Understanding Company Costs and Production
What Are the Costs?
Total Revenue, Total Cost, and Profit
Start with the goal of the company: understand their decisions, knowing what they are trying to do.
A key question is: What is the benefit of a company?
Profit = Total Revenue (TR) – Total Cost (TC)
Key Definitions:
- Total Revenue: The amount received from the sale of production.
- Total Cost: The market value of the factors used in production.
Accounting and Economic Costs
- An economist refers to the cost of production of a company, which includes all opportunity costs.
- The opportunity costs of a company are sometimes obvious and sometimes not.
Types of Costs:
- Explicit Costs: Costs that require an outlay of company money.
- Implicit Costs: Costs that do not require an outlay of company money.
Accounting and Economic Profit
- Since economists and accountants calculate costs differently, profits are also calculated differently.
Profit Definitions:
- Economic Profit: Total revenue minus total cost, including both explicit and implicit costs.
- Accounting Profit: Total revenue minus total explicit cost.
Production and Costs
- Firms incur costs when buying factors to produce goods and services they plan to sell.
- Examine the relationship between production and total cost.
- An important assumption: We assume that the firm’s size is fixed and that it can only alter the quantity of the product by varying the number of workers (only realistic in the short term).
The Production Function
Definition:
- Production Function: The relationship between the amount of inputs used to produce a good and the quantity produced of that good.
Rational people think at the margin.
Marginal Concepts:
- Marginal Product: The increase in the amount of output produced by adding one more unit of a factor.
- Diminishing Marginal Product: The property whereby the marginal product of a factor decreases as the quantity of the factor increases.
Fixed Costs and Variable Costs
The company’s total cost can be divided into two types:
- Fixed Costs (FC): Those that do not vary with the quantity produced.
- Variable Costs (VC): Those that vary with the quantity produced.
Therefore, total costs:
TC = FC + VC
Average Cost Definitions:
- Average Total Cost (ATC): Total cost divided by the quantity of production.
- Average Fixed Costs (AFC): Fixed costs divided by the amount of output.
- Average Variable Cost (AVC): Variable costs divided by the amount of output.
Relationship between Marginal Cost (MC) and Average Total Cost (ATC):
- Whenever marginal cost is less than the average total cost, the latter is decreasing.
- Whenever marginal cost is greater than the average total cost, the latter is increasing.
- Therefore: The marginal cost curve intersects the average total cost curve at its minimum point.
Costs in the Short and Long Term
- The distinction between fixed costs and variable costs depends on the time horizon.
Long Term:
- All factors are variable. All costs are variable.
Short Term:
- Some factors are fixed and others variable. There are fixed costs and variable costs.
- Since some costs are fixed in the short run but variable in the long term, the long-term cost curves of a firm differ from short-term cost curves.
Long-run costs are typically lower than or equal to short-run costs.
Economies and Diseconomies of Scale
- Economies of Scale (or increasing returns to scale): Occur if the long-term ATC is decreasing (decreasing with increasing production level). This is often due to specialization.
- Diseconomies of Scale (or decreasing returns to scale): Occur if the long-term ATC is increasing (increases with the level of production). This is often due to coordination problems.
- Constant Returns to Scale: Occur if the long-term ATC is constant (does not change with the level of production).