Question

Paola is thinking of opening her own business. For each of the production inputs listed below, indicate whether the input incurs an implicit cost, explicit cost, or no cost. [LO 12.3\(]\) a. Borrowed capital. b. Investment from savings. c. Donated supplies.

Short answer

Borrowed capital: explicit cost. Investment from savings: implicit cost. Donated supplies: no cost.

Step-by-step solution

Understand Implicit and Explicit Costs

Implicit costs are the opportunity costs of using resources that could have been employed elsewhere, typically without a direct cash outlay. On the other hand, explicit costs involve direct monetary payments.

Analyze Borrowed Capital

Borrowed capital comes from loans which require repayment with interest. Since this involves a direct outlay of money for interest payments, it is considered an explicit cost.

Evaluate Investment from Savings

When Paola uses her own savings, she foregoes the interest she could have earned had she kept the money in a savings account. This forgone interest represents an implicit cost, as there is no direct cash outlay.

Consider Donated Supplies

Since the supplies are donated, there is no monetary exchange from Paola. Therefore, donated supplies incur no cost to her business.

Key concepts

Implicit Cost

Implicit costs reflect the value of resources that could have been utilized differently, representing a missed opportunity. These costs do not involve direct monetary expenses. Instead, they relate to the foregone benefits when resources are used for another purpose. For instance, if an individual like Paola decides to use her personal savings to fund her business instead of earning interest in a bank, the interest that she could have earned is an implicit cost. Implicit costs are crucial in understanding the full scope of business choices because they reveal the opportunity costs associated with these decisions. Awareness of implicit costs ensures that businesses make educated decisions by weighing potential gains against what is given up.

Explicit Cost

Explicit costs are those that involve a clear, direct outflow of money from a business. These costs are easy to track and are documented in financial transactions. Common examples of explicit costs include salaries, rent, and loan payments. In Paola's context, when she borrows capital, she agrees to repay the principal amount plus some interest. The interest paid here is an explicit cost, as it is a direct financial expense tied to using borrowed funds. Understanding explicit costs is vital for managing budgets because they are straightforward and impact the business's financial liquidity.

Opportunity Cost

Opportunity cost is a core business concept that represents the benefits lost when one alternative is chosen over another. It's the value of the best foregone option when making a decision. For Paola, if she invests her savings into her business, the opportunity cost is the interest she would have earned had she kept her savings in a bank account. This concept highlights the costs of decisions by illustrating that every choice has implicit consequences. Calculating opportunity costs aids in strategic decision-making by emphasizing the trade-offs involved in each choice. When businesses understand this, they can prioritize actions that yield the greatest benefits.

Monetary Payments

Monetary payments are the direct financial outlays involved in conducting business operations. These are the expenses where actual cash is expended, typically for services, goods, or funding. In a business scenario, monetary payments tend to illustrate explicit costs because they are tangible and easily quantifiable in financial statements. For instance, when a business like Paola's makes loan repayments, these payments are monetary outflows that affect the company's cash flow. Understanding and managing these payments is vital for budgeting and financial planning. It ensures that a business maintains the cash reserves needed to support its daily operations and long-term goals.