University of South Carolina Arnold School of Public Health Dept. of Health Services Policy and Management
Copyright © 1999-2006 Samuel L. Baker
Click here to skip to the money cost concept section.


Basic concepts:

The Economic Problem

The basic economic problem is the scarcity of social resources to satisfy human wants and needs.

Cost and the necessity of choice, even in health care

When a high percentage of all spending in our economy is for health care, we wonder if some of the resources going into health care could be better used elsewhere, as

Opportunity Cost

Opportunity cost is the most fundamental cost concept.

The opportunity cost of doing or getting something is:

Opportunity cost is what you forgo.

Example: The opportunity cost of buying a box of Cracklin Oat Bran is one-and-a half boxes of Wheat Chex, if that's your second favorite cereal.

Example: Your opportunity cost for taking this class includes:

Opportunity cost is not resources used

Strictly speaking, the cost of something is not the resources used up to get it.

Instead, the cost is what else you could have done with those resources.

Resources have value only because you can use them to make goods and services that have value.

Using prices for costs

Opportunity cost can be hard to use in practice.

Dollar costs (prices) are

Nevertheless, we should not lose sight of opportunity cost.

For example:

Costs and prices

Prices can reflect society's opportunity cost If the market system works properly then the price ratio of any two goods or services tells you what the social tradeoff actually is, how many of good X you give up to get each unit of good Y.

For this to work properly, you have to have strong competition and savvy consumers. Competition will then force the sellers to be efficient, and provide goods and services at prices in line with costs.

The issue of how well the market works is one to which we will return in a future week, when market concepts are discussed. For an example of what can go wrong, though, consider petroleum and ethanol. OPEC, the oil cartel, manipulates the price of oil. The U.S. government indirectly manipulates the price of ethanol, as does (according to some observers) the Archer Daniels Midland agricultural products company. With all this manipulation going on, it would be astounding if the ratio of gasoline and ethanol prices was anywhere close to the how much ethanol the world would have to give up to get one more gallon of gasoline.

Even if prices don't reflect social opportunity cost, they can reflect an individual's opportunity cost, if the good or service is something you have to buy.  If you have a motor you need to operate, and it can run on gasoline or ethanol, and you cannot make your own gasoline or ethanol, then the opportunity cost of a gallon of gasoline in terms of ethanol really is the the price of a gallon of gasoline divided by the price of a gallon of ethanol.

That completes a chunk of material. Now I'm about to change the subject and talk about specific money cost concepts. This might be a good time to take a break. Use the link near the top of this page to jump back to here when you are ready to resume.

Money cost concepts

In this section, we assume that we can use dollar costs for costs.  We go over some concepts that are used in cost accounting.

The concepts are:

Total cost

... is a function (math concept) of quantity

Total cost = TC(Q)

Total cost at Q = the total cost per unit of time of producing Q units of output per unit of time

Costs are "flows," not "stocks"

The Q in the TC(Q) formula stands for Quantity per Unit of Time.

All our cost measures

including total cost, fixed cost, variable cost, marginal cost, average cost
have a time dimension. They are denominated in units of currency per unit of time.

For example, a U.S. firm presenting annual budget numbers would use "dollars per year" as its cost units. For a monthly budget, the cost units would be dollars per month.

For brevity, I'll leave "per unit of time" out sometimes, but it's always implicitly there.

Total cost example

Here's the total cost per month of providing different numbers of screening mammograms per day.
Output rate 
0 5 10 15 20 30 40 50
Total cost per month $6,172 $9,462 $10,337 $13,627 $14,502 $18,667 $20,417 $22,167
Source: Physician Payment Review Commission, The Costs of Providing Screening Mammography, 1989.  This study was done just after Medicare started paying for screening mammograms.

The term "Total cost" is used to refer to the whole table, representing the relationship between output flow and cost flow.  It's not just any one number in the table, unless you say something like, "the total cost at an output of 30 per day."

Total cost graphed

Total cost is an increasing function of quantity.  Usually, the more your produce, the more your total cost.

Fixed cost

The cost of producing 0 output in a given time period.

Fixed cost = costs that can't be avoided in the "short run"

"Short run" means a time period in which many costs can't be avoided. (Wait -- isn't that circular?)

Fixed cost is a function of Q (quantity per unit of time) in the trivial sense that it's a constant function.  Fixed cost is the same at all levels of Q.

Fixed cost example

First let's do the fixed cost associated with the capital outlay. The capital outlay is a lump of money we need before we start.
Capital outlay required before the first patient is seen:
Mammography unit and processor $80,000
Start-up supplies $2,000
Property improvements $15,000
Furniture $5,000
Office equipment $3,500
Miscellaneous $500
Capital outlay -- total of above $106,000

The capital outlay is a stock, really, rather than a flow. To use our cost concepts, we have to convert it to a flow.  We do that by imagining that we borrow the money and then pay back the loan over a period of years at so many dollars per month. That "so many dollars" per month is part of our fixed cost flow.

Amortized capital cost per month 
at a 0.12 interest rate for 6 years.
This is the monthly fixed cost flow
associated with our initial capital outlay.

There are other fixed costs per month.  These are costs that recur monthly independent of how many patients come through.
Other fixed costs per month
Maintenance $425
Promotion $250
Accounting $100
Insurance $100
Rent $875
Telephone $100
Taxes $750
Clerk/Receptionist salary and benefits $1,500
Other fixed costs -- total per month $4,100

Combine the information from the two tables to get the total fixed cost flow per month.
Summary of fixed costs Sound applet
Monthly capital cost $2,072
Recurring fixed cost $4,100
Total fixed cost flow per month $6,172

Fixed cost in the cost table

Let's add a row for fixed cost to the total cost table we saw earlier.
Output 0 5 10 15 20 30 40 50
Total cost $6,172 $9,462 $10,337 $13,627 $14,502 $18,667 $20,417 $22,167
Fixed cost $6,172 $6,172 $6,172 $6,172 $6,172 $6,172 $6,172 $6,172
The fixed cost is the same at all output rates. That is why it's called "fixed."
The fixed cost is the total cost of being open but producing 0.

Total Cost and Fixed Cost graphed

Fixed cost goes straight across, because it's "fixed" -- the same -- at all output rates.

Variable cost

Variable cost equals total cost minus fixed cost. In the "long run," all costs are variable. (Circular definition again!)

Variable cost example

Here are the variable costs for screening mammograms.
Variable costs per month (20 working days per month)

Tests per day
Cost category Unit cost 5 10 15 20 30 40 50
Radiological technologist
$2,415 $2,415 $4,830 $4,830 $7,245 $7,245 $7,245
Film $3.00 $300 $600 $900 $1,200 $1,800 $2,400 $3,000
Medical Records $2.00 $200 $400 $600 $800 $1,200 $1,600 $2,000
Supplies and miscellaneous $2.00 $200 $400 $600 $800 $1,200 $1,600 $2,000
Postage $1.00 $100 $200 $300 $400 $600 $800 $1,000
Forms $0.75 $75 $150 $225 $300 $450 $600 $750
Total monthly variable cost 
(all above added up)

$3,290 $4,165 $7,455 $8,330 $12,495 $14,245 $15,995
The costs in this table vary with the output rate, so they are variable costs.

Variable cost graphed

Variable cost goes up in parallel with total cost.

Marginal cost

Marginal cost is Marginal cost is the additional cost of producing one more.

Marginal cost example

Calculating the marginal cost for our example is a bit tricky, because the radiological technologist is "lumpy."
To start with marginal cost, let's put the technologist's costs aside for a moment, and first do the marginal cost for the items for which we have unit costs.  Those are straightforward.
Cost category Unit cost 
(cost per mammogram)
Film $3.00
Medical Records $2.00
Supplies and miscellaneous $2.00
Postage $1.00
Forms $0.75
Adding the above shows that film, medical records, supplies and miscellaneous, postage, and forms cost $8.75 per mammogram.

$8.75 is therefore the marginal cost of a screening mammogram
if the technologist is going to be there anyway.

This means:  If a woman walks in unexpectedly and offers $8.76 for a screening mammogram,
and your technologist is not busy,
then you can make $0.01 by doing a mammogram for her.

Marginal cost of larger output changes that mean adding a technologist

If you are considering signing a contract to provide, say, 5 more mammograms per day,
$8.75 may not be your whole marginal cost per mammogram, because you may have to add a technologist, depending on whether or not your current technologists are working to capacity.

Here's our table again, with marginal cost lines added. If we consider only these specific output rates (0, 5, 10, etc.), it simplifies our calculation.
Tests per day
0 5 10 15 20 30 40 50
Tests per month 0 100 200 300 400 600 800 1000
Total cost $6,172 $9,462 $10,337 $13,627 $14,502 $18,667 $20,417 $22,167
Fixed cost $6,172 $6,172 $6,172 $6,172 $6,172 $6,172 $6,172 $6,172
0 1 1 2 2 3 3 3
Variable cost $0 $3,290 $4,165 $7,455 $8,330 $12,495 $14,245 $15,995
Marginal cost 
from previous output level
$3,290 $875 $3,290 $875 $4,165 $1,750 $1,750
marginal cost per unit
$32.90 $8.75 $32.90 $8.75 $20.83 $8.75 $8.75

The lumpiness of the technologist makes the marginal cost jump up or down, depending on whether we do or do not have to add a technologist to achieve the next higher output rate.
The marginal cost is high when we have to add a technologist. It's low otherwise. Average cost and marginal cost diagram

Economies of scale

Once we grow past 30 per day, we can expand by more tens to 40 or 50 per day without having to add more technologists.

Marginal cost and the price we can afford to charge

Here's a small slice of that table again, for your reference.
Tests per day 0 5
Tests per 20-day month 0 100
Total cost $6,172 $9,462
Fixed cost $6,172 $6,172
Technologists needed 0 1
Variable cost $0 $3,290
Marginal cost from previous output level Not applicable $3,290
Corresponding marginal cost per unit
(row above divided by 100 tests per day)
Not applicable $32.90
If we're currently doing zero business, and we have an opportunity to contract for 5 films a day, we must charge at least $32.90 per film to break even on the 5 films.
$32.90 is the marginal cost per film of going from 0 films per day to five.
Tests per day 30 40
Tests per 20-day month 600 800
Total cost $18,667 $20,417
Fixed cost $6,172 $6,172
Technologists needed 3 3
Variable cost $12,495 $14,245
Marginal cost from previous output level $4,165 $1,750
Corresponding marginal cost per unit $20.83 $8.75
If we're already doing 30 tests per day, we can make money if we get any more than $8.75 each for the extra tests above 30.

Marginal cost is the concept to use when considering changes.

You compare the costs with the change
 to the cost without the change.

The difference is the marginal cost of the change.

Compare that with the marginal benefit of the change to decide whether the change is advantageous.

Average cost

Average cost is
Total cost at output = Q, divided by Q.
Average cost can tell you one thing: Whether you're making money overall.
If you charge all customers the same price then Revenue/(Units sold) = your price. Profit = Revenue minus Cost,
so profit per unit = Price minus Average Cost.
Average cost = Total cost divided by the Number of Tests = TC(Q)/Q
Tests per day 0 5 10 15 20 30 40 50
Tests per month 0 100 200 300 400 600 800 1000
Total cost $6,172 $9,462 $10,337 $13,627 $14,502 $18,667 $20,417 $22,167
Average cost (Can't divide 
by 0.)
$94.62 $51.69 $45.42 $36.26 $31.11 $25.52 $22.17
Average cost falls as tests per month goes up -- another indication of economies of scale.

Average Cost and Marginal Cost

Tests per day 0 5 10 15 20 30 40 50
Tests per month 0 100 200 300 400 600 800 1000
Total cost $6,172 $9,462 $10,337 $13,627 $14,502 $18,667 $20,417 $22,167
Average cost Can't divide
by 0 
$94.62 $51.69 $45.42 $36.26 $31.11 $25.52 $22.17
Marginal cost 
from previous output level
$3,290 $875 $3,290 $875 $4,165 $1,750 $1,750
marginal cost per unit
$32.90 $8.75 $32.90 $8.75 $20.83 $8.75 $8.75

Look at the 50 column:

Can we really provide extra tests at just over $8.75 each and make money?
Offering a group a price just above its marginal cost will let us make money on that group.

Price discrimination

Average cost as the break-even price

Tests per day 0 5 10 15 20 30 40 50
Tests per month 0 100 200 300 400 600 800 1000
Total cost $6,172 $9,462 $10,337 $13,627 $14,502 $18,667 $20,417 $22,167
Average cost Can't divide 
by 0 
$94.62 $51.69 $45.42 $36.26 $31.11 $25.52 $22.17
We make money overall if our average price to all customers is greater than the average cost.

Short-run and long-run decisions

In the short run, it pays to sell to any customer who'll pay marginal cost. In the long run, when you can get out of your fixed cost, you shut down if your average price is not more than average cost.

Key cost concepts review

Opportunity cost Monetary cost concepts:

The views and opinions expressed in this page are strictly those of the page author. The contents of this page have not been reviewed or approved by the University of South Carolina.