Implicit Costs, Explicit Costs, & Opportunity Costs

Together, implicit and explicit costs are opportunity costs:

Opportunity Costs = Explicit Costs + Implicit Costs

Let’s look at each cost to learn why it is so.

Explicit Costs

We’re all used to explicit costs in our lives. Go to the grocery store, pay. Rent a house, pay. Finance a car, pay (interest). Buy jeans, pay. Turn on the light, pay (electricity). Watch Netflix, pay (internet, subscription). You get the picture. In every situation mentioned, a financial outlay happened, i.e. money was spent.

For firms, explicit costs are just like those I mentioned above. If you can think of anything a firm has to pay money for, that is an explicit cost. For example, rent, leases, electricity, water, employees, raw materials, interest on loans, freight, gas, office furniture and supplies, software, security, etc. Any of these implies a payment. Money changes hands (and away from the firm’s).

Implicit Costs

Implicit costs are those that reflect the value of an opportunity that was given up or not pursued, an opportunity that was foregone.

Two classic examples of implicit costs are foregone interest and foregone wages. These are amounts of money that failed to materialize, failed to happen, thus the word foregone. Let’s understand these better with a couple of examples.

Foregone Interest

Suppose you have money saved in a bank, earning interest. Say you have $1,000 deposited at an annual rate of 5%. This means that every year that you keep your money there, untouched, you earn $50. Now suppose you want to buy a TV. You are lucky, the TV is on sale and the price tag is exactly the money you have in the bank. You go to the store and come back with a brand-new TV that you can’t wait to try.

What is the true cost of that TV? Pause for a moment to reflect on this. I said “true cost”, go check.

Although at first glance you may feel tempted to say the TV cost you only its price tag, which is $1,000, its actual cost is bigger: buying the TV by using the money you had in bank cost you the opportunity of earning interest on that money. By using it, you give up the opportunity of earning interest, so the interest that you never earned is an implicit cost of buying your TV. FYI, the money you paid for the TV is an explicit cost because an outlay happened, money exchanged hands.

Foregone wages

The actress Mayim Bialik rose to stardom as a dorky teenager on the TV series Blossom, which aired on NBC from 1991 to 1995. When the series ended, Mayim continued her studies and eventually received a Ph.D. in neuroscience from UCLA, her dissertation “Hypothalamic regulation in relation to maladaptive, obsessive-compulsive, affiliative, and satiety behaviors in Prader-Willi syndrome” (sounds fun). Sadly, the life of a researcher and university professor was not for Mayim, who saw the long hours the profession requires as preventing her from being with her two young sons and still earn a decent living. So, she let go of being a neuroscientist in real life to become a neuroscientist in the famous Big Bang Theory series, where she played Amy Farrah Fowler, a nerdy neuroscientist (wait, what!?). The world lost a neuroscientist but gained another, of sorts (fun fact: Mayim often serves as a scientific advisor on the show, ensuring all her experiments and lingo are accurate).

Back to implicit costs… you are probably seeing where I am trying to get with this story. When Mayim gave up being a neuroscientist in real life to become one on TV, she also let go of the possibility of earning a wage at the university. Albeit small in comparison to what she earns on the series, the wages that Mayim never earned from the university are an implicit cost of playing Amy Farrah Fowler (and delighting the world with her comedy).

For firms, implicit costs are just like those I mentioned above. When firms use their own funds to pay for expenses (ha, to pay for explicit costs), they miss out on the opportunity of earning interest on said funds. When an entrepreneur quits one job or profession to pursue her dreams and run a business, she misses out on the opportunity of earning a wage doing something else.

Opportunity Costs

Now I know what you are thinking: an implicit cost is surely an opportunity cost. Smile if you did. And you are right: the value of an opportunity not pursued is a cost, both for people and for firms. Despite not involving a financial outlay, there are distinct possibilities of earning money that never happened, so they represent an opportunity cost.

As it turns out, an explicit cost is also an opportunity cost. To see why, consider the following. When you spend money on going to the movies, what else will you not be able to do with the money you paid for your ticket? When you spend money on rent, what else are you not doing with that money? Spend it on food, gas, going to the movies? You get the idea: every piece of money spent on one thing cannot be spent on another, so every time we pay for something we inevitably forego the opportunity of spending it on something else.

Thus, both explicit costs and implicit costs are opportunity costs.

© 2019 Joana Girante. All rights reserved.
%d bloggers like this: