Final answer:
Differential costs are the differences in total costs that arise from choosing one alternative over another. They are particularly important in the context of short-run costs, focusing on variable costs that change with production and excluding fixed or sunk costs.
Step-by-step explanation:
Differential costs refer to the difference in total costs that result from selecting one choice instead of another. This is best understood in the context of a firm's short-run total costs, which are composed of fixed costs and variable costs. Fixed costs, also known as sunk costs, are expenses that have already occurred and cannot be altered; they do not play a role in future economic decisions or pricing. In contrast, variable costs are associated with the costs of producing output and tend to exhibit diminishing marginal returns, causing the marginal cost of producing additional units to rise.
When confronted with different production scenarios or business decisions, only the costs that change as a result of these decisions are relevant, known as differential costs. For instance, if one production method costs $1,000 and another costs $1,500, the differential cost is $500. This concept is crucial because it highlights the incremental cost associated with a particular business decision over another, allowing for more informed decision-making.