Having developed some concepts that describe the technical aspects of production, it is now possible to discuss the firm's costs in a rigorous manner. Before we can do this, however, some conceptual difficulties about the proper definition of "costs" must be cleared up.

At least three different concepts of costs can be distinguished:

1. opportunity cost;
2. accounting cost; and
3. economic cost.

For economists, the most important of these is opportunity cost. Resource scarcity means that any decision to produce some good necessitates doing without some other good. For example, when a car is produced, an implicit decision has been made to do without the, say, 15 bicycles that could have been produced using the labour, metal and paint that went into the car.

The other two concepts of cost are more directly related to the theory of choice of firms. The accountant's view of cost stresses out-of-pocket expenses, historical costs, depreciation and other book-keeping entries. the economist's definition (which draws in obvious ways on the idea of opportunity cost) defines cost to be the minimum payment necessary to keep a resource in its present employment.

The concept of entrepreneurial cost provides a good illustration of the divergences that arise between economists and accountants on the definition of costs. Much of what the latter term "profit" would be called "entrepreneurial cost" by the former. Accounting profit is a payment to the owner of a firm, and that part of the payment which is necessary to keep the owner in the particular business, economists would argue, is a cost of that business. Economic profit, then, is income which accrues to the entrepreneur in excess of the earning capacity of his/her resources in some other employment. By working for the firm and/or devoting some of his/her funds to its operation, the entrepreneur incurs opportunity costs. Therefore, such services should be considered an input to the firm and some monetary cost should be inputted to them.

The Short Run - Long Run Distinction

In the context of producer theory, the terms "short run" and "long run" are used to indicate the length of time over which a firm has a chance to alter its decisions. If only a short period is allowed, it may be necessary for a firm to treat some of its inputs as being fixed. It may be technically impossible to change the level of employment of these inputs on short notice.

For example, if a time interval of one week is chosen, it would be necessary to treat the size of a firm's plant as absolutely fixed. Similarly, an entrepreneur may be committed to a particular business in the short run and it would be impossible (or extremely costly) for him/her to retire. Over a longer period, however, a firm might not want to treat either of these inputs as being fixed since it is clear that firm's size of plant can be altered and that the entrepreneur can indeed quit the business.

The distinction to be made, then, is between a period over which the levels of some inputs' usage are fixed and a longer period over which all (or more) inputs become variable. By doing so, economists are able to study the different types of responses that a firm might make.

For the purpose of the upcoming analysis, it will be assumed that, in the short run, land input is held constant at the level T⁰ and the firm is only free to vary its labour input. The short-run production function is therefore given by

Q = F(T⁰, L) = TP_L⁰ .

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