Production Process: Short and Long-Run Costs and Output Decisions

Decisions of Firms

Firms make decisions based on information to maximize profits. These decisions involve:

  • Quantity of output to supply

  • How to produce that output (which technique to use)

  • Quantity of each input to demand

These decisions are based on information such as:

  • Price of output

  • Techniques of production available

  • Price of inputs: These determine production costs.

Costs in the Short Run

  • Fixed Cost (FC): Any cost that does not depend on the firm's level of output and is incurred even if the firm produces nothing. There are no fixed costs in the long run.

    • Examples: insurance, rent

  • Variable Cost (VC): A cost that depends on the level of production chosen.

    • Examples: steel for cars, overtime wages to workers

  • Total Cost (TC): Total fixed costs plus total variable costs.

    • TC = TFC + TVC or TC = FC + VC

Total Variable Cost (TVC)

The total of all costs that vary with output in the short run. TVC tends to increase as production increases.

Marginal Cost (MC)

The increase in total cost that results from producing one more unit of output, or the change in TVC that results from producing one more unit of output (since fixed costs don't affect MC). MC measures the additional cost of inputs required to produce each successive unit of output.

  • In the short run, firms are constrained by fixed inputs, leading to diminishing returns to variable inputs and limiting production capacity.

  • As a firm approaches capacity, it becomes increasingly costly to produce successively higher levels of output.

  • Marginal costs ultimately increase with output in the short run due to fixed production scales.

Average Costs

  • Average Variable Cost (AVC): Total variable cost divided by the number of units of output.

  • Average Total Cost (ATC): Total cost divided by the number of units of output.

    • TC = TFC + TVC implies that \frac{TC}{q} = \frac{TFC}{q} + \frac{TVC}{q} which means ATC = AFC + AVC

Summary of Cost Concepts

  • Accounting Costs: Out-of-pocket costs, also called explicit costs.

  • Economic Costs: Costs that include the full opportunity costs of all inputs, also called implicit costs.

  • Total Fixed Costs (TFC): Costs that do not depend on the quantity of output produced and must be paid even if output is zero.

  • Total Variable Costs (TVC): Costs that vary with the level of output.

  • Total Costs (TC): The total economic cost of all inputs used by a firm in production.

    • TC = TFC + TVC

  • Average Fixed Costs (AFC): Fixed costs per unit of output.

    • AFC = \frac{TFC}{Q}

  • Average Variable Costs (AVC): Variable costs per unit of output.

    • AVC = \frac{TVC}{Q}

  • Average Total Costs (ATC): Total costs per unit of output.

    • ATC = \frac{TC}{Q} or ATC = AFC + AVC

  • Marginal Costs (MC): The increase in total cost that results from producing one additional unit of output.

    • MC = \frac{\Delta TC}{\Delta Q}

Example Calculation

Given:

  • Q = 3

  • TFC = 10

  • TVC = 75

  • TC = TFC + TVC = 10 + 75 = 85

Perfect Competition

Perfect competition is an industry structure in which:

  • There are many firms, each small relative to the entire industry.

  • Each firm produces identical (homogeneous) products, and no firm is large enough to have any control over prices.

  • New competitors can freely enter and exit the market.

  • Homogeneous products: Undifferentiated products that are identical to one another.

    • Example: American-grown strawberries are indistinguishable from Mexican-grown strawberries, and Saudi oil is indistinguishable from Russian oil.

This implies a perfectly elastic demand curve in the short run, which is a horizontal line at the market equilibrium price. A firm in perfect competition cannot sell its product for a price higher than the market price because consumers would buy from other producers.

Revenue Concepts

  • Total Revenue (TR): The total amount a firm takes in from the sale of its product; price per unit times the quantity of output.

    • TR = P \times q

  • Marginal Revenue (MR): The additional revenue a firm takes in when it increases output by one additional unit. In perfect competition, P = MR. The marginal revenue curve and the demand curve facing a perfectly competitive firm are identical.

Profit-Maximizing Level of Output

  • When marginal revenue is greater than marginal cost (MR > MC), added output means added profit.

  • Firms will produce an additional unit of output as long as the revenue from selling it exceeds the cost of making it.

  • The profit-maximizing perfectly competitive firm will produce up to the point where the price of its output equals short-run marginal cost (P^* = MR = MC).

  • The profit-maximizing output level for all firms is where MR = MC, but in perfect competition, this simplifies to P = MC.

If price is above marginal cost, profits can be increased by raising output. Beyond the profit-maximizing output level, added output will reduce profits. Profit-maximizing output is the point at which P^* = MC.

Long-Run Decisions

Firms face three short-run circumstances:

  1. Firms that earn economic profits.

  2. Firms that suffer economic losses but continue to operate to reduce or minimize those losses.

  3. Firms that decide to shut down and bear losses equal to fixed costs.

Short-Run Conditions and Long-Run Directions

  • Firms Earning Positive Economic Profits: A profit-maximizing firm produces where P^* = MC. Profit is the difference between total revenue and total cost.

  • Firms Earning Zero Economic Profits (Breaking Even): Occurs where price equals average total cost (P = ATC), implying a normal rate of return and zero economic profits.

  • Minimizing Losses: operating profit (or loss) or net operating revenue is total revenue minus total variable cost (TR - TVC).

    • If TR > TVC, the excess revenue can offset fixed costs and reduce losses, so the firm keeps operating in the short run.

    • If TR < TVC, the firm suffers losses exceeding fixed costs and can minimize losses by shutting down in the short run.

Condition P>AVC As long as price is high enough to cover the average variable costs, the firm gains by operating in the short-run instead of shutting down. Thus, if P>AVC, the firm should continue to operate in the short-run even if the firm is suffering losses

In the long-run, however, the firm should consider a future permanent shut down because total costs are still greater than total revenue when the firm suffers losses.

  • Condition P When the price is below the minimum point on the AVC curve, then TR < TVC. The firm will stop producing and bear losses equal to TFC. If P<AVC, the firm should shutdown in the short-run. The minimum point of the AVC curve is called the shut-down point.

Shutdown Point

The lowest point on the average variable cost curve. When price falls below the minimum point on AVC, total revenue is insufficient to cover variable costs, and the firm will shut down and bear losses equal to fixed costs.