An Economic Approach to Costs

The question a firm always needs to ask, in some fashion or another, is this - Can I cover my costs of production?

Now remember that in economics we are dealing with decision making which is, what I like to call, even, beyond the bottom line. I use this terminology because many of the costs relevant to decision making do not show up on the balance sheet or the income statement. For instance, our costs include the opportunity costs of owner-supplied inputs including capital and labor. These do not show on your typical cost accounting statements (there are systems of accounting that do try to get at these -- EVA and Managerial Accounting in particular...)

Let's use an example here. Suppose that you are a stockbroker who owns a building in a strip mall that you rent out for $1000 per month. You earn $50,000 as a stockbroker. Suppose you decide that you are going to open up that donut shop you always wanted to and be your own boss - pursuing your own personal version of the American dream! To do this you quit your job as a broker, you let your tenant's lease lapse and you move Donut Delight into the building (after you buy $10,000 worth of donut-cooking equipment and a cash register.)

At the end of one year you go to your accountant and he offers you a bottle of champagne! According to their calculations you have Total Revenues of $125,000 and Total Costs of $70,000 and your profits are thus $55,000 -- she pats you on the back noting that most businesses lose money the first year and that you earned more than you did as a broker. Then you call me to celebrate - bad move...

I explain the situation a bit differently... To run Donut Delight you quit your job as a broker - can't do both simultaneously, after all (oops - you just incurred an opportunity cost $50,000 per year in lost wages.) You also let your tenant's lease lapse and moved Donut Delight into the building (oops - you just incurred an opportunity cost of $12,000 per year in lost rental income.) You also sunk $10,000 into the equipment (oops - so you lost the interest income on $10, 000) -- lets assume a 5% interest rate -- so you lost $500 over the year (I am assuming here that you can sell the equipment back into the market for your $10,000 - a mighty stretch - but fine for pedagogical purposes.)

Now lets recalculate that profit: Your annual revenues are indeed $125,000 per year and you must subtract out your accounting costs of $70,000. We agree to here -- you have $55,000 left. But now you must pull out the value of owner-supplied inputs. Your labor was worth $50,000 per year in its next best use so we must subtract it (unless of course you believe your labor is worth zero...) and now we are down to a profit of $5,000 (you frown mightily.) It gets worse -- the rental income you have decided to forgo is $12,000 per year so now you must pull it out and you are now losing $7,000 per year (you cry.) It gets worse... we forgot the $500 in interest income you have forgone. Pull it out and you are left with a true economic profit that sits at a negative $7,500. I offer you a bottle of aspirin to combat the champagne and the profits...

Now you know why Thomas Carlyle referred to economics as the dismal science...

Actually, for many years it was thought that this was because a number of economists were intellectual contemporaries with Parson Thomas Malthus who predicted that food production could only grow arithmetically while population would grow geometrically and we were all doomed to starvation.

A more interesting thesis has been recently put forth by Sandra Peart and David Levy. They maintain that "the dismal science" was used as a pejorative term that was rooted in deep racism. To quote from: Peart, Sandra J. and David M. Levy, Valuing (and Teaching) the Past, Journal of Economic Education, Vol. 36, No. 2, Spring 2005.

"In an alternative account - one which we suggest is accurate, though less widely known - economics became the dismal science because of an avowedly unrealistic view of human nature which denied that races are inherently different. Here, the dismal science ought to be read as the "Negro science" because economists were committed to a fixed, race-blind human nature. Economists supposed that people are equally competent. They opposed racial slavery, and they favored markets instead."

Last Updated: July 18, 2006