Costs of Production

Introduction to Firm Decisions

• Firms make decisions on:
  • How much output to produce
  • The price to charge
• Perfectly competitive market firms have no control over price.
• Other market structures (monopolistic competition, monopoly, oligopoly) will be discussed in later chapters.
• Costs are independent of market type, applicable to all firms.

Objective of a Business

• Primary objective: Maximize profit.
• Profit = Total Revenue - Total Cost
• Firms can have other objectives but must maximize profit to survive.

Types of Costs

Explicit Costs

• Require a cash outlay.
• Examples: Raw materials, wages, electricity.

Implicit Costs

• Do not require a cash outlay but represent opportunity costs.
• Example: Foregone wages from alternative employment.

Accounting vs Economic Profit

• Economic Profit = Total Revenue - (Explicit Costs + Implicit Costs)
• Accounting Profit = Total Revenue - Explicit Costs
• Economic profit is usually less than accounting profit due to positive implicit costs.

Investments vs Costs

• Investments (e.g., buying a pizza oven) are not considered production costs.
• Cost includes foregone interest as implicit costs.
• Depreciation is a tax advantage, not a determinant of market value.

Production Function

• Shows relationship between inputs (e.g., labor) and output (e.g., pizzas).
• Short-run changes in output are constrained by fixed capital.

Average Product (AP)

• AP = Total Product / Number of Workers

Marginal Product (MP)

• MP = Change in Output / Change in Number of Workers
• Declines due to Law of Diminishing Marginal Product.

Cost Curves

Total Cost

• Sum of fixed and variable costs.
• Total cost curve becomes steeper due to diminishing returns on labor.

Average Cost Measures

• Average Fixed Cost (AFC) = Fixed Cost / Quantity
• Average Variable Cost (AVC) = Variable Cost / Quantity
• Average Total Cost (ATC) = Total Cost / Quantity = AFC + AVC
• Marginal Cost (MC) = Change in Total Cost / Change in Output

Graphing Cost Curves

• Rising Marginal Cost: Due to diminishing marginal product.
• U-shaped ATC: Initially falls due to declining AFC, then rises due to rising AVC.
• Efficient Scale: Quantity that minimizes ATC.
• MC intersects ATC and AVC at their minimum points.

Long-Run vs Short-Run Costs

• Long Run: No fixed costs, all inputs are variable.
• Short Run: At least one fixed cost.

Long-Run Average Total Cost (LRATC)

• Represents the lowest cost at which a firm can produce any given level of output.
• Economies of Scale: Decreasing LRATC with increased output.
• Constant Returns to Scale: LRATC remains constant with increased output.
• Diseconomies of Scale: Increasing LRATC with increased output.

Conclusion

• Understanding costs is crucial for profit maximization.
• Next chapters will explore revenue behavior and profit maximization strategies.