Friday, March 28, 2014

Explain-er with real life example: The difference between accounting costs and "economic" costs. This is why every one hates economists but love their accountant.

Here is a graph (HT: Big Picture Agriculture) that shows the relationship over time (1972-2012) between the Average Total Cost ("ATC") of producing a bushel of corn  (RED line) and its Market Price (BLUE line).

You can see at various times the ATC exceeds the price and vice versa.  Sometimes they make a profit, sometimes they lose money...So goes the agricultural commodities market and the roller coaster that is farming.

Look at the year 2006.  I inserted a dotted line to show in 2006 the price of a bushel of corn equaled the Average Total Cost of Producing a bushel of corn  The lines intersect at $2.50.  So, the farmer is "breaking even"...right?

Not so fast.  I believe I am making a correct assumption in assuming the creator of this chart included cost data that is ONLY comprised of "Accounting Costs" or "Money Costs".  This simply means explicit costs that are paid for with cash (or credit).  Accountants care only about accounting costs when they tally up the numbers and then subtract them from Revenue to obtain "Accounting Profits".

Economists, on the other hand, care about explicit accounting costs and IMPLICIT opportunity costs---are you surprised? Probably not...

Economists believe that the farmers accountant UNDERESTIMATES the cost of being a farmer because opportunity costs are not added to the the total cost of farming.

Simple example.  Lets say I make $50,000 per year as a teacher but decide to quit teaching and become a farmer.  In the first year I make enough in farming to pay myself $40,000.

This $40,000 is an accounting cost (real money paid to me!). However, economists take it one step further and suggest that I have to account for that lost $10,000 income I experience when I choose to farm.  

My total cost to farm is not $40,000, but $50,000.  Economists add in that $10,000 in foregone income as an implicit cost for me and my farming operation.

Once I add in the additional implicit cost of $10,000 that accountants do not, then my ATC of producing is going to be HIGHER than what you see at ANY POINT in the above graph.

The RED line will shift UP at every given price. 

So, for the most part, profits will be LESS in economic terms as opposed to accounting terms because of the inclusion of implicit opportunity costs.

Go back to 2006 on the graph. If we add in the opportunity cost then the ATC of producing corn will be something MORE than $2.50 and instead of breaking even as accounts would figure. The farmer will experience "economic losses".

My labor is not the only implicit cost economists like to account for.  Go here for a more comprehensive look at the topic.

There has to be an accountant vs economist joke in here somewhere. Because I teach economics I don't have much of a sense of humor, so you tell me a good one.  :)

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