payments and implicit (opportunity) costs. The true cost of any resource is its best alternative use, not necessarily what you paid for it. Sunk costs, money already spent that cannot be recovered, should be ignored when making current decisions.
Explicit costs
Direct, out-of-pocket payments a firm makes for inputs to its production process within a given period. Think of these as the costs that show up on a receipt or invoice: wages paid, materials purchased, rent cheques written.
Implicit costs
Costs that reflect a forgone opportunity rather than an actual cash payment. In simple terms, these are the hidden costs you bear by choosing one option over another, even though no money changes hands.
Economic cost / opportunity cost
The value of the best alternative use of a resource. This is the economist's definition of cost, and it may equal or exceed a firm's explicit cost. If you own a building and use it for your business, the opportunity cost is what you could earn by renting it to someone else, not the zero you pay yourself.
Sunk cost
A past expenditure that cannot be recovered, regardless of what the firm does next. Because it cannot be undone, a sunk cost has an opportunity cost of zero and should not influence current decisions. Think of it as money that is already gone: "no use crying over spilt milk."
Durable good
A product that provides services over a long period, typically many years (e.g. machinery, buildings, vehicles). Measuring the cost of durable goods requires special care because their value changes over time.
Expensing
An accounting method that treats the full purchase price of an asset as a cost at the time of purchase. In simple terms, the entire amount hits the books in one go.
Amortising
An accounting method that spreads the purchase price of an asset over its useful life, following rules set by an accounting body or tax authority. Think of it as paying off the cost in instalments on the books, even though the cash left in one lump sum.
Economists count all relevant costs: both explicit payments and implicit opportunity costs.
Accountants may measure costs to comply with tax laws or to make financial statements look favourable, which can differ from the economic measure.
A manager who wants to make sound decisions must think like an economist and include opportunity costs.
When a firm purchases an input on the open market and uses it immediately, the opportunity cost equals the market price (the explicit cost). The firm's next best option would be to resell it at that price.
Opportunity cost becomes especially important when the input is not available on a market, or was purchased in the past. In these cases the opportunity cost can exceed the explicit cost.
Owner's time example: Maoyong pays himself $1,000/month but could earn $11,000/month elsewhere. His opportunity cost is $11,000, not $1,000.
"Free lunch" example: Your parents pay for lunch, but the meal still costs you the best alternative use of your time (studying, working, etc.).
MBA applications and recessions: During economic downturns, the opportunity cost of leaving work falls (lower wages, higher unemployment risk), so MBA applications rise. When the economy improves, the opportunity cost rises and applications fall.
Meredith's conference (Solved Problem 7.1): Her opportunity cost of attending the derivatives talk is the net benefit she forgoes from the Buffett speech: $100 value minus $40 ticket = $60 opportunity cost.
Capital is a durable good. Two measurement problems arise: how to allocate the purchase cost over time, and what to do when the asset's value changes.
If the firm rents capital: The rental payment is the relevant opportunity cost per period. This avoids both problems.
If the firm owns capital: The true opportunity cost is the amount the firm could earn by renting the asset to others, regardless of what the firm originally paid.
No rental market exists: Compare the alternatives. A truck costing $20,000 can be used for a year and sold for $17,000, or the $20,000 can earn 5% interest ($21,000 at year end). Opportunity cost of using the truck = $21,000 - $17,000 = $4,000 (comprising $3,000 depreciation + $1,000 forgone interest).
If the value of owned capital rises (e.g. land), the opportunity cost rises with it. A beauty parlour that bought a building when rents were $1,000/month faces an opportunity cost of $2,000/month if local rents have doubled.
A sunk cost is a past expenditure that cannot be recovered. It should be ignored in current decision-making because its opportunity cost is zero.
Resaleable forklift: A firm buys a forklift for $25,000 and can resell it for $25,000. This is not a sunk expenditure; the opportunity cost is $25,000.
Specialised equipment: The firm buys equipment for $25,000 that cannot be resold. The entire $25,000 is sunk. Opportunity cost = $0.
Partial sunk cost: Equipment bought for $25,000, resaleable for $10,000. The sunk portion is $15,000; the opportunity cost is $10,000.
Land example: A firm paid $300,000 for land now worth $200,000. The $100,000 difference is sunk. If the land is worth $240,000 as a production facility, the firm should use it (a $40,000 gain over the $200,000 market value), not be misled by the original $300,000 purchase price.
There are no major formulas in Section 7.1. The key relationships are conceptual:
Opportunity cost of using a durable asset for one year = (Value if not purchased at end of year) - (Resale value at end of year)
In the truck example: $21,000 - $17,000 = $4,000, which equals Depreciation ($3,000) + Forgone interest ($1,000)
Opportunity cost of attending event A = Net benefit forgone from best alternative event B
MBA admissions and recessions: During the 2008 Great Recession, MBA applications surged because the opportunity cost of leaving work fell sharply. As unemployment dropped below 5% by late 2015, applications declined again. This is a clean, testable prediction of opportunity cost theory.
DIY vs hiring a professional: Fixing your own plumbing feels free, but if you earn $50/hour and the job takes four hours, you have spent $200 of your time. If the plumber charges $150 and finishes in 30 minutes, hiring out is cheaper once you count your opportunity cost.
"I save money by doing it myself." Students (and most people) forget to count the opportunity cost of their own time. Doing something yourself only saves money if the opportunity cost of your time is very low or the professional's fee is very high.
Confusing sunk costs with opportunity costs. A sunk cost is not an opportunity cost. If you cannot recover the money, it should not factor into your current decision. Students often want to "get their money's worth" from a sunk expenditure, which leads to bad choices.
Using the original purchase price instead of current market value. The relevant cost for decision-making is what the asset is worth now (its opportunity cost), not what was paid for it in the past. The land example ($300,000 paid, $200,000 current value) is a classic exam trap.
Thinking opportunity cost is always equal to explicit cost. It often exceeds explicit cost, especially for owner-operated firms where the owner's time has a high market wage.
⚠️ Exam questions love to test whether you can identify the opportunity cost of an action versus the explicit cost. Always ask: "What is the best alternative I am giving up?"
⚠️ Sunk-cost problems are a staple. You will be given a scenario where past spending is irrelevant, and the correct answer requires you to ignore it.
⚠️ The opportunity cost of capital when no rental market exists (depreciation + forgone interest) is a common calculation question.
⚠️ Be prepared to explain why MBA applications rise during recessions, using opportunity cost reasoning.
True or False: A sunk cost should be included in a firm's current decision about how much to produce.
False. Sunk costs cannot be recovered and have zero opportunity cost.
Fill in the blank: The economic cost of a resource is the value of its ____.
Best alternative use (i.e. its opportunity cost).
True or False: If a firm owns a building, the opportunity cost of using it is zero because the firm pays no rent.
False. The opportunity cost is what the firm could earn by renting the building to someone else.
Fill in the blank: During recessions, MBA applications tend to ____ because the opportunity cost of leaving work ____.
Rise; falls.
True or False: Explicit costs and opportunity costs are always equal.
False. Opportunity costs can exceed explicit costs, e.g. when an owner's time is worth more than the salary they pay themselves.
Q: A firm bought a piece of land for $300,000. The land's current market value is $200,000. The land is worth $240,000 to the firm as a production site. Should the firm use the land for production or sell it? Explain using opportunity cost.
A: The firm should use the land for production. The relevant comparison is between the land's value in production ($240,000) and its opportunity cost (the next best alternative, which is selling it for $200,000). The firm gains $40,000 by producing on it. The original $300,000 purchase price is irrelevant because the $100,000 difference is a sunk cost.
Q: Meredith can attend a free derivatives class or pay $40 to hear a talk she values at $100. What is her opportunity cost of attending the derivatives class?
A: Her opportunity cost is the net benefit she forgoes from the Buffett talk: $100 - $40 = $60. She gives up $60 of consumer surplus by choosing the derivatives class.
Q: A firm can buy a truck for $20,000 or keep the cash in the bank at 5% interest. After one year the truck can be sold for $17,000. What is the opportunity cost of using the truck for one year?
A: The opportunity cost is $4,000. Without the truck, the firm would have $21,000 at year end ($20,000 + $1,000 interest). With the truck, it has $17,000 from the sale. The difference, $4,000, equals depreciation ($3,000) plus forgone interest ($1,000).
Q: An owner-manager pays himself $2,000/month but could earn $15,000/month working for another firm. What is the opportunity cost of his time?
A: $15,000/month, the value of his best alternative use. The $2,000 he pays himself is an explicit cost, but the full opportunity cost of his time is what he forgoes by not taking the outside job.
This connects to Chapter 6 (Production) because the production function tells you what inputs you need; this chapter puts prices on those inputs. The distinction between explicit and opportunity costs reappears throughout the course: in profit calculation (Chapter 8), firms earn zero economic profit in perfect competition precisely because economists count opportunity costs. The sunk-cost concept also matters in game theory and strategic decision-making later in the course.
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