Defining the concept of cost in economics

  • By Marion Cohen, Alain Grandjean
  • Updated on 14 July 2022

This text has been translated by a machine and has not been reviewed by a human yet. Apologies for any errors or approximations – do not hesitate to send us a message if you spot some!

The notion of cost, at the heart of economic reasoning, is used constantly in everyday life. Economics is sometimes defined as the art – or science – of achieving objectives at the lowest possible cost.

Yet the meaning of this word is far less obvious than it might seem. 1 Common parlance confuses costs with expenses. Moreover, the actors who bear the costs in question are rarely specified: are they specific economic agents (a household or a company), the State, the community in general? Finally, the term cost is often accompanied by an adjective or an object complement: “direct cost, full cost, average cost, marginal cost, social cost, economic cost, abatement cost, production cost”… and sometimes both, as in the notion of “marginal abatement cost”.

This fact sheet aims to clarify these concepts, which is obviously essential if we are to know what we are talking about when we aim, for example, to minimize the costs of reducing greenhouse gas emissions or, more generally, to find the most economical solutions, i.e. “at the lowest cost”.

The notion of cost is not limited to the notion of expenditure

For most of us, cost is an apparently simple notion: a cost is an expense. But it’s just that: when we say “doing this is going to cost me”, we don’t necessarily mean money. It can be physical effort, moral effort or damage. It can be time. The cost to an individual is therefore not always expressed in monetary terms, and is in fact not limited to monetary expenditure.

From an economic point of view, a cost can be seen as a levy on a resource (oil, labor): building a house “costs” cement, concrete, tiles, energy, water, human labor, etc. The monetization (the translation or expression in currency) of these costs should not mislead us. The monetization (translation or expression in currency) of these costs should not mislead us: costs are not euros (which are only symbols and do not disappear when “spent”) but the realities they measure.

Beneficial actions may therefore be too “costly” from a household’s point of view

This first distinction between cost and expenditure helps us to understand that actions that appear to be economically profitable (i.e. that bring in more money than they cost) are not always carried out. For example, it can be monetarily profitable for a household with the means to invest to have its home insulated: the energy savings (and therefore the lower energy bill) pay off the initial cost of the work and the cost of financing it. Despite this, and despite the fact that home insulation is promoted by scientists, NGOs and public authorities as a major way of reducing greenhouse gas emissions, the volume of work is struggling to take off.

The explanation for this apparent paradox lies in the fact that households have to bear many hidden costs, not included in simple insulation expenditure: the time required for reflection and negotiation within the household, the search for and choice of solutions and companies, the risk of not choosing the right solution, the trade-off between these major investment expenses (and this mental energy) and those needed for vacations, etc.

From a company’s point of view, a cost is an expense 2

In the corporate world, it’s usually a little simpler.

A cost for the company is an expense. You have to pay for the time and effort of your employees (through salaries), which means you have to spend money. In accounting, all these expenses are counted as company costs, while revenues are counted as income; the balance of the two determines whether or not the company is making a profit (find out more in the module on business accounting). Conversely, what has no impact on the accounts does not count. This is the case, for example, when a company destroys or pollutes natural areas without paying anything in return.

A nuance in this assimilation of costs and expenses: provision and amortization

Some recognized costs are not cash outflows. This is the case for depreciation and provisions.

Amortization consists in spreading an investment over several years. A depreciation charge does not therefore simultaneously result in a cash flow (the total cash flow takes place when the investment is paid for).

Provisions are included in expenses, but do not constitute a monetary expense in their own right. A provision is an expense that is likely to be incurred as a result of events that have occurred or are in progress, but for which the timing or amount is not precisely defined. For example, an ongoing lawsuit with a third party following a dispute, a provision for the future dismantling of an industrial plant… If these provisions are properly calculated and validated, they will result in future expenditure.

The different meanings of cost for the company: a few definitions

Even when it’s equated with an expense, the term cost takes on different meanings depending on the person using it and the adjectives associated with it.

So, for an entrepreneur, the different types of cost correspond to different moments in the life of the company (reflected in accounting or internal management documents). Let’s take the example of an industrial company.

The direct cost (also called “direct production cost” or “direct cost price”) of production (and more precisely of production of a given product) designates all the expenses necessary for current production: salaries and purchases directly used or consumed in this production.

But the company also has other expenses which are referred to as “indirect” (expenses for research, marketing, administrative management, etc.). It may also have investments to amortize, or expenses linked to loans (interest and repayment of principal). It can allocate part of these overheads to production, and deduce a “full” cost price for the production or product in question. These different types of cost are indicators for the entrepreneur, enabling him to make (or have his staff make) management decisions: setting sales prices to absorb costs, deciding on production volumes to be launched, deciding on any work to be subcontracted, etc.

The terms “average cost” and “marginal cost” are more commonly used by economists. The average cost of a product is the total cost divided by the number of units produced. Marginal cost is the cost of the last unit produced. This notion is often used in electricity economics, for example (see our fact sheet on the electricity sector ).

The notion of “abatement cost”, much used in debates on the fight against climate change, refers to the cost (calculated in monetary terms) of a given action in relation to the CO2 emissions it makes it possible to avoid.

At the macroeconomic or collective level: one man’s expenses are another man’s revenues

On the one hand, certain costs are not taken into account in either corporate or government accounting. This is the case, for example, with the destruction of our natural heritage, which is in fact a deduction from a resource.

On the other hand, one person’s expenses are another person’s income: when a company pays a salary, this constitutes an expense for the company, but an income (a “receipt”) for the employee.

So, if we’re looking at two actors A and B, the (monetary) cost for A+B is not the sum of the (monetary) costs for A and B, but their “consolidation”: in our example, the salary represents a zero cost for the whole made up of the company and the employee. In practical terms, this means that the monetary cost of a given action is a term that only makes sense if we specify for whom the cost is.

This is particularly obvious in the case of public spending, where common reasoning (“we have to cut it”) always forgets that the counterpart is revenue that goes into someone else’s pocket. As we explained in the module on public debt and deficit, ” one man’s debt and deficit are another man’s savings and surplus “.

Two initial conclusions can be drawn at this stage:

  • Monetary costs are transfers of purchasing power from one economic actor to another, while costs in kind (the destruction of an oil stock, a coastal zone, climate stability), which we will call “real costs”, are losses for all. Real cost is not the same as expenditure, since one person’s expenditure is another’s income.
  • For it to make sense to say “this is what such and such an item costs”, we need to specify what we mean by cost and who bears the cost.

A cost is not money that disappears

As we explained in the module on money, for decades money has been created ex nihilo by a simple set of entries when banks grant credit. Once created, it circulates from pocket to pocket, never disappearing. 3

When we say “this object costs me 50 euros”, the word cost is not used in the sense of “consumption of resources”, because the 50 euros are not consumed (money not being edible); they are simply displaced. This expression is therefore a “metonymy”, like the expression “to have a drink”.

In the same way, when we speak of businessmen who know how to “make money”, this does not mean that they know how to create money ex nihilo – which is a banking privilege – (unless they are counterfeiters!), but that they know how to fill their pockets with money that comes from other pockets…

And yet, in common parlance, we tend to think of money as disappearing or being “swallowed up”. For example, we read in Le Monde on May 9, 2008 that a London trader “burned” $250 million to set up his hedge fund. Elsewhere, we learn that a batch of drugs was burned, and millions went up in smoke. Was the drug money really burnt? Obviously not. The drugs burned for real.

The explanation for these differences in language lies in the fact that, for a microeconomic actor (a household, a company, an administration), money is perceived as the equivalent of purchasing power: when money is spent, this purchasing power is consumed and therefore disappears. On the other hand, at the macroeconomic level, money circulates and does not disappear. 4 So the fact that we express microeconomic costs in money should not be confused with the false idea that money can be consumed at the collective level…

As money is not consumed, the cost is not money disappearing. The real cost is of another kind: the destruction of real, non-renewable resources.

The “real” cost to society: the destruction of natural resources

A cost is, by definition, the consumption of something that disappears, a withdrawal from a resource.

Economists equate costs, in the sense of resource consumption, with business expenses.

When a company consumes purchased materials or uses labor, accountants record an expense in its accounts. For economists, this expense is a cost, because they consider that the company is consuming a resource. Moreover, for most economists, the price of a good or service “consumed” adequately reveals its cost. 5 All in all, then, they consider that a company’s “expenses” (or, more rigorously, its charges) are a good estimate of its costs, in the sense of resource consumption.

This is the view expressed by Marcel Boiteux, a renowned economist and former Chairman of EDF, in a very clear but debatable note:

“Fortunately, there’s an old “trick” we’ve been using for centuries that doesn’t work so badly. The procedure consists of assigning to each elementary scarcity (a hectare of arable land, a ton of copper, a skilled worker’s hour, etc.) a coefficient, higher or lower according to the intensity of need, which we call a price. This price is multiplied by the total quantity of the scarce resource mobilized throughout the production chain – the quantity revealed by the consolidated balance sheet – to obtain a cost. The consolidated costs obtained successively for each of the rare resources used to manufacture the final product can then be added together to provide a total … which we call a cost price. And, for the same result, the best solution is the one that costs the least, since it’s the one that mobilizes the fewest primary rarities, respectively weighted by their price.

Commonplace? But that’s what cost price really means in a market economy. Admittedly, markets are imperfect, and the price is sometimes weighed down by undue profit (undue because it exceeds the normal profit that remunerates the intrinsic scarcity of good bosses or wise investors, all along the chain of activities that goes from primary resources to the final consumer). But the system still provides orders of magnitude far more significant than the transcendent intuitions of the militants of the great causes of the moment.” 6

This assimilation of a company’s expenses to costs, in the sense of the withdrawal of resources, is erroneous

First of all, there’s nothing obvious about this a priori. Business accounting was not designed to optimize the use of collective resources. It was created to enable entrepreneurs to link the flow of income and expenses to changes in their assets. The link between the individual activity of economic players and the “social optimum” did not begin to be analyzed (with the emergence of “economic science”) until many centuries after the birth of accounting.

Then, and above all, the finitude of the world and the postulate of “strong sustainability”. 7 lead us to a very different conclusion.

The real cost of our activities is the destruction of our natural heritage

If we consider that, on the one hand, we are collectively drawing from a finite pool of natural resources while benefiting from free ecosystem services 8 and that, on the other hand, we are individually rather happy to have work, a collective resource that has become superabundant and renewable, then from the collective point of view, the cost that really counts is the destruction of this natural heritage and not the consumption of work. But, as we shall see, accounting does precisely the opposite.

Let’s entrust a Martian with the task of watching the manufacture of the metal part of a pickaxe. He sees the ore emerge from the mine, become a rod, then a pickaxe, and finally disappear when used. He sees the ore gradually running out. He also sees that this production process consumes energy and water. Finally, he sees that this production has created pollution that weakens natural resources and some of the planet’s regulatory capacities. The production of pickaxes, he says, costs iron ore and energy, and generates pollution. He also sees that this production has provided work for human beings.

The curious thing is that the cost of materials, the one that really counts in the eyes of the Martian, is precisely the one that accounting doesn’t really take into account. In fact, it only takes into account what circulates from one pocket to another, from man to man, from human enterprise to human enterprise. As we explained in the module on accounting, nature doesn’t get paid for the services it provides, nor for the damage it suffers. It takes in no revenue and incurs no expenditure.

In short, the costs of accounting consist exclusively of a pile of human income.

This income can take the form of salaries, dividends or other capital income, such as the annuities received by a landowner from the value of the land or the resources in the subsoil.

Let’s put it more precisely: a household’s purchases constitute a company’s sales, and thus the income that enables it to pay salaries, make purchases, distribute dividends and so on. The same applies to companies: the purchasing company brings in income to its supplier, which can pay salaries, purchases etc. Another example: for a bank, financial expenses are elements of banking income which can then be paid out in the form of salaries, purchases, dividends and so on. So if we consider the economy as a whole: all purchases are in fact roughly equivalent to all wages and other income paid out.

This accounting choice is particularly relevant for entrepreneurs, in the defense of their individual interests, and on a collective level, in a world that is constantly seeking to reduce the share of labor in production: you can only manage well what you can count.

On the other hand, it has become inappropriate in a world where scarcity has been reversed: it is no longer labor that is scarce, but natural resources. Saving labor has even become the worst thing of all: replacing man by machine puts man out of work, which costs (in accounting and/or human terms) everyone; conversely, putting everyone to work pays off for everyone.

Let’s sum up: the manufacture of picks, like that of any other product, costs the community materials and energy (non-renewable), provides work and earns money for the person who sells it.

How to measure the cost of labor?

The preceding reasoning is a little excessive: human labor is finite after all. It’s a good idea for a community not to waste it, and therefore to be aware of the cost of making people work. Digging holes, filling them back up and then digging them again is probably not the best thing to do economically!

What’s more, work can be tedious, a source of ill-health and even reduce life expectancy. On an individual level, this can be a cost. Next, we’ll look at the collective level.

Finally, work is highly heterogeneous. Human labor has an opportunity cost (see box), which is all the greater because it is difficult to replace (a surgeon’s skill is harder to replace than that of a non-specialized laborer).

Definition: opportunity cost

An opportunity cost is measured as the loss caused by not using a resource for a given purpose.

At the individual level, it’s a mainly monetary notion, which can be presented as follows: if I’m able to earn €200 an hour, and if I do a job paying €20 an hour, this job has an opportunity cost of €180 for me.

In a consulting company, assigning consultants to work paid at a level of 100 euros when they could be assigned to other work paid at 300 euros has an opportunity cost of 200, even if the company actually receives an income of 100 euros.

At the collective level, the opportunity cost can be expressed in non-monetary terms; to remain more global, it can be called “opportunity loss”. Allocating space to urbanization thus costs the community a loss of biodiversity, while assigning highly-skilled workers to “mundane” tasks is a “waste” – in other words, a loss of opportunity.

Nevertheless, when millions of people are looking for work, this means that the cost of labor to the community is zero, or even negative. It would therefore be infinitely preferable to put these people to work than to waste energy resources (by replacing human labor with machines), which are “costly” in the true sense of the word. While putting them to work may cost the public purse money (which, as we’ve seen, doesn’t disappear, and to go further see the module on public debt and deficit), this “cost” is out of all proportion to the double waste thus avoided.

On the other hand, certain categories of workers may be lacking, even though they provide major services (this is the case, for example, of healthcare workers in France, since the COVID crisis), and their opportunity cost to the community is high, and therefore poorly assessed by their accounting cost.

The true cost of labor to the community therefore depends on the state of the labor market (which needs to be carefully segmented, as some skills may be in short supply while others are in excess). The usual convention of expressing the cost of labor in monetary terms in terms of what it costs employers (net salary plus social security contributions), whether public or private, is unsatisfactory for a line of reasoning that aims to reduce costs as seen by the community. It would be preferable to modulate these costs according to the relative scarcity of the qualification concerned.

The government must factor the cost to the community into its decisions

As a service provider and redistributor, the State has expenditures and revenues. State expenditures are “microeconomic” costs (i.e., the responsibility of an actor). They are measured by public accounting systems in the same way as business expenses are measured by private accountants. They are not costs to the community (in the sense of resource extraction as defined above).

Two examples show how this way of thinking, which equates the State with a company, has led to erroneous conclusions. In both cases, the lack of public money, often considered the main constraint by most observers, was not.

  • The First World War could not last long (a few weeks for some economists) because it could not be financed. 9 the State was not strong enough. But in the end, the money was found (admittedly by increasing taxes and debt, but that’s another subject).
  • Germany’s recovery in 1933-34, and then the power of the Third Reich, were easily financed by printing money. The real constraints, those at the heart of this country’s economic strategy, have always been its “physical” supply, hence the oil substitutes during the blockade, the conquests of access to energy sources and, finally, the difficulties of the military campaign against Russia (notably for lack of energy).

Nevertheless, the State budget is not infinite, so we have to choose carefully which expenditures to make. But there is a big difference between steering public action using “macroeconomic” reasoning under budgetary constraints, and doing so based solely on microeconomic criteria. In “macroeconomic” reasoning, the cost criterion to be used is, by construction, a “collective cost” criterion; it can be called “macroeconomic cost”.

The Easter Island fable helps us understand the difference.

With purely microeconomic reasoning aimed at saving on accounting costs, the King of Easter Island would create his monumental statues by saving on expensive labor and using wood energy in large quantities. With macro-economic reasoning, the king, aware of the need to permanently replenish the community’s forest capital, would limit the production of statues to the maximum compatible with human resources… and with a reasoned use of wood energy.

Conclusion: managing the State’s accounts is not the same as managing them like a company director. Public-sector management must be based on macroeconomic cost criteria.

The social optimum must be calculated on the basis of macroeconomic rather than microeconomic costs

The various methods for analyzing public choice, and the core of the economic theory of social choice 10 reason by generalizing the individual behavior of one agent to the collective of all economic agents.

Here we look at why these theories are inappropriate.

When economists calculate and seek to maximize “social well-being”, they ignore macroeconomic costs.

According to the theories mentioned above, each economic agent seeks to maximize his or her satisfaction, called “utility” by economists, under budgetary constraints. If the economy is divided into companies and households, the company’s well-being (utility) is its profit (net accounting result). In practice, economists focus on household consumption.

For the community, “social well-being” is calculated by means of a “utility function”, which consists of an aggregation (addition) of individual utilities. In economic discourse and in macroeconomic models, GDP is taken as an approximation of this social utility.

Economists’ optimization reasoning then consists in seeking collective aggregate satisfaction (the utility function mentioned above) by limiting costs as much as possible, understood in the “microeconomic” sense, i.e. as the aggregate expenditure of the players.

If we reason according to the postulate of strong sustainability, this approach becomes inappropriate. In fact, it means that the destruction of natural capital is not taken into account (since even its monetary cost is not quantified). If the community has a “hedonistic” or consumerist utility function, it’s easy to understand that its rational economic calculation then leads it to… self-destruction, since, despite appearances, it doesn’t take any macroeconomic cost into account in its calculation!

Once again, it is necessary to separate the microeconomic level, which concerns the analysis of the behavior of each economic agent (as well as the possible aggregation of these behaviors), and the “macroeconomic” level, which takes into account collective resources and gains, such as the conditions for the survival of the community.

The specific case of public infrastructures allows us to deepen our analysis.

Widely used in national planning, cost-benefit analysis aims, as its name suggests, to draw up a balance sheet of the costs and benefits (in the broadest sense, not limited to the monetary dimension) of a public investment project (a freeway, a building, a bridge, etc.). It takes into account not only conventional revenues and costs (expenses and income in the accounting sense), but also social and environmental benefits and costs.

For example, if it is decided to build a new freeway, the method adds to the cost of the project (in the sense of all the expenditure incurred over the period) the “cost” represented by the disfigurement of a natural landscape, the loss of habitat for a rare wildlife species, the increase in noise and air pollution, or more recently, the impact on climate change. On the benefits side, the method quantifies the time saved, the number of deaths and injuries avoided, the economic benefits of opening up the road, and so on.

For each of these items, we identify a metric and give it a monetary value. For example, for the impact on climate change, we evaluate the greenhouse gas emissions (measured in tonnes of CO2 equivalent) generated by the freeway (over its entire lifetime) and then put a price on them. We then compare all the “costs” with all the “benefits” to see to what extent the project is really opportune for society.

This method obviously poses numerous ethical and methodological problems. How can we put a price on things that have no price (human life, GHG emissions, the destruction of a natural habitat, time)? How can we assess future benefits and damages?

It also poses a problem of coherence, since it places microeconomic values such as individual time savings on the same level as macroeconomic values such as the possibly irreversible destruction of the natural heritage, and thus allows complete substitutability.

Conclusion

We have just seen that the word cost has several meanings. Its use needs to be clear on at least two levels.

  • Are we talking about monetary expenditure or resource consumption?
  • Who bears the cost in question: an economic agent (household, company, State) or the community (all economic agents, including the State)?

The cost to the community, which we call the “macroeconomic cost”, is made up of the consumption of non-renewable natural resources and the labor mobilized, insofar as it is lacking elsewhere. The convention of evaluating these costs in monetary terms by piling up microeconomic costs is a source of error. It can lead to wasting scarce resources (natural resources) and not using abundant resources (people looking for work).