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 workers. 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 the 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 analyse production a 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.
Average total cost tells us the cost of a typical unit of output if the total cost is divided evenly over all the units produced. Marginal costs tell us the increase in the 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 differs 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.