Chapter+13+(JEM)+-+The+Cost+of+Production

The Cost of Production

In this chapter, it mainly focuses on how firms' decisions about prices and quantities depend onthe market conditions they face, or the industrial organization. That is, how firms produce goods with given costs of resources, land, labor, and capital.

First, costs are the money used by the firms to produce goods. For example, a game producing company would hire workers to work, buy tools for workers to use, and then sell what they produce. The workers hired and tools bought out are considered the costs of production.

Total revenue : the amount of money a firm receives for the sale of its output. Total cost : the market value of the inputs a firm uses in production Profit = Total revenue - Total cost

The goal of all firms is to maximize profit - making the highest total revenue with the lowest total cost.

Another type of cost that we have already learned in previous chapters is called the opportunity cost. However, unlike the costs mentioned above, opportunity cost does not necessarily have to do with money. So, it is considered an implicit cost - input cost that do not require an outlay of money. When money is involved, it becomes explicit cost - input cost that require an outlay of money.

There are also two different types of profits that are similar to explicit and implicit costs:

Economic profit : Total revenue - Implicit cost - Explicit cost Accounting Profit : Total revenue - Explicit cost

The relationship between the quantity of inputs used to make a good and the quantity of output of that good is shown in a Production Function. As you see, initially, the marginal product, the increase in output that arises from an additional unit of input, is increasing up to A. However, after that, marginal product starts to decrease, until the total output starts to decrease. This phenomenum is called diminishing marginal product.

Diminishing marginal product happens because of the overwhelming number of laborers compared to the number of capitals used to produce goods. Originally when the number of laborers are smaller than the number of capitals, some of the tools are used and the output is produced. The more the firm hires laborers, the more efficient the process becomes and fills up the unused capitals. However, after firm hires an equal number of laborers as the number of capitals, if the firm starts to hire more workers, the workers must share the capitals, and the how process of production would take more time, which in short, becomes inefficient. In general, total cost rises at an increasing rate.

We can derive a total cost curve from the production function: As you see, the initial point of the total cost curve does not start at zero. This is because: Total Cost = fixed cost + variable cost Fixed costs are the costs that do not vary with the quantity of output produced - such as capitals. Variable costs do vary with the quantity of output produced - such as laborers.

Other variables that we can derive from the Total Cost function are: Average Total Cost = Total Cost / Quantity (ATC TC/Q) Marginal Cost =   △Total Cost / △ Quantity (MC   △    TC/△ Q)

where ATC = AVC + AFC

MC is rising because of the diminishing marginal product, as mentioned previously. ATC is U shaped because it is the addition of AVC and AFC. AFC, as you see, constantly decreases because it is the cost that does not vary with the quantity of output, where as AVC does vary and rises.

Because MC has to do with the rate of the change of ATC - in Calculus terms, the derivative - when MC is less than ATC, ATC decreases, and when MC is higher than ATC, ATC increases. ATC and MC intersect where ATC is the lowest.

Questions: 1. What are costs? 2. How do firms measure profits? 3. Why is MC increasing?

Answers: 1. Costs are the money used to produce goods. Costs include TC, VC, MC, and FC. 2. Profit = TC - TR 3. MC rises because of diminishing marginal product.