Cost of production

 

So far we have assumed that supply curves are generally upward sloping. Economist describe it as having a positive/direct relationship with Price and Quantity.

In other words it means higher price will encourage firms to supply more.

But, just how much should firms choose to supply at each price level? It depends largely on how much of Profit firms will make.

Thus, the main Objective of any firm is to maximize Profit.

What is Profit?

Profit is made by firms earning more from the sales of goods than the cost to produce it. A firms total profit is thus the difference between its total sales revenue (TR) and its total cost of production (TC). Total Profit= TR – TC

Example: John is the owner of John’s Ice cream Parlour. The amount John’s Parlour receive from the sale of Output (Ice cream) is called TR.

The amount John’s Parlour pays to buy inputs (milk, sugar, flavours, workers etc.) is called TC.

John gets to keep any revenue that is not needed to cover the cost.

Therefore, Profit=TR – TC

How Economist and Accountants view Cost and Profit?

In simple logic, profit is made by firms earning more from the sales of goods than the cost to produce.

Firms Total Profit is the difference between its Total Sales Revenue (TR) and its Total Cost of Producing (TC).

Profit = TR – TC

Left hand side of the equation is easy to solve as TR = P x Q. Whereas, the right hand side of the equation is complex, as different professionals view cost differently.

Cost as Opportunity Cost

Recall, opportunity cost is, whatever you give up to obtain some item.

The owner of John’s Ice cream Parlour pays $10,000 to buy milk, cream and other ingredients. The $ spend on buying milk/cream/ingredients is an opportunity cost as the owner John can no longer use 10,000 to buy something else.

John hires workers and equipment to make ice cream, the wages paid to workers $10,000 and rent on equipment $10,000 are part of John’ firm cost. These cost are called Explicit Cost.(Payment to non owners of a firm for their resources)

On the other hand, imagine John is a qualified teacher and could earn $ 25,000 as an income. If he saves a part of his income he can also earn an interest of $ 2,000.This is John’s foregone income and interest is also part of his cost. This cost is called Implicit Cost. (The opportunity costs of using resources owned by the firm)

How Economist and Accountant Measure Cost?

Economist are keen to study how firms make production and pricing decision, so they give importance to all opportunity cost.

Accountants monitor the flow of money into and out of firm to pay for the cost.

How Economist and Accountant Measure Profit?

Since both professionals measure cost differently so their measure of profit is different too.

Economic Profit = Total Revenue – Total Opportunity Cost (Explicit + Implicit Cost)

Accounting Profit = Total Revenue – Total Explicit Cost

Economic Profit verses Accounting Profit

Example: John’s Ice cream Parlour

Item Accounting Profit Economic Profit
Total Revenue  $50,000.00 $50,000.00
Explicit Cost·         Ingredients/Material

·         Wages

·         Rent

$10,000.00

$10,000.00

$10,000.00

 

$10,000.00

$10,000.00

$10,000.00

 

Implicit Cost·         Foregone Salary/Wage

·         Foregone Interest

$0

$0

$25,000.00

$2,000.00

Profit  $20,000.00 $57,000.00 (-)

Analysis

According to accounting profit, John’s Ice cream Parlour is profitable by $20,000.00. But it overstates profit as it ignores implicit cost.

According to economic profit(subtracting both explicit and implicit cost from total revenue). John’s Ice cream Parlour has an economic loss of $-57,000.00.In other words, John’s firm is not able to cover opportunity cost. Thus, the firms resources would earn a higher return if used for other alternatives, a better option !

How do firms cost vary with output over the short and long run/term

Short run is a time period during which at least one factor of production is fixed.

Long run is a time period long enough for all inputs to be varied/changed/altered.

In the short run a firm is limited/constraint in what inputs it can increase.

Example: John’s Ice cream Parlour might be able to use more materials/ingredients or possibly more workers to produce more ice creams, but will not have time to open another Ice cream Parlour.

On the other hand, over the long run, a firm has much more flexibility. It can, if chooses to expand the whole scale of production.

Example: John’s Ice cream Parlour can hire additional workers, install more equipments, build a second Parlour.

In the above illustration we are making a distinction between Fixed Factors (eg. Parlour) and Variable Factors (eg. Labour), to distinquish between Short Run and Long Run.

Cost in the Short Run

A firm’s cost of production, depends on its output.
Why?
Reason is simple, the more it produces, the more factor it must use. The more factor it uses, it incur greater cost. This relationship depends on two elements.
1. The productivity of the factors – the greater is the productivity, the smaller will be the number of then that is needed to produce a given level of output, and hence the lower the cost of output.
2. The price of the factors – the higher their price, the higher will the cost of the production.
Analysis: In the Short Run
1. Some factors are Fixed in supply, which means they do not vary/change with output. They are called Fixed Cost, it remains the same whether the firm produces nothing or little or lot.
Example: Rent of John’s Ice cream Parlour, remains fixed whether the Parlour produces ice cream or not.
2. Some factors are Variable in supply, they vary/change with output. They are called Variable Cost.
Example: Labours/workers in John’s Ice cream Parlour. To produce more ice creams, requires more labours/workers and thus increases cost of John’s Ice cream Parlour.
Therefore, Total Cost is the sum of both Fixed Cost and Variable Cost. TC=TFC+TVC

The Law of Diminishing Returns

Population growth + diminishing returns = starvation

This was analysed long ago, in 1798, by a 32 year old British economist Reverend Thomas Robert Malthus.

He stated, if the population of the world grows rapidly, food output may not keep pace with it. There will be diminishing returns as more and more people crowd onto the limited/fixed amount of land available.

Analysis

Production in the Short Run is subject to diminishing returns.

Example: Assume John’s Ice cream Parlour has only two factors, one is fixed (parlour) and other is variable (worker/labour).

Since Ice cream Parlour (land as regarded by Thomas Malthus) is fixed in supply, output per period of time can be increased only by increasing the number of workers/labours employed.

Imagine what would happen as more and more workers/labours crowd onto a fixed are of the parlour/land. (The parlour cannot go on yielding more and more output indefinitely). As a result, after a point, the additions to output from each extra worker/labour begin to diminish.

“ The principle that beyond some point the marginal product decreases as additional units of variable factor are added to a fixed factor.”

Other Costs in the Short Run

John the owner of the John’s Ice cream Parlour is aware of the fact that as the level of output (ice cream) changes, the incur cost will also vary/change.

So how much should he produce?

He needs to answer the following two questions about cost of producing ice creams.

1. How much will it cost to produvce a tyical/one unit of ice cream?

2. How much will it cost to increase production of one more ice cream?

Analysis:

1. How much will it cost to produce a typical/one unit, the answer is, divide the firm’s cost by the quantity of output it produces. It is called Average Total Cost (ATC). ATC=TC/Qty

Since, TC is the sum of FC and VC, ATC can be expressed as the sum of AFC and AVC.

Therefore, TC=FC+VC

ATC=TC/Qty

AFC=FC/Qty

AVC=VC/Qty

2. How much will it cost to alter the level of production,the answer in simple words, the amount the TC rises when production increases by one unit. The extra cost of producing one additional/more unit is called Marginal Cost (MC). MC=Change in TC/Change in Qty.

MC=ΔTC/ΔQty

Summary:

TC=FC+VC

Cost of one/typical unit = ATC=TC/Qty

Cost of producing one additional/more unit = MC=ΔTC/ΔQty

 

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