Chapter 13- costs of production
Introduction In previous chapters, we summarized the firm’s production decisions by starting with the supply curve. Although this is suitable for answering many questions, it is now necessary to address the costs that underlie the supply curve in order to address the part of economics known as industrial organization—the study of how firms’ decisions about prices and quantities depend on the market conditions they face.
What Are Costs?
Economists generally assume that the goal of a firm is to maximize profits.
Profit=total revenue - total cost
Total revenue is the quantity of output the firm produces times the price at which it sells the output. Total cost is more complex. An economist considers the firm’s cost of production to include all of the opportunity costs of producing its output. The total opportunity cost of production is the sum of the explicit and implicit costs of production. Explicit costs are input costs that require an outlay of money by the firm, such as when money flows out of a firm to pay for raw materials, workers’ wages, rent, and so on. Implicit costs are input costs that do not require an outlay of money by the firm. Implicit costs include the value of the income forgone by the owner of the firm had the owner worked for someone else plus the forgone interest on the financial capital that the owner invested in the firm.
Accountants are usually only concerned with the firm’s flow of money so they record only explicit costs. Economists are concerned with the firm’s decision-making, so they are concerned with total opportunity costs, which are the sum of explicit costs and implicit costs. Because accountants and economists view costs differently, they view profits differently:
Because an accountant ignores implicit costs, accounting profit is greater than economic profit. A firm’s decision about supplying goods and services is motivated by economic profits.
Production and Costs
For the following discussion, we assume that the size of the production facility (factory) is fixed in the short run. Therefore, this analysis describes production decisions in the short run.
A firm’s costs reflect its production process. A production function shows the relationship between the quantity of inputs used to make a good (horizontal axis) and the quantity of output of that good (vertical axis). The marginal product of any input is the change in output that arises from an additional unit of that input. The marginal product of an input can be measured as the slope of the production function or “rise over run.” Production functions exhibit diminishing marginal product—the property whereby the marginal product of an input declines as the quantity of the input increases. Hence, the slope of a production function gets flatter as more and more inputs are added to the production process.
The total-cost curve shows the relationship between the quantity of output produced and the total cost of production. Because the production process exhibits diminishing marginal product, the quantity of inputs necessary to produce equal increments of output rises as we produce more output, and thus, the total-cost curve rises at an increasing rate or gets steeper as the amount produced increases.
The Various Measures of Cost
Several measures of cost can be derived from data on the firm’s total cost. Costs can be divided into fixed costs and variable costs. Fixed costs are costs that do not vary with the quantity of output produced—for example, rent. Variable costs are costs that do vary with the quantity of output produced—for example, expenditures on raw materials and temporary workers. The sum of fixed and variable costs equals total costs.
In order to choose the optimal amount of output to produce, the producer needs to know the cost of the typical unit of output and the cost of producing one additional unit. The cost of the typical unit of output is measured by average total cost, which is total cost divided by the quantity of output. Average total cost is the sum of average fixed cost (fixed costs divided by the quantity of output) and average variable cost (variable costs divided by the quantity of output). Marginal cost is the cost of producing one additional unit. It is measured as the increase in total costs that arises from an extra unit of production. In symbols, if , , , , , , , and , then:
When these cost curves are plotted on a graph with cost on the vertical axis and quantity produced on the horizontal axis, these cost curves will have predictable shapes. At low levels of production, the marginal product of an extra worker is large so the marginal cost of another unit of output is small. At high levels of production, the marginal product of a worker is small so the marginal cost of another unit is large. Therefore, because of diminishing marginal product, the marginal-cost curve is increasing or upward sloping. The average-total-cost curve is U-shaped because at low levels of output, average total costs are high due to high average fixed costs. As output increases, average total costs fall because fixed costs are spread across additional units of output. However, at some point, diminishing returns cause an increase in average variable costs, which in turn begins to increase average costs. The efficient scale of the firm is the quantity of output that minimizes average total cost. 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. Therefore, the marginal-cost curve crosses the average-total-cost curve at the efficient scale.
To this point, we have assumed that the production function exhibits diminishing marginal product at all levels of output, and therefore, there are rising marginal costs at all levels of output. Often, however, production first exhibits increasing marginal product and decreasing marginal costs at very low levels of output as the addition of workers allows for specialization of skills. At higher levels of output, diminishing returns eventually set in and marginal costs begin to rise, causing all cost–curve relationships previously described to continue to hold. In particular:
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.
Costs in the Short Run and in the Long Run
The division of costs between fixed and variable depends on the time horizon. In the short run, the size of the factory is fixed, and for many firms, the only way to vary output is hiring or firing workers. In the long run, the firm can change the size of the factory and all costs are variable. The long-run average-total-cost curve, although flatter than the short-run average-total-cost curves, is still U-shaped. For each particular factory size, there is a short-run average-total-cost curve that lies on or above the long-run average-total-cost curve. In the long run, the firm gets to choose on which short-run curve it wants to operate. In the short run, it must operate on the short-run curve it chose in the past. Some firms reach the long run faster than others because some firms can change the size of their factory relatively easily.
At low levels of output, firms tend to have economies of scale—the property whereby long-run average total cost falls as the quantity of output increases. At high levels of output, firms tend to have diseconomies of scale—the property whereby long-run average total cost rises as the quantity of output increases. At intermediate levels of output, firms tend to have constant returns to scale—the property whereby long-run average total cost stays the same as the quantity of output changes. Economies of scale may be caused by increased specialization among workers as the factory gets larger while diseconomies of scale may be caused by coordination problems that often occur in extremely large organizations. Adam Smith, 200 years ago, recognized the efficiencies captured by large factories that allowed workers to specialize in particular jobs.
Conclusion
This chapter developed a typical firm’s cost curves. These cost curves will be used in the following chapters to see how firms make production and pricing decisions.
Summary of Firm's Production Decisions and Costs
In industrial organization, understanding costs is essential for analyzing a firm's production and pricing decisions. A firm's profit is calculated as total revenue minus total cost, where total cost includes both explicit and implicit costs. Explicit costs require monetary outlays, while implicit costs account for forgone income and investment returns.
Key measures of cost include:
Fixed Costs: Do not vary with output (e.g., rent).
Variable Costs: Vary with output (e.g., raw materials).
Total Costs: Sum of fixed and variable costs.
Average Total Cost: Total costs divided by output.
Marginal Cost: The cost of producing one additional unit.
The production function describes the input-output relationship, reflecting diminishing marginal returns. Cost curves are identifiable: the marginal-cost curve is upward sloping, and the average-total-cost curve is U-shaped.
In the short run, production capacity is fixed, while in the long run, firms can adjust their production facilities. Economies of scale lead to decreasing average total costs at low production levels, while diseconomies of scale increase costs at high levels, with constant returns to scale at intermediate levels. Firms choose between various production scales based on cost efficiency.