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Basic Economics

Costs and Production

Firms are defined as economic organizations that purchase inputs and sell outputs. We will assume that a firm's objective is to maximize profits. Let's take a look at some equations relating to costs.

Profit = Total Revenue (TR) - Total Costs (TC)
Total Revenue = Price x Quantity Sold
Total Costs = Sum of all opportunity costs related to the production process
Opportunity Costs = Explicit Costs + Implicit Costs

Explicit costs of production include:

  • wages and salaries to employees
  • costs of raw materials
  • taxes

Implicit costs of production include:

  • value of time of owner/entrepreneur
  • opportunity cost of financial capital invested in the firm i.e. interest rate foregone

"Economic profit" is the difference between total revenue and total cost, where total cost includes both explicit and implicit costs. In contrast, "accounting profit" is the difference between total revenue and explicit cost. For example: A dancer gives dancing lessons for $20 per hour. Instead, he could be performing on stage for $30 per hour. What is the economic profit of performing on stage?

Total costs = $0 (explicit cost) + $20 (implicit cost)
Economic Profit = $30 (TR) - $20 (TC)

Recall that supply is primarily determined by the productivity of inputs, and the cost of the inputs. The production functions show the relationship between quantity of inputs and the quantity of output.

The short run refers to a period in which at least one input (usually capital) is fixed. The short run production function shows a relationship between total output and inputs, when one input is varied and one is fixed. This is also referred to as the total product (TP). Average product (AP) is the average production per unit of variable input, and is equal to TP/L, where L is labour (the variable input). Marginal product (MP), shows the change in total output when input changes by one unit. Therefore, MP is the slope of the total product curve, and thus shows the productivity of labor.

Total Product Function

A very key assumption, is that of the diminishing marginal product (or diminishing marginal returns). If we add more and more of the variable input(s) and there is at least one fixed input, then eventually the MP of the variable input will decline. The TP curve will flatten out as the quantity of the variable input increases. Therefore, MP may rise initially, but it must fall (TP is increasing but at a decreasing rate).

Product and Cost curves

To go from production to cost, we assume that the costs of inputs are fixed (i.e. a firm can hire all the labour it wants at the going wage). Cost are divided into two broad categories:

  • Fixed costs - costs that do not vary with output, such as cost of plant or some fixed inputs
  • Variable costs - costs that vary with output, such as cost of labour or other variable inputs.

Total costs (TC) is the sum of Total Fixed Costs (TFC) and Total variable Costs (TVC). Graphically, TFC is represented by a horizontal line since costs are fixed. The total cost eventually gets steeper as more is product is produced. Average cost (AC) is how much a typical unit costs and is equal to TC divided by number of units produced. Mathematically we have,

AC = (TFC + TVC)/Q = AFC + AVC
AFC: average fixed costs
AVC: average variable costs

Note that AFC will constantly fall as output increases. AVC will fall and then increase due to diminishing returns. Marginal Cost (MC) is the change in total cost divided by change in output, and addresses the question: how much will it cost to produce one additional unit of output?