Unit 6: Production & Costs

Jim’s Guide for Unit 6:  Production and Costs

Adam Smith
Division of labour is the great cause of its increased powers , as may be better understood from a particular example, such as pin making…The effect is similar in all trade and also in the division of employments…The advantage is due to three circumstances. (1) improved dexterity, (2) saving of time, (3) application of machinery, invented by workmen, or by machine-makers and philosophers.

– Adam Smith, The Wealth of Nations


In the previous units, covering Elasticity and Consumer Choice, we were taking a deeper look at choice, consumption, and the demand curve. Of course, consumer behavior and the demand is relatively easy to understand because, after all, we each have a lot of experience. Each of us is a consumer. Consumption is what we do. After all, living means consuming and choosing. When someone suggest that somebody “needs a life”, we’re often actually saying they should be working (producing) less and consuming more.

Now, in this chapter we switch our focus. Instead of looking at consumption & consumers, we are going to look at production & the firms that do it. In some ways, the analysis gets a little more complex at this point, but the essential thinking is the same: decisions are made rationally by comparing marginal benefits vs. marginal costs. The complexity comes in because calculating marginal benefit is more difficult for a firm, and because calculating marginal cost is more complex for a firm. The issue of the marginal benefit a firm receives when it produces goods will be left to the next four units which deal with market structures and competition.

In this unit we will limit our focus to trying to understand a firm’s marginal costs. It is very important that you understand how production costs behave, and marginal cost in particular, because we will be using this information in the coming units when we look at how firms in different markets actually make their decisions. A little extra “investment” in mastering the basic concepts and graphs of this chapter will pay off well when get to later studying the next four units. So, in this unit, we have these main objective:

    • Explain the law of diminishing returns and how it affects production and costs in the short run.
    • Explain implicit and explicit cost, the calculation of pure economic profit and the difference between economic profit and accounting profit.
    • Compute average fixed cost, average variable cost, average total cost and marginal cost when given total cost data. Sketch a family of typical short run cost curves and explain the relationships between those curves.
    • Show the typical company’s long run average cost curve and explain how it is derived. Explain economies and diseconomies of scale and the causes of each

Constrained Maximization with a Different Goal:
Firms Want to Make Profits – Maximize Profits, Actually

The model of consumer decision-making was relatively simple:

    • Consumers want to maximize utility, which is a “sense of benefit of satisfaction” they get from consuming.
    • Consumers’ task is to decide how many units of each product to buy
    • Consumers choices are limited by the prices they face in the market and the limited budget they have to spend
    • Consumers decide how what quantity to purchase by comparing the marginal utility to the price (marginal cost) of the product.

A business firm’s decision-making is somewhat similar. The differences largely arise because the objective is different. Consumers try to maximize utility. Firms, however, try to maximize profits for the firm’s owners & investors. Some people mistakenly believe that firms try to maximize sales. Others (often employees) think the firm just tries to minimize costs. Most firms do neither. Instead the behavior of firms can be understood by assuming that they try to maximize profits. Profits are the difference between Total Revenue (money collected from customers by selling them products) and Total Costs (monies paid to produce the goods sold).

To produce goods, sell those goods,and maximize profits, firms must make three decisions.

  1. It must make a long-run decision: Commit to what industry to be in, what product(s) to make, and what technology or size of plant to use. This is the long-term strategic decision. It will commit the firm to certain kinds of spending and costs. Once the firm makes this decision, it is contractually committed to paying certain costs. Most firms make this decision at the beginning and only rarely do they ever re-consider the decision.
  2. The short-run production decision: Given the long-run decision in number 1, the firm is limited in it’s range of choices. Basically, it can choose how much to produce. In the context of economic models, this is described as choosing what Q (quantity) of output to produce.Given that it has already committed to a certain technology (long-run decision), the choice of how much to produce dictates how much short-term, or variable costs, must be incurred.
  3. Finally, the firm decides what price to charge. Of course, the firm is limited by what consumers are willing to pay and what price competitors charge.
  4. The last step isn’t really a decision, it’s a calculation of how much profit was made given the quantity buyers purchased at the firm’s selected price.

We will focus primarily on the how decision #1 is made towards the end of this unit. Most of this unit focuses on two issues: what is a cost? and how do costs vary in the short-run when we produce more (or less) output? By analyzing costs in the short-run, we can develop the firm’s short-run supply curve. First, though, we need to look at what is (and isn’t a cost). Economists are agreed on what’s a cost, but accountants seem to have a different view.

Economic Profits: Economists and Accountants Look At Costs Differently

Accountants and economists both spend a lot of time analyzing and measuring costs. But, the two groups look at costs somewhat differently, largely because accountants and economists have different objectives and different reasons for studying costs. (of course, personally, I rather like the economists)

Accountants keep track of actual, exact transactions. So, when accountants add up costs, they like to see actual transactions – you know, receipts, money spent, and all that. If accountants can’t establish a good rationale and paper trail for what something costs, they tend to not count it. Accountants try very hard to be exact. In effect, accountants think of costs as “purchased resources”. Since there is a clear, explicit dollar amount attached to each purchased cost, the costs accountants record are referred to as explicit costs of production.

Economists, however, are much more comfortable with approximations. Economists want to make sure the all resources used in production are counted, even if we can’t establish good, exact numbers for it. Economists think of costs as “all resources used, whether it was purchased or not”. That makes for a significant difference. Economists also realize that the best measure of cost is opportunity cost, not necessarily the price that was paid. Economists look for hidden costs. These hidden opportunity costs are called implicit costs. An example of an implicit cost is the time of the business owner who operates a business and doesn’t pay themselves a fixed salary. The owner’s time is valuable. It has an opportunity cost, so the economist tries to estimate the value of that opportunity cost and include it in any models of firm decision-making. So economists include both the explicit costs (same as the accountant) and implicit costs (which isn’t shown in accounting statements).

Profit, of course, is what’s left after take Total Revenue and subtract the firm’s costs. Since an accountant only subtracts explicit costs, an accountant gets a different number for profit than the economists calculates. An economist is subtracting both explicit and implicit costs, so the economist gets a smaller profit number. This number is called economic profit. Economic profit is always lower than accounting profit.

There are other differences between accountants and economists, too. Personally, I find economists to be sexier, smarter, more honest, more loving, more desirable, more charismatic, more exciting, better role models,……………………. (but then I’m an economist!).

TIP: From here on in this course, anytime you encounter the term “profit”, it will refer to “economic profit”. This is especially important when thinking about the models in the coming units that describe various market structures.

Fixed vs. Variable Costs: Does Producing More Mean Spending More?

Once we have calculated all the costs, explicit and implicit, that are involved in production, we need to divide these costs into two groups: Fixed and Variable. The reason we want to categorize different costs as either fixed or variable is because we will eventually build a model of how firms decide what quantity to produce and offer for sale. So, economists separate all costs into these two groups based on whether or not the cost increases when the firm decides to increase Q (produce more output). The firm must spend more on variable costs when the firm decides to produce more output. Variable costs increase directly when Q increases, and variable costs go down when Q is decreased. Fixed costs, though, don’t increase when the firm increases Q. Fixed costs also don’t change when Q is decreased. Fixed costs simply don’t change when Q changes — that’s why they’re called “fixed”.

In reality, even fixed costs can be changed by the firm’s management, if they wait long enough to re-write some contracts. Economists distinguish two time periods: the “long run” and the “short run”.  How long is “short-run” depends on contracts.

How Long is the “Short-Run”? – It’s All About Commitment

A common difficulty in this unit is understanding what “short run” vs. “long run” means. Unfortunately, there is no way to give a fixed answer — it doesn’t refer to some fixed amount of calendar time. Instead, “short run” vs. “long run” is all about commitment (or the lack of it). A period of time is “short run” IF a firm is committed (legally) to some particular cost or expenditure, regardless of what production decisions they might make. On the other hand, “long-term” means a period of time long enough that a firm can stop or get out of any and all commitments.

It may be easiest to understand by imagining the cost of renting a building. If there is a 2-year lease, then the amount of the rent payment is fixed for 2 years and the firm is committed to paying it. The firm cannot avoid paying the rent (without penalty) — it’s committed, even if the firm doesn’t need or use the building. So, anything during that two-year period is short-run with respect to the rent.  After 2 years, the lease expires and the firm could renew it, change it, increase it, eliminate it, or whatever. There’s no commitment in the long-term. As long as the lease is in effect, the cost of the rent is considered a fixed cost. If the analysis is dealing with a period of time beyond when the lease expires, that is long-run.

Some technologies just naturally require long periods of commitment. Some don’t. How flexible an industry is often has to do with how long it’s cost commitments are.  For example, let’s compare two very different businesses.  The first one (business A) is a small business that takes used goods on consignment from individuals and then sells them on e-Bay for a commission.  The second business is a giant integrated paper-and-forest products firm (business B).  A, the e-Bay seller, probably has some fixed commitments but they are very short in calendar terms. Let’s suppose the owner runs the business out of their own home & garage.  No commitment there. Maybe they have a 6-month commitment to a web-hosting business to pay monthly for a website.  Maybe they bought a computer just for the business.  If so, then “short-run” is anything less than the time it would take to get out of these two commitments  Obviously business A can be free and clear of any existing cost commitments in 6 months or less – that’s their “short-run”. Anything longer than 6 months is “long-term” for business A.

In contrast, consider Business A, a giant integrated forest-products-and-paper company.  They have long-term leases (10 years) with tree farmers to provide a source of trees to make into pulp.  They have a giant mill that cost $500 build. It will last 20 years and is financed with money borrowed over the next 10 years.  The mill is scrap if it isn’t used for making paper and nobody else would want to buy it.  For this paper company, Business B, anything less than 10 years should probably be considered “short-term”.  “Long-term” is longer than 10 years.  So the exact calendar time that corresponds to “short” vs “long” term depends on your contractual commitments.

The Critical Graph: ATC, AVC, and MC

There are a lot of graphs in this unit and even more terms of types of cost: average cost, total cost, fixed cost, variable, marginal cost, average variable, average total, long-run average, etc. The three most critical cost curves to focus on are: Marginal Cost (MC), Average Total Cost (ATC), and, slightly less important, Average Variable Cost (AVC). These three cost curves have distinctive shapes and a certain graphical relationship to each other as illustrated here. It’s a good idea to study this graph well.

Three features of this graph should stand out.

First, both the ATC and the AVC are broad U-shaped curves. They start somewhat high, then as Q increases (firm produces more output), the curves drop down, then eventually turn upward again.

Second, all three curves eventually start climbing and increasing. If you try to increase Q enough, in other words the firm tries to produce very, very large quantities, then costs increase dramatically and become very, very high.

Finally, you should note that the Marginal Cost curve always intersects the two average cost curves (AVC and ATC) at the very bottom of the average costs curves. This phenomenon is a mathematical result. The marginal cost is the change in the total cost when Q is increased by one. Mathematically, if MC is below ATC, then the Total Cost is decreasing and hence the ATC must be downward sloping. If MC is above ATC (MC>ATC), then Total Cost is increasing and ATC is now upward sloping. You’re already familiar with this phenomenon, just not in this context. Think about your grade point average in college. It’s a grade point average. It tells us the average grade you’ve received in all the courses you’ve taken so far. It’s like an ATC curve. The number of courses you’ve taken is like Q. The marginal course is the course you are presently taking. This economics course is the next course, the incremental course, the marginal course. What happens if you get a grade in this class that’s lower than your grade point average? Your grade point average will decline. Let’s re-state that. If your marginal grade (this course) is less than your average (GPA), then your average is declining (downward sloping). Just like when MC is less than ATC, then ATC is declining. Of course, that’s only hypothetical, because I certainly hope your grade in this class is greater than your average. In that case, if you get a grade in this class that’s better than your average, your average will increase. If MC > ATC, then ATC is increasing. In other words, MC intersects ATC at the bottom.

Why Are Short-Run Costs U-Shaped? — Law of Diminishing Returns

We just noted above that cost curves typically decline at first, but eventually start increasing. Why? The reason is because of the Law of Diminishing Returns. It has to do with fixed inputs vs variable inputs. Fixed inputs are the resources that are fixed when we increase Q: things like machines and buildings. Fixed costs are the costs of obtaining these fixed inputs. Variable inputs are the inputs that must increase when we increase Q: things like raw materials, direct factory labor, and parts. Variable costs are the costs of obtaining the variable inputs.

Variable inputs must be increased when output is increased, but the exact relationship isn’t constant. As we make larger quantities of output (Q), it takes even larger quantities of variable inputs. For example, once the firm has reached a reasonable production level, a 10% increase in Q will require more than a 10% increase in the variable inputs. Eventually, it becomes near-impossible to increase output (in the short-run) because we have reached “capacity”. The fixed inputs limit our eventual capacity to produce. This is called diminishing marginal returns and it’s why short-run average cost curves turn upward eventually.

Economies of Scale: Is Bigger Always Better & Cheaper?

The last concept in this cost unit involves looking at costs over the long-run. In the long-run, all costs are variable. In the long-run, the firm can make any commitment it wants. It can change the size of the factory or building. It can choose a different technology that involves different short-run commitments. This is actually decision #1, the long-run decision, I listed above. You can think of a firm making a long-run cost decision as if they were looking at a menu. The menu lists all the different technologies they could use to produce the product. Each menu entry represents a particular technology and particular set of fixed-cost commitments. This means that each menu item represents a different set of short-run costs curves (the key graph of ATC & MC). When the firm makes it’s long-run decision, it is picking which short-run ATC curve to commit itself to.

It turns out that there is a pattern to the different technologies and their short-run cost curves that the firm could choose. If the firm chooses technologies that are only capable of producing very small quantities of output, the short-run cost curves are pretty high. If the firm gets larger and commits to regularly producing larger amounts of output (higher Q), it can typically choose more efficient and lower ATC technologies. This is called economies of scale. Economies of scale mean being bigger results in lower average costs. Economies of scale typically result from the division of labor, the subject of Adam Smith’s quote at the top of this page. Eventually, if a firm tries to be too big. That is, it tries to choose technologies that will allow it to produce huge amounts of output, then the firm encounters diseconomies of scale. Diseconomies of scale often happen because the firm has become too large to manage efficiently. When we put these different technology options, this menu of size-technology choices, onto a graph we see a pattern emerge. That pattern is the long-run average cost curve.

What’s Next?

We still need to examine how the firm decides how much output (Q) to produce in the short run, and we will do that in units 8-11. In the next unit, though, we will continue to look at the firm’s costs by examining how the firm decides how much resource to buy. In the process of figuring out how firms decide how many workers to hire, we might even discover some basic principles about how to make ourselves more valuable to our employers (and hopefully, even get paid more money!)

“Economist: Someone who sees something in
practice and wonders if it would work in theory.”
– former Senator Ernest “Fritz” Hollings

To finish this unit, be sure to:

  1. Read the textbook (see the Reading Guide for what chapters and pages to read in the textbook or other source)
  2. Take a look at any tutorials, videos, or articles in Closer Look
  3. Try the practice quiz
  4. Complete the worksheet assignment
  5. Complete the Graded assignments in your school’s Learning Management System