Basic kinds of cost decomposition

Table: Some basic cost decompositions in economics

Introduction: This table shows some of the most basic ways of decomposing costs in economics.

Basic cost decompositions	AC = PC + TC	AC = rK+wL	AC= VC+FC	AC =C+G+I+EX-IM
Abbreviations	· AC is all cost · PC is production cost, that is costs associated with transforming inputs into outputs or “direct” production expenses · TC is transaction cost, that is costs associated with making exchange or “indirect” production expenses	· AC is all cost · K is capital, or resources used to pay equipment · L is labor, or resources used to pay wages	· AC is all cost · VC is variable cost with respect to production volume. · FC is fixed cost or cost that are independent of the production volume in some significant interval	· AC=Y is all cost · C is consumption · G is public expense · I is investment. · EX is export · IM is import
Definition by examples	· PC e.g. cost of materials used in production, cost of people in production that does not do maintenance · TC e.g. cost of management monitoring and administration. Cost of research, marketing, accounting, maintenance and service of customers	Trivial	· VC e.g. electricity, raw materials, semi manufactures · FC e.g. firm specialized personnel (accountants and researchers), leases, cost of buildings, machines and vehicles	Trivial
Associated theory and its objective	Transactions cost economics: To explain the interaction between transaction environment and organizational design. This being a tool for what to do when environment change and to devise more efficient organizations	Microeconomics: General equilibrium analysis use production function Y=F(K,L) for analysis of specialization and exchange, or comparative advantages etc	Microeconomics: Partial equilibrium analysis of firm and consumer maximization. This categorizing is also used in accounting theory	Macroeconomics: To explain the interaction, and predict the future of macro variables as those above plus L, r, M etc. Also similar analysis at sector level

Notes:

Classic microeconomics (the models developed before 1960) assumes that TC is zero. This assumption is rightly needed to simplify and focus attention on, e.g. economics of specialization and exchange, in a rigorous way. But it is a very crude assumption because empirical evidence suggests that TC has grown from 25% of GDP in 1870 to 50% of GDP in 1970 (more info here). Roughly speaking, before the arrival of transaction cost economics the typical economist did not care about how L and K were transferred into Y in the production function (Y=F(K,L)). F was considered the domain of engineers not economists. This is reasonable under the TC=0 assumption because then Y=F(K,L)=AC=rK+wL=PC and engineers should know much more about production costs than economists. However, in the real world TC and PC are equally important. TC is the cost of coordination and motivation associated with specialization and exchange. The size of TC is determined by how intelligently the exchange is organized and this is something that economists should know about (more info here).

AC (all costs) could be approximated by the GDP (gross domestic product) from the national account. Approximated because the national account only measures the “white” economy thereby excluding the “black” and the “green” economy. White economy is legal and marketed activities subject to tax payments and must be reported to authorities. An economic activity, which is not lawfully reported, is black. Finally, economic activities that are not taxable, marketed or illegal is green economy. Important examples of the green economy include private cookery, laundering and cleaning. Unfortunately for TCE the national account is constructed almost exclusively to fit the use of macro economists. Who knows in the future the national statistic’s might also provided a TCE national account. This could facilitate a surge of empirical research in the field of transaction cost economics (more info here).

AC =C+G+I+EX-IM