Implicit cost facts for kids

Imagine you have a cool toy. You can play with it, or you could lend it to a friend for a small fee. If you choose to play with it, you don't get the fee. That lost fee is a bit like an implicit cost in economics. It's a hidden cost, something you give up when you use your own things instead of earning money from them.

Understanding Implicit Costs

In the world of economics, an implicit cost is a special kind of cost. It's also known as an imputed cost or implied cost. Think of it as the value of what you miss out on when you use something you already own. You don't pay money for it directly, but you still "pay" by giving up another opportunity.

For example, if a baker owns their bakery building, they don't pay rent to themselves. But they could rent that building to someone else and earn money. The rent they could have earned is an implicit cost. It's a cost because they chose to use the building for their own business instead of renting it out.

What is Opportunity Cost?

The idea of implicit cost is closely linked to opportunity cost. Opportunity cost is the value of the next best thing you didn't choose. Every time you make a decision, you give up other choices. The best choice you gave up is your opportunity cost.

Let's say you have an afternoon free. You can either play video games or help your neighbor with chores for $10. If you play video games, your opportunity cost is the $10 you could have earned. Implicit costs are a type of opportunity cost for businesses.

Implicit vs. Explicit Costs

It's helpful to compare implicit costs with explicit costs.

• Explicit costs are the direct payments a business makes. These are easy to see and track. Examples include paying for ingredients, salaries for employees, or electricity bills. You write a check or transfer money for explicit costs.
• Implicit costs are not direct payments. They are the value of resources a business already owns and uses, but could have used differently to earn money. They are "hidden" because no money changes hands.

Think of it this way: an explicit cost is like buying a new video game. An implicit cost is like choosing to play that game instead of selling your old game for cash.

Why Implicit Costs Matter for Businesses

Understanding implicit costs is very important for businesses to know their true success. Economists look at two types of profit:

• Accounting profit: This is what most people think of. It's a business's total money earned (revenue) minus its explicit costs. It shows if the business is making money from its direct operations.
• Economic profit: This is a deeper look. It's total revenue minus both explicit and implicit costs. Economic profit tells a business if it's truly making the best use of all its resources. If a business has a positive economic profit, it means it's doing better than its next best alternative.

Because economic profit includes these extra opportunity costs, it will always be less than or equal to accounting profit. A business might have a good accounting profit, but a low or even negative economic profit. This means it could be earning more money by doing something else with its resources.

A Real-World Example: The Land Value

A famous economist named Richard Lipsey used a great example in 1975. Imagine a company that owns a piece of land in a busy city. They bought this land a long time ago for a very small amount, maybe $50. Now, that same land could be rented out for $10,000 every month!

The company uses the land for its own factory. They don't pay rent, so there's no explicit cost for the land. However, the implicit cost is the $10,000 per month they could be earning by renting it out.

If the company isn't making enough money to cover this $10,000 implicit cost (after all other costs), it might be smarter to close the factory, rent out the land, and earn that $10,000. This example shows why businesses should always consider the current value of their assets, not just what they paid for them in the past.

See also

• Explicit cost
• Cost
• Economic profit
• Imputation (economics)
• Cost of goods sold