The cost of production (0)

The costs of production
Production
Decisions about production require individual agents to make decisions about the allocation and use of physical inputs.

• Objectives of agents, technology , availability and quality of inputs determine the nature of these decisions.
  

Since the objectives are often pecuniary, it is often necessary to relate the decisions about the physical units of inputs and outputs to the costs of production.

• If the prices of the inputs and the production relationships are known (or understood ), it is possible to calculate or estimate all the cost relationships for each level of output.
  

In practice however , the decision maker will probably have partial information about some of the costs and will need to estimate production relationships in order to make decisions about the relative amounts of the different inputs to be used.
Production is an activity where resources are altered or changed and there is an increase in the ability of these resources to satisfy wants.

• Before goods can be distributed or sold , they must be produced.
  
• Within the market model, production and costs of production are reflected in the supply function
  

Production, more specifically,

• the technology used in the production of a good (or service )
  
• the prices of the inputs determine the cost of production.
  

Production processes increase the ability of inputs (or resources) to satisfy wants by:

• a change in physical characteristics
  
• a change in location
  
• a change in time
  
• a change in ownership
  

At its most simplistic level, the economy is a social process that allocates relatively scarce resources to satisfy relatively unlimited wants.
To achieve this objective , inputs or resources must be allocated to those uses that have the greatest value .
Consumers or buyers wish to maximize their utility or satisfaction given (or constrained by)

• their incomes,
  
• preferences,
  
• the prices of the goods they may buy.
  

The behavior of the buyers or consumers is expressed in the demand function. In a market setting, this is achieved by buyers (consumers) and sellers ( producers ) interacting. The producers and/or sellers have other objectives.
Profits may be either an objective or constraint.
As an objective, a producer may seek

• to maximize profits or
  
• minimize cost per unit
  

As a constraint the agent may desire

• to maximize "efficiency,"
  
• market share ,
  
• rate of growth or
  
• some other objective constrained by some "acceptable level of profits.
  

In the long run, a private producer will probably find it necessary to produce an output that can be sold for more than it costs to produce.

• The costs of production ( Total Cost, TC) must be less than the revenues (Total Revenue ,TR).
  

Production and Cost
Production is a technical relationship between a set of inputs or resources and a set of outputs or goods.

• QX = f( inputs [ land , labor , capital], technology, . . . )
  
• Legal and social/cultural institutions influence the production function.
  

Costs
Costs are incurred as a result of production. The important concept of cost is opportunity cost ( marginal cost). These are the costs associated with an activity.

• When inputs or resources are used to produce one good, the other goods they could have been used to produce are sacrificed.
  

Economic Cost: the monetary value of all inputs used in a particular activity or enterprise over a given period .
Economic costs reflect the opportunity cost of resources.
Costs may be in real or monetary terms ;

• implicit costs
  
• explicit costs
  

Explicit Costs: paid directly in money - money costs.

• A firm incurs explicit costs when it pays for a factor of production at the same time it uses it.
  

Explicit Cost = payments by a firm to purchase the service of productive resources (wages, interest , rent, capital)
Explicit Costs
Explicit costs are those costs where there is an actual expenditure in a market.
The costs of labour or interest payments are examples .
Costs
Implicit Costs: measured in units of money, but are not paid for directly in money.
The costs of nonpurchased inputs, to which a cash value must be imputed because the inputs are not purchased in a market transaction .

• A firm incurs implicit costs when it uses capital, inventories or owner’s resources.
  

Implicit Costs = opportunity costs associated with a firm’s use of resources that it owns (wages foregone by owner, interest rates loss through purchases)
Some implicit costs are estimated and used in the decision process.
Depreciation is an example.
Opportunity costs or MC should include all costs associated with an activity.
Many of the costs are implicit and difficult to measure. A production activity may adversely affect a person ’s health. This is an implicit cost that is difficult to measure.

• Another activity may reduce the time for other activities. It may be possible to make a monetary estimate of the value.
  

Accounting Costs: Measures the explicit costs of operating a business - RESULTS FROM PURCHASES OF INPUT SERVICES .
Economic Profit : the difference between the total revenue and the cost of all inputs used by a firm over a given period. It is the TR - OC.

• OC are the explicit and implicit costs of the best alternative actions forgone. (TR-TC)
  

From now on, if I refer to “profit” that is referring to economic profit.
Normal Profit
In neoclassical economics , all costs should be included :

• wages represent the cost of labour
  
• interest represents the cost of kapital
  
• rent represents the cost of land
  
• “normal profit [ P ]” represents the cost of entrepreneurial activity
  

Normal profit includes risk
Economic Costs
Profits to an
Accountant
Profits to an
Economist
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Economic (opportunity) Costs
Production and Costs
COST CURVES:

• Fixed Costs (TFC) = costs that do not vary with output (present even when output, q, = 0)
  

• Variable Costs (TVC) = costs that vary with the rate of output
  

• Total costs (TC) = TFC + TVC
  

• Average Variable Cost (AVC) = total variable cost/ number of units produced
  

• Average Fixed Cost (AFC) = fixed costs/ output (units produced)
  

• Average Total Cost (ATC) = total cost (variable and fixed) / number of units produced
  

• Marginal Cost (MC) = the change in total cost required to produce an additional unit of output.
  

• Explicit Cost = payments by a firm to purchase the serviced of productive resources (wages, interest, rent, capital)
  
• Implicit Costs = opportunity costs associated with a firm’s use of resources that it owns (wages foregone by owner, interest rates loss through purchases)
  

QX = f (L, K, R, technology . . .)
QX = quantity of output
L = labour input
K = Kapital input
R = natural resources [land]
Decisions about alternative ways to produce good X require that we have information about how each variable influences QX.
One method used to identify the effects of each variable on output is to vary one input at a time. The use of the ceteris paribus convention allows this analysis .
The time period used for analysis also provides a way to determine the effects of various changes of inputs on the output.
Long Run
The long run is a period that:

• Is short enough that technology is unchanged.
  
• All other inputs (labour, kapital, land . . .) are variable, i.e. can be altered.
  
• These inputs may be altered in fixed or variable proportions. This may be important in some production processes.
  

If inputs are altered, the output changes.

• QX = f(L, K, R, . . . ) technology is constant
  

Short Run
The short run is a period in which at least one of the inputs has become a constant and at least one of the inputs is a variable.
If kapital (K) and land (R) are fixed or constant in the short run, labour (L) is the variable input.
Output is changed by altering the labour input.

• QX = f (L) Technology, K and R are fixed or constant.
  

Market Period
When Alfred Marshall included time into the analysis of production and cost, he included a “market period” in which inputs, technology and consequently outputs could not be varied.

• The supply function would be perfectly inelastic in this case .
  

The Long Run
The long run is a period of time where:

• technology is constant
  
• All inputs are variable
  

Long run period is a series of short run periods.

• For each short run period there is a set of TP, AP, MP, MC, AFC, AVC, ATC, TC, TVC & TFC for each possible scale of plant
  

Economies and Diseconomies of Scale
Economies of scale, in microeconomics , are the cost advantages that a business obtains due to expansion. They are factors that cause a producer’s average cost per unit to fall as scale is increased.
Economies of scale is a long run concept and refers to reductions in unit cost as the size of a facility, or scale, increases .
There are two typical ways to achieve economies of scale:

• High fixed cost and constant marginal cost
  
• Low or no fixed cost and declining marginal cost
  

Diseconomies of scale are the opposite
Economies of scale may be utilized by any size firm expanding its scale of operation.
The common ones are

• purchasing (bulk buying of materials through long- term contracts),
  
• managerial (increasing the specialization of managers),
  

Why are economies of scale important?
- Firstly, because a large business can pass on lower costs to customers through lower prices and increase its share of a market. This poses a threat to smaller businesses that can be “undercut” by the competition
- Secondly, a business could choose to maintain its current price for its product and accept higher profit margins.
The LRAC
LRAC is “U-Shaped”

• The LRAC initially decreases due to “economies of scale”
  
  • Economies of scale are due to division of labour.
    
• Eventually, “diseconomies of scale” begin
  
  • usually lack of adequate information to manage the production process
    

Calculations of LRAC
With a little mathematics, the long run cost functions can be calculated. It is easier to use equations rather than tables and graphs.
If consumer behavior, production and cost are understood, you can then think about how to achieve your objectives.
Economic (opportunity) cost
Explicit costs
Implicit costs
Normal profit
Economic profit
Short run
Long run
Total product (TP)
Marginal product (MP)
Average product (AP)
Law of diminishing returns
Fixed costs
Variable costs
Total cost
Average fixed cost (AFC)
Average variable cost (AVC)
Average total cost (ATC)
Marginal cost (MC)
Economies of scale
Diseconomies of scale
Short-run Production Costs
Summary of definitions
Total Fixed Costs = TFC
Total Variable Costs = TVC
Total Costs = TC
Average Fixed Costs = AFC
Average Variable Costs = AVC
Average Total Costs = ATC
Marginal Cost = MC
Economies and Diseconomies of Scale

• Labor Specialization
  
• Managerial Specialization
  
• Efficient Capital
  
• Other Factors
  

• Diseconomies of Scale
  
• Constant Returns to Scale
  

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