Chapter 5: The Firm and the Cost of Production

Introduction

Inputs (factors of production) are converted into outputs (services and goods) through production process. In order to produce output and supply to market, a firm hires factors of production from factor markets.

Economists distinguish between the time frames short run and long run when studying the production and cost relationship. In the short run, some factors of production cannot be changed. The long run is a time frame in which a firm can adjust the usage of all resources, if it deems necessary.

Production, Cost and Profit

The basic factors of production available to a society are natural resources, labor, capital and entrepreneurship. The exact way in which production comes about is determined by the available technology used.

Profit is the difference between total revenue and total cost, and the objective of a firm that produces a good or service is to maximize its profit. When producing a given level of output, the firm chooses the amount of different inputs in a way that minimizes the production cost of that particular level of output.

In economics, cost has a different definition than its common use. When economists think of cost, they add the opportunity cost, which is the next best alternative given up, to the out-of-pocket costs or explicit expenses. In other words, the cost includes not only the explicit expenses you must pay, but also the monetary value of time, effort and other resources you have to give up. The sum of all these costs is called the economic cost.

Total revenue is the amount of money a firm receives from the sale of output.

Marginal revenue, on the other hand, is the additional revenue that a firm earns when it increases production by one more unit.

If a firm is producing, the firm’s profit will be maximized when marginal revenue and marginal cost are equalized or marginal profit is equal to zero. That is the firm will continue as long as the increase in total revenue by producing and selling an extra unit exceeds the rise in total cost. Once the increase in total revenue and total cost from an extra unit produced are equal, the firm can no longer increase its profit.

The next best alternative use of that resource is the opportunity cost of that particular resource and all the inputs used in the production have an opportunity cost. They are different from direct expenditures or the price paid explicitly for the resource. They, nevertheless, need to be fully accounted for when calculating economic costs.

Costs that are direct expenditures or the price paid plainly for a project are called explicit costs. Accounting costs is another term that is used for such costs.

Implicit costs are costs for which no direct payments are made but a firm incurs them when it gives up the next best alternative action or project.

When there is a decrease in the market value of capital over a particular period, it is called economic depreciation.

As the concept of cost is different, economic profit and accounting profit bear different meanings. Accounting costs are the explicit costs, based on direct monetary expenditures alone. However, economic profit is the difference between total revenue and total cost or more explicitly total economic cost, which includes not only the accounting or explicit cost but also the opportunity cost of all factors of production.

Production and Costs

Unlike the output produced and the price charged which depends on the type of market structure in which the firm operates, how to minimize the cost of production for a given level of output is the same regardless of the market structure.

Nevertheless, in the analysis of the relationship between production and costs, the time frames of short run and long run should be distinguished. The short run refers to a time frame in which certain inputs cannot be changed whereas the long run is a time frame in which a firm can adjust the usage of all resources if it deems necessary.

The inputs that are fixed in the short run are called fixed inputs. However, the inputs that can be changed quickly in the short run are referred as variable inputs. To increase output in the short run, a firm must use more variable inputs.

It is assumed that when more and more of the same input is used while the other input and everything else is fixed, output will continue to increase, but the increase in total output for each additional unit of the same input will eventually decrease. Capital, K, however, is fixed in the short run.

Given the production technology and the level of capital, K, the amount of maximum output that a firm can produce for different levels of labor is known as total product of labor (TPL).

The feasible amount of output levels that the firm can produce in a week and those that are not achievable are separated by the total product curve of labor. The total product curve shows the technologically efficient points of producing the given the level of output.

On the other hand, marginal product of labor (MPL) refers to the additional output produced when a small amount of additional labor is employed with all other inputs remaining the same.

If a firm keeps increasing the amount of labor it uses, ceteris paribus, the total output will increase. Nevertheless, if the additional labor is more productive than the previous one, the total output will increase more; if not, it will increase less.

As more and more labor is used, given that everything else is the same, the increase in the total output for each additional unit of labor input such as marginal product might at first increase, which is called increasing marginal returns.

However, marginal product will eventually decrease if more and more labor is used while keeping the other inputs fixed. This is known as diminishing marginal returns.

In other words, law of diminishing returns refers to the decrease in the marginal product of a variable input. When additional units of a variable input—typically labor—are added to fixed input—typically capital— the marginal product of variable input firstly increases and then finally decreases.

Moreover, the productivity of labor on average can be calculated. Average product of labor (APL) is equal to the division of the total product by the quantity of labor employed.

The average product of labor will change in accordance with the marginal product of labor. If the marginal product of additional workers exceeds the average product of labor, the average product will increase since additional workers will be more productive than the average productivity of previously employed workers.

What is more, there is a very tight relationship between the total, marginal, and average product curves. When the total product curve is steepest, the marginal product curve is at its highest.

Different Types of Costs

Different types of costs that firms bear are as follows:

• Total cost (TC),
• Average costs (AC),
• Fixed costs (TFC),
• Variable costs (TVC)
• Average fixed costs (AFC),
• Average variable costs (AVC),
• Marginal cost (MC).

The total cost is the economic cost of all the resources, including the cost of entrepreneurship, which is called normal profit. It is the total fixed cost plus the total variable cost. As the firm has to employ more labor and pay more in wages to produce more output, the total cost will increase with the output even though costs of inputs that are fixed in the short run will remain the same.

Even if a firm produces nothing, it has to keep paying for its fixed inputs in the short run. The sum of all the fixed costs a firm has to pay for, fixed inputs, is called the total fixed cost (TFC). The total fixed cost does not vary with the level of output.

Total variable cost refers to the sum of all variable costs a firm pays for variable inputs. A firm cannot change the amounts of its fixed inputs used in the short run; therefore, it has to use more of its variable inputs to increase production.

The Average cost (AC) tells us the cost per unit. It is equal to the total cost divided by the amount of output produced.

The Average fixed cost (AFC) gives the fixed cost per output. It is calculated as the total fixed cost divided by the quantity of output produced.

The Average variable cost (AC) measures the variable cost per unit of the output produced. Its behavior is connected to the behavior of the total variable cost and is normally U shaped.

The Marginal cost (MC) is the cost of producing the last unit of output. It shows the change in the total cost as the output changes. The marginal cost is calculated as the increase in the total cost (or total variable cost) divided by the increase in the output. The marginal cost is responsible for the U shaped average cost and average variable cost and goes through the minimum points of both curves.

Due to aforementioned explanations, the behavior of TC and TVC depends on MC, which in turn is linked to the MPL. Similarly, AVC is at the end linked to the average product of a variable input. As APL increases, AVC decreases and hits its minimum when APL is at its maximum. Once APL starts to fall, AVC begins to rise and generate a U shape. TC and TVC increase less for each additional unit of output when MC is decreasing. The lower the MC is, the flatter the TC and TVC curves become. Moreover, when AVC and AC are above MC, additional units of production continue to decrease both averages. When they are below MC, producing more increases both. So, the MC curve cuts the AC and AVC curves at their minimum. Because TFC stays the same, independent of the output produced, the shape of the TC curve is exactly the same as the TVC curve but lies above it.

The Short Run and the Long Run in Production

As discussed earlier, a firm has to use inputs (labor and capital) and use more of them to increase production. In the short run, capital is fixed and the firm can only increase labor to increase production but diminishing returns sets in eventually as discussed earlier. Whereas, in the long run, the firm can change the amount of capital it uses as well. When more capital is used for a given amount of labor employed, output will increase.

For each plant size, when the firm increases the quantity of labor to increase output, the total cost (TC) increases. A larger plant size requires the use of larger fixed inputs or higher total fixed costs, but decreases marginal costs and hence average costs at higher levels of output.

The scale of production affects costs. Given the fixed factor prices, when all inputs are raised at the same time by the same percentage, if the output increases more than the percentage increase in inputs, we call this as increasing returns to scale. If the output increases by the same percentage as the increase in all inputs, this is called constant returns to scale.