The costs of production

The economy is made up of thousands of firms that produce goods and services. Some of them are large and employ thousands of workers and have thousands of shareholders. Others are small and employ only a few workers and may be owned by one person or family.

According to the law of supply, firms are willing to produce and sell a greater quantity of a good when the price of the good is higher, and this response leads to a supply curve that slopes upward.

What are costs?

Total revenue, total cost and profit

To understand what decisions a firm makes we must understand what it’s trying to do. Economists usually assume that the goal of a firm is to maximize profit and they find that this assumption works well in most cases. The amount that the firm receives for the sale of its output is called the total revenue. The amount that the firm pays to by inputs is called its total cost. Profit is a firm’s revenue minus total cost:

Profit = Total revenue – total cost To see how a firm goes about maximizing profit, we must consider fully how measure its total revenue and its total cost. Total revenue equals the quantity of output the firm

produces times the price at which it sells its output.

Costs as opportunity costs

A firm’s opportunity costs of production are sometimes obvious and sometimes less so. Explicit costs are input costs that require an outlay of money by the firm. Implicit costs are input costs that do not require an outlay of money by the firm.

The cost of capital as an opportunity cost

An important implicit cost of almost every business is the opportunity cost of the financial capital that has been invested in the business. The opportunity cost equals the interest on the bank loan plus the forgone interest on savings.

Economic profit versus accounting profit

An economist measures a firm’s economic profit as the firm’s total revenue minus all the opportunity cost (explicit and implicit) of producing the goods and services sold. An accountant measures the firm’s accounting profit as the firm’s total revenue minus the firm’s explicit costs.

For a business to be profitable from an economist’s standpoint, total revenue must cover all the opportunity costs, both explicit and implicit.

Production and costs

Firms incur costs when they buy inputs to produce the goods and services that they plan to sell. In the analysis that follows, we make an important simplifying assumption: we assume that the size of the firm is fixed and that the firm can vary the quantity of the good produced only by changing the number of worker. This assumption is realistic in the short run, but not in the long run.

The production function

The relationship between quantity of inputs used to make a good and the quantity of output of that good is called the production function.

The marginal product of any input in the production is the increase in the quantity of output obtained from one additional unit of that input. When the number of workers increases, the marginal product declines. The diminishing marginal product is the property whereby the marginal product of an input declines as the quantity of the input increases.

From the production function to the total cost curve

Our next goal is to study firm’s production and pricing decisions. For this purpose, the most important relationship is between quantity produced and total costs. The graph for it is called the total cost curve. If we compare the total cost curve with the production function we see, that these two curves are opposite sides of the same coin. The total cost curve gets steeper as the amount produced rises whereas the production function gets flatter as the production rises. These changes in slope occur for the same reason.

The various measures of cost

From data on a firm’s total cost we can derive several related measures of cost which will turn out to be useful when we analyze production an pricing decisions.

Fixed and variable costs

Some costs, called fixed costs, do not vary with the quantity of output produced. They are incurred even if the firm produces nothing at all. Some of the firm’s costs, called variable costs, change as the firm alters the quantity of output produced.

A firm’s total cost is the sum of fixed and variable costs.

Average and marginal cost

A key part of the decision how much to produce is how the cost will vary as he changes the level of production. To find the cost of the typical unit produced, we would divide the firm’s total costs by the quantity of output it produces. This is called average total cost. Average fixed cost is the fixed cost divided by the quantity of output and average variable cost is the variable cost divided by the quantity of output. Although average total cost tells us the cost of the typical unit, it does not tell us how much total cost will change as the firm alters its level of production. For this we have the marginal cost that shows the increase in total cost that arises from an extra unit of production

   () =  () ()

  () = h    (∆) h   (∆ )

Average total cost tells us the cost of a typical unit of output if total cost is divided evenly over all the units produced. Marginal costs tell us the increase in total cost that arises from producing an additional unit of output.

Cost curves and their shapes

The efficient scale of the firm is the quantity of output that minimizes average total costs.

Whenever marginal cost is less than average total cost, average total cost is falling. Whenever marginal cost is greater than average total cost, average total cost is rising. This is true for all firms. To see why, consider what happens to average cost as output goes up by one unit. If the cost of the extra unit is above the average cost of units produced up to that point, then it will tend to pull up the new average cost of a unit. If the new unit actually costs less than the average cost of a unit up to that point, it will tend to drag the new average down. But the price of an extra unit is what economists call marginal cost. We can say: the marginal cost curve crosses the average total cost curve at its minimum.

Typical cost curves

The three properties that are most important to remember:

Marginal cost eventually rises with the quantity of output
The average total cost curve is U-Shaped
The marginal cost curve crosses the average total cost curve at the minimum of average total cost

Cost in the short run and in the long run

The relationship between short-run and long-run average total cost

For many firms, the division of total costs between fixed and variable costs depends on the time horizon. Because many decisions are fixed in the short run but variable in the long run, a firm’s long-run cost curve differ from its short-run cost curves. The long-run average total cost curve is a much flatter U-shape than the short-run average total cost curve.

Economies and diseconomies of scale

The shape of the long-run average total cost curve conveys important information about the technology for producing a good. When long-run average total cost declines as output increases, there are said to be economies of scale (the property whereby long- run average total cost falls as the quantity of output increases). When long-run average total cost rises as output increases, there are said to be diseconomies of scale. When long-run average total cost does not vary with the lever of output, there are said to be constant returns to scale.

Economies of scale often arise because higher production levels allow specialization among workers. Diseconomies of scale can arise because of coordination problems that are inherent in any large organizations.

monopolisitc competition

Monopolistic competition is a market structure in which many firms sell products that are similar but not identical. Monopolistic competition describes a market with the following attributes:

 Many sellers:

there are many firms competing for the same group of customers

 Product differentiation:

Each firm produces a product that is at least slightly different from those of other

firms.

 Free entry:

Firms can enter or exit the market without restriction.

Monopolistic competition, like oligopoly, is a market structure that lies between the extreme cases of competition and monopoly.

Competition with differentiated products

To understand monopolistically competitive markets, we first consider the decisions facing an individual firm.

The monopolistically competitive firm in the short run

Each firm in a monopolistically competitive market is like a monopoly. Because its product is different from those offered by other firms, it faces a downward sloping

demand curve. Thus, the monopolistically competitive firm follows a monopolit’s rule for profit maximation: it chooses the quantity at which marginal revenue equals marginal cost and then uses its demand curve to find the price consistent with that quantity. In the short run, the monopolistically competitive market structure and the monopolist market structure are similar.

The long run equilibrium

When firms are making profits new firms have an incentive to enter the market. This entry increases the number of products from which customers can choose and, therefore, reduces the demand faced by each firm already in the market. In other words, profit encourages entry, and entry shifts the demand curves faced by the incumbent firms to the left. As the demand for incumbent firms’ products falls, these firms experience declining profit. Conversely, when firms are making losses firms in the market have an incentive to exit.

This process of entry and exit continues until the firms in the market are making exactly zero economic profit. The demand curve and the average total cost curve must be tangent once entry and exit have driven profit to zero. Because the profit per unit sold is the difference between price and average total cost, the maximum profit is zero only if these two curves touch each other without crossing.

To sum up, two characteristics describe the long-run equilibrium in a monopolistically competitive market:

As in a monopoly market, price exceeds marginal cost. This conclusion arises because a profit maximization requires marginal revenue to equal marginal cost and because the downward sloping demand curve makes marginal revenue less than price.
As in a competitive market, price equals average total cost. This conclusion arises because free entry and exit drive economic profit to zero.

Monopolistic versus perfect competition

There are two noteworthy differences between monopolistic and perfect competition: excess capacity and the mark-up.

Excess capacity: The quantity of output in a competitive market is smaller than the quantity that minimizes average total cost. Thus, under monopolistic competition, firms produce on the downward sloping portion of their average total cost curves. The quantity that minimizes average total cost is called the efficient scale of the firm. Whereby firms are said to have excess capacity under monopolistic competition.

Mark-up over marginal cost

For a competitive price equals marginal cost. For a monopolistically competitive firm, price exceeds marginal cost, because the firm always has some market power.

Monopolistic competition and the welfare of society

A monopolistically competitive market has the normal deadweight loss of monopoly pricing. There is no easy way for policy makers to fix this problem, because the policymakers would need to regulate all firms that produce differentiated products. Because such products are so common, the administrative burden of such regulation would be overwhelming. Also monopolistic competitors are making zero profits. A regulation would make them have losses.

Another way in which monopolistic competition may be socially inefficient is that the number of firms in the market may not be the ideal one. Whenever a new firm considers entering the market with a new product, it considers only the profit it would make. Yet its entry would also have two external effects:

The product-variety-effect
The business-stealing-effect

Both of these externalities are closely related to the conditions for monopolistic competition.

Advertising

When firms sell differentiated products and charge prices above marginal cost, each firm has an incentive to advertise in order to attract more buyers to its particular product. The amount of advertising varies substantially across products. Firms that sell highly differentiated consumer goods typically spend between 10 and 20 per cent of revenue for advertising. Firms that sell industrial products typically spend very little on advertising and firms that sell homogenous products spend nothing at all.

The debate over advertising

Critics of advertising argue that firms advertise in order to manipulate people’s tastes. Much advertising is psychological rather than informational. They also argue that advertising impedes competition. Advertising often tries to convince consumers that products are more different than they truly are.

Defenders of advertising argue that firms use advertising to provide information to customers. Defenders also argue that advertising fosters competition. Because it allows customers to be more fully informed about all the firms in the market, customers can more easily take advantage of price difference.

Advertising as a Signal of quality

Many types of advertising contain little apparent information about the product being advertised. Defenders of advertising argue that even advertising that appears to contain little hard information may in fact tell consumers something about product quality. The willingness of the firm to spend a large amount of money on advertising can itself be a signal to consumers about the quality of the product being offered. What is most surprisingly about this theory of advertising is, that the content of the advertisement is irrelevant. A firm signals the quality of its product by its willingness to spend money on advertising.

Brand names

Advertising is closely related to the existence of brand names. In many markets, there are two types of firms. Some firms sell products with widely recognized brand names, while other firms sell generic substitutes. Most often, a firm with a famous brand name spends more on advertising and charges a higher price for its product.

Critics of brand names argue that brand names cause consumers to perceive differences that do not really exist. Economists have defended brand names as a useful way for consumers to ensure that the goods they buy are of high quality. First, brand names provide consumers with information about quality. Second, brand names give firms an incentive to maintain high quality.

The debate over brand names thus centres on the question of whether consumers are rational in preferring brand names over generic subsitiutes.