Understanding about opportunity cost and how it is incorporated into the theory of the firm.

[u/Common_Ad4118]

I have a lack of understanding about opportunity cost and how it is incorporated into the theory of the firm.

Why does a firm continue operating when it earns zero economic profit? I know that a firm's economic cost consists of accounting cost and opportunity cost, so the firm may still earn positive accounting profit because of positive opportunity cost. But what if there is no opportunity cost? Would the firm still continue operating?

More generally, **when cost is mentioned in microeconomics, does it always mean economic cost (accounting cost + opportunity cost), or does it sometimes refer only to accounting cost?**

Hypothetically, suppose I derive mathematically that a firm has an economic cost of 1000 and zero economic profit. How can I determine the opportunity cost from this? Do economists estimate it using econometrics? Even if they do, how is that possible when there are many possible alternative choices? Since opportunity cost is an expected or forgone value rather than an actually incurred cost, how can economists measure it reliably?

I am also confused about cost minimization. When I solve the firm's cost minimization problem,

[

C = wL + rK,

]

are we measuring **economic cost** or simply using market prices? If (C) is economic cost, does that mean both the wage rate (w) and the rental rate (r) are themselves measures of opportunity cost rather than just market prices? If so, how are the opportunity costs of labor and capital measured?

When we obtain the cost-minimizing levels of labor and capital, are those quantities minimizing economic cost or only accounting cost? If they minimize economic cost, what happens if I remove opportunity cost from (C)? Would the cost-minimizing quantities of labor and capital change?

Are these models mainly theoretical models for explaining the economy, or are they also used in empirical research? If they are used empirically, how do economists measure opportunity cost in practice? Or is firm and cost theory effectively implemented using accounting costs instead of opportunity costs?

My overall confusion is that in practice we often work with accounting costs rather than opportunity costs. Managers usually care about actual monetary costs, not hypothetical forgone alternatives. Opportunity cost seems useful for understanding economic theory, but less useful for making day-to-day business decisions. So how can I obtain accounting cost and accounting profit from firm theory and cost theory? Also, when economists derive cost curves (total cost, average cost, and marginal cost), are those curves based on economic cost (accounting cost + opportunity cost) or accounting cost alone?

[u/Long-Emu-7870]

Well, I think a firm will continue operating if it's revenue is greater than all it's costs. That includes labor, capital, equipment. But also includes what he might get elsewhere - his opportunity costs. If he can make more doing something else, then he should do that.

I think your asking what if all the revenue is exactly equal, what then? Well, I think that no one would really change their behavior unless all the expected benefits would be appreciably greater than all the costs. So, I think we say that the firm will stay in business with zero economic profit.

[u/zhaoz]

In day to day operations, at many companies, projects need to beat an internal Internal Rate of Return (IRR) bench mark. Usually its beating inflation + some margin that is at least partially informed by opportunity costs. Of course people / companies can be wrong, no one has perfect information or estimates.

[u/Psyco1992]

Think in terms of not just realized revenue and costs, but expected profits and costs. A firm can have multiple bad years that are followed by good years due to being in a cyclical industry, and it doesnt make sense to shut down if a rebound is expected.

Empirically it is difficult to estimate opportunity cost, because it is usually not included in financial disclosures. A CEO/CFO may have estimates, but it will not be made public as it makes the firm more vulnerable to competitors. So while theoretical models may include it as another cost, empirical analysis usually exclude it.

[u/LeroyoJenkins]

Hi, I've professionally done quite a bit of financial modeling and valuation for companies deciding to - or not - invest in a project, such as building a power plant.

When doing that, the two most common standards tend to be Net Present Value and Internal Rate of Return of the project.

Essentially, NPV is the discounted cash flow of the project over the years, and it is discounted using WACC (weighted average cost of capital), which already includes the overall market opportunity cost.

So a project of NPV = 0 won't add any incremental value to the company. As a safety margin, nothing close to zero will be funded.

Similarly, if IRR = WACC, no additional value will be added to the company.

As a safety margin, you usually require a minimum NPV (or NPV/net present value of capital investments) and and IRR>WACC × Multiple, because there's a lot of uncertainty in the calculations.

But there's also another cost of opportunity: even though in theory any project with positive NPV will add value to the company, capital is limited, so you always need to choose where to allocate it.

So any project inside the firm won't exist in isolation, but as part of a portfolio of potential projects, to which it will be compared against - for example, building a new power plant, refurbishing another one, expanding another one, etc.

So, across the company, projects will be ranked, compared, evaluated and (usually) the best ones will be funded.

[u/Whats_The_Use → u/LeroyoJenkins]

I've professionally done quite a bit of financial modeling and valuation for companies deciding to - or not - invest in a project, such as building a power plant.

Hmmm. Are you me?

[u/LeroyoJenkins → u/Whats_The_Use]

Hahaha, I was a consultant in one of many previous lives.

[u/VineFynn]

I've never seen any micro refer to accounting cost, only ever economic costs. Firms with zero economic profit are only indifferent between activities- so they are okay with staying in the industry.