The first classic cost economists identify is opportunity cost. Suppose you are a reseller of products. Product A costs $50, whereas product B costs $25. You only have $50, so you have to make a choice. You think product A will sell better, so you buy it but forgo buying two product B's. You resell A for $75, earning a profit of $25. Later on, you discover B could have sold for $40 each, so you could have made a profit of $30. Even though you made a profit, you could have made more profit on product B, which you did not buy. The extra profit is the opportunity cost, since you had to give up buying product B. For large corporations buying and reselling thousands of products, opportunity costs can be extremely complex. Entire teams of financial managers try to figure out the best possible ways to make a profit on different products.
Economist Peter Murrell identified costs in contracts, particularly as they relate to farming. A landowner may want his field farmed. He can contract the work in one of two ways: by sharecropping or fixed rent. Sharecropping involves sharing the profits of the crop with the sharecropper. Fixed rent is renting the land for a fixed monthly rental. In either case, risk plays into the equation. Sharecropping assures more profit to the landowner, but only if the crop is successful. If a drought occurs, the landowner may actually make no profit. Fixed rent assures income, but at a potentially lower profit. For the person doing the farming, the advantages and disadvantages are reversed. Each choice carries its own cost, and contracts are usually negotiated between farmer and landowner. For example, the landowner may want a minimum monthly rent, plus a percentage of the profit.
To understand marginal costs, you must understand the Law of Diminishing Returns first. Suppose you own a factory that makes pens, and you have a purchase order for 1,000 pens. In a perfect world, one worker makes 10 pens per day, two workers make 20 pens per day, three workers make 30 pens and four workers make 40 pens. In the real world, however, things are different. One worker makes 10 pens per day, two workers make 19 pens, three workers make 27 pens and four workers make only 32 pens. This is the Law of Diminishing Returns in action.
Marginal cost is defined as the change in cost divided by the change in quantity produced. Marginal cost and the Law of Diminishing Returns go hand-in-hand. You now have a choice to make in order to fill the pen purchase order. You can forgo some of the order to a competitor, or you can hire more workers. If you hire more workers, each additional one will make fewer and fewer pens. The labor cost per each additional pen goes up. This is the marginal cost. At one point, you may actually reach a break-even point on the labor cost. If you cross it, you will be making additional pens at a loss. Economists have written volumes on marginal costs and the Law of Diminishing Returns, and how to overcome these two very real problems.
According to Dr. Tilman Slembeck, the Rational Rule of Economics is to maximize your benefit for the lowest cost. The best choice fulfills the Rational Rule. Suppose two grocers sell apples. One grocer charges one dollar per apple, and the other grocer charges 50 cents per apple. The choice in this case is the cheaper apple. Many times, the best choice is not that easy. Suppose your car is broken down, and you need a part to fix it. One auto parts store sells the part for $50, and has it in stock. Another auto parts store sells it for $30, but it has to be ordered and there is a two-week waiting period. If you can wait, buy the $30 part. If you need your car for work, you must buy the $50 part, since you will lose pay by waiting. Sometimes the choices can be even more complex, such as for a large retailer. Financial analysts spend countless hours studying costs and developing the best choices using the Rational Rule.