The Costs of Production
The Costs of Production
The firm’s objective
Economists normally assume that companies maximise profits
Profit = Total revenue - Total costs
Total revenue is the amount a firm receives for the sale of its output.
Total cost is the amount a firm pays to buy the inputs into production.
Companies exist to create shareholder value (NPV of all future profits)
Various measures of the costs of production
Cost concepts, shapes of cost curves
Costs as opportunity costs
A firm’s cost of production includes all the opportunity costs of making its output of goods and services.
A firm’s cost of production include explicit costs and implicit costs.
Explicit costs are input costs that require a direct outlay of money by the firm.
If, instead, the entrepreneur had borrowed the $300,000 at 5 per cent interest, both accountants and economists would count the $15,000 interest payment as a cost.
Implicit costs are input costs that do not require an outlay of money by the firm.
An entrepreneur invests $300,000 in a factory. If this money had been deposited in a savings account, the entrepreneur would have earned $15,000 per year.
The $15,000 in forgone interest is an implicit cost of the entrepreneur’s business
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Economic profit versus accounting profit
Production and costs: basic concepts
The production function
Describes the relationship between quantity of inputs and the quantity of output.
The increase in output that arises from an additional unit of input
Diminishing marginal product
the marginal product of an input declines as the quantity of the input increases.
The short run
is a period of time during which
at least one
factor of production is fixed.
e.g., in the short run, the size of a firm’s factory is fixed.
The long run
Is the period of time needed for all factors of production to become variable.
the production function to the total-cost curve
Various measures of costs
Fixed costs (FC): costs that do not vary with the quantity of output produced.
Examples: capital equipment, rent
Variable costs (VC): costs that do vary with the quantity of output produced.
Examples: material costs
Total cost (TC) = FC + VC
Average costs (AC): costs divided by the quantity of output
Marginal costs (MC): the increase in total cost that arises from an extra unit of output
Cost curves and their shapes
Marginal cost eventually rises
due to diminishing marginal product
U-shaped average-total-cost curve
Average fixed costs declines as output rises
Diminishing marginal product eventually dominates
Efficient scale: the output level with the lowest ATC
The marginal-cost curve crosses the average-total-cost curve at the minimum of average total cost.
ATC falls if MC<ATC
ATC rises if MC>ATC
Typical cost curves1
Costs in the short and long run
The long-run average total cost curve is flatter and lies below the short-run curves
in the short run, certain inputs are fixed;
in the long run, the firm has greater flexibility – it can choose which short-run curve it wants to use.
Short run and long run average total cost
Economies and diseconomies of scale
Economies of scale
long-run average total cost falls as the quantity of output increases
Diseconomies of scale
long-run average total cost rises as the quantity of output increases
Constant returns to scale
long-run average total cost stays the same as the quantity of output changes