In any economic decision making, there has to be a consideration of and benefits involved for it to make economic sense. In this respect, an analysis of the cost function is crucial in identifying and classifying the different cost components. This is necessary in identifying the relevance of each component and its implications for economic decisions. Consequently, the laconic discussion below explains the opportunity cost concept citing an example to demonstrate. The discussion then explains the meaning of long-run and short-run in an economic context and demonstrates the application of the cost concept in decision making by providing an economic argument that can convince a sales person to agree to a buyer’s price. Finally, the discussion identifies and explains the costs that are most relevant to a firm in decision making.
– Opportunity cost
Decisions to allocate resources or take an action should be highly guided by an analysis of its viability in terms of benefits and costs. In consideration of the costs involved, a key cost for consideration should be the opportunity cost. However, the cost tends to be ignored in decision making as it does not reflect on the direct costs of taking an action of allocating a resource, but is rather an indirect cost. (Frank & Bernanke, 2001, p. 31)
Opportunity cost is the value or benefit of the best alternative forgone in taking an action or resource allocation. To demonstrate the concept, assume that you have two choices for your weekend; to either write an e-book worth $120 or attend a conference as a guest speaker for a $150 fee. In this case, a choice for one makes the value of the alternative forgone to be the opportunity cost. Thus, if you chose to attend the conference and get the $150, the opportunity cost of attending the conference is the $100 as the e-book’s value and the opportunity cost of writing the e-book is the $150 you forgo as the fee for attending the conference. (Frank & Bernanke, 2001, p. 31)
– Short-run and long-run.
Definition of short-run and long-run is based on the state of the input factors considered. In that respect, short-run is the duration within which at least some production factors remain constant. On the other hand, long-run is the duration that is long enough for all factors to have changed. This takes into consideration that the factors of production are land/natural resources, capital and labor. Thus, the definition does not depend on the length of time since some industries are capable of varying their input factors in months while others can only take years to vary all input factors hence short-run and long-run could be months or years in duration. (Baron & Lynch, 1989, p. 86)
– Economic argument.
For an economic argument that would convince your hometown sales person to accept your price for his car rather than sell to you at the asking price, opportunity cost concept would be crucial given an alternative offer with a lower price by a salesperson from another town. If it is assumed that you got an offer to buy a car for an asking price of $8,000 from your hometown sales person while the same model has an asking price of $7000 in another town with an addition logistics cost of $400, below is an economic argument that can be used to convince your hometown salesperson to sell the car to you at $7300. (Krugman, 2004, p. 25)
A purchase from your hometown sales person would have an opportunity cost of the savings that you would have gotten by purchasing from the other town’s sales person. That means that the opportunity cost would be the difference between the asking price from your hometown sales person and the total of the asking price and the transaction costs from the other town. [8,000-[7000+400]] = $600. Thus, buying from your hometown sales person would cost you $400 hence the transaction can only make economic sense for you to buy from him if he sold the car to you at $6,400 or less. Thus, a price of $6,400 from him would have no opportunity cost even if you bought from the other sales person, but any price below $6,400 would make it expensive for you to purchase from the other sales person hence the need to lower his price to below $6,400 for it to have an economic incentive to you. (Frank & Bernanke, 2001, p. 32)
– Relevant costs for a firm.
In a firm’s production and economic decision making, consideration of the relevant cost is crucial in achieving optimal results. In this respect, a consideration of the components of total cost shows two key components; fixed cost and variable cost.(Krugman, 2004, p. 25) Fixed cost remains constant irrespective of the amount of output whereas variable cost varies with output variation. In this respect, the most relevant cost for consideration in decision making is the variable cost that varies with the output produced since fixed cost would not change irrespective of the output level. Hence, variable costs are the most relevant for a firm. (Frank & Bernanke, 2001, p. 39)
The discussion has demonstrated the importance of differentiating types of costs for the purpose of achieving optimal solutions in decision making. In this respect, opportunity cost has been shown as a crucial cost to consider in decision making as it helps identify the actual costs by considering not only the implicit costs, but also explicit costs. In addition, short-run and long-run in economic considerations also comes out as important since the two durations have different cost implication. Finally, the cost function has also been analyzed for its components bringing out variable cost as the most relevant in a firm’s decision making due to its variation with output change.
Baron, J. & Lynch, G. (1989). Economics. Boston: Richard D. Irwin Inc.
Frank, R. & Bernanke, B. (2001). Principles of Micro Economics. New York: McGraw-
Krugman, P. (20004). Microeconomics. New York: Worth Publishers.