Lecture 5.
Producer
Behavior: Production and
Costs
The Various Measures of Cost
Part #1. Breakdown
of costs.
Total revenue (TR)=> the amount a firm receives for the sale of its output
• Price and total revenue have a positive relationship when demand is
inelastic (gas; coffee; bread)=> when price increases, total revenue will
increase too.
• Price and total revenue have a negative relationship when demand is
elastic (fast food; airline tickets; movie or concert tickets)=> increases in
price will lead to decreases in total revenue.
• Price changes will not affect total revenue when the demand is unit
elastic=> maximum total revenue is achieved where the elasticity of
demand is 1.
Total cost=> the market value of the inputs a firm uses in production
Profit=> total revenue minus total cost
Formula: Profit = Total revenue − Total cost.
TR = P (price of the good) × Q (the quantity of the good sold).
Example:
• P = $4
• Q = 100
• Total revenue = $400.
Explicit costs (aka “accounting costs”)=> the actual expenses that are incurred
when producing certain goods or services (“out-of-pocket expenses”).
Attention: explicit costs are recorded in the books of accounts and are mentioned
in financial records like the income statement and balance sheet.
Examples:
• Wages paid to employees
• Rent expenses
• The cost of raw materials
• Advertising/promotional costs
• Building/land costs
• Cost of purchasing the tangible assets like furniture
• Utility costs (utility bills)
• Shipping costs
Implicit costs (aka “economic costs”)=> the sum of accounting cost and
opportunity cost.
Attention: economic cost is greater than accounting cost because of the addition
of opportunity cost.
More examples?
1. Access to capital=> if a company cannot borrow money or secure
investments=> the opportunities that could have been enabled by accessing
capital are implicitly lost.
2. Loss of interest income on funds=> if a company invests money into its
production activities and loses out on that interest=> the opportunity to gain
interest is an implicit cost.
3. Possible profit forgone due to lack of efficient production=> poorly
managed operations/inefficient production processes can lead to the loss of
potential profits.
6. Depreciation=> when an asset depreciates in value, the company is
not able to recover the original cost.
7. Time + resources spent on one business instead of other tasks
(opportunity costs)=> companies that invest resources into a single
project or mission while neglecting the potential of other opportunities.
8. Loss of goodwill or reputation=> the cost of negative press,
customer complaints, and other forms of public opinion.
Attention: an important implicit cost of almost every business is the opportunity cost of the
financial capital that has been invested in the business. Suppose, that Mr. X used $300,000 of
his savings to buy his business from its previous owner. If Mr. X had instead left this money
deposited in a savings account that pays an interest rate of 5 percent, she would have earned
$15,000 per year. To own his business/factory=> he has given up $15,000 a year in interest
income. This forgone $15,000 is one of the implicit opportunity costs of Mr. X`s business.
Two views on implicit costs:
An accountant=> will not show this $15,000 as a cost because no money flows out of the
business to pay for it.
An economist=> the $15,000 in interest income that Mr. X gives up every year as an implicit
cost of his business.
Economic profit: Total Revenue - Accounting/Explicit Cost
Accounting profit: Total revenue - (Explicit Cost + Implicit Cost)
Part #2. Production
and costs
Main costs?
Production function=> the relationship between quantity of inputs used to make a good and the quantity of output of that good (quantity
produced).
Formula: Q = K+L
– Q=> the number of unites produced.
– L=> the number of labor hours (specialists employed).
– K=> the quantity of capital (equipment).
Example: a bakery that produces bread. Suppose the bakery’s production
function is Q = 10L + 2K. This means that for every additional hour of labor, the
bakery can produce 10 more loaves of bread, and for every additional unit of
capital, it can produce 2 more loaves of bread. If the bakery employs 5 bakers (L
= 5) and owns 3 ovens (K = 3). The production function:
Q = 10(5) + 2(3) = 50 + 6 = 56 loaves of bread.
Meaning: the bakery can produce a maximum of 56 loaves of bread with 5 bakers
and 3 ovens.
Why Production
Functions matter?
1. Efficiency analysis=> by analyzing the production function, businesses can identify
the most efficient combination of inputs to maximize output.
2. Cost management=> firms can predict how changes in input prices will affect
production costs. This information is vital for budgeting and cost management.
3. Optimal production levels=> by assessing different input combinations, firms can
find the point where marginal costs equal marginal revenue.
4. Technological advancements=> highlight the impact of technological changes on
production. Innovations can shift the production function upward, indicating higher
output levels for the same inputs.
5. Economic policy=> policymakers use production functions to analyze the potential
growth of an economy based on available resources.
Part #3. The various
measures of cost
(1) Fixed and Variable Costs
A. Fixed costs=> the costs that must be paid regardless of the
volume of the product/service you sell.
General fixed
costs?
Land and buildings=> assuming you will lease/purchase your space to
begin with (may include your rent/mortgage payments)
Equipment=> special equipment that is unique to your industry (if
necessary!)
Furniture/fixtures=> particularly if you have office space and/or retail
space involved
Communication system=> costs related to setting up and maintaining internal and external
communications for the business (telephone/mobile lines, Internet connections)
Vehicles/transportation=> this includes costs (i.e., vehicle costs, insurance and licensing) for
any vehicles the business will require in order to service the customer, such as vehicles for
transporting product, making deliveries, or going to sponsor community events
Insurance=> consider other insurance costs such as insuring against theft, fire,
etc.
Banking charges=> setting up an account + banking services
Utilities=> costs for water, sewage, heating and power
Office supplies=> such as photocopying, stationery,
postage and other supplies
Maintenance and repairs=> an estimate of potential
costs to maintain/repair land, buildings, equipment,
furniture, fixtures and vehicles on an annual basis.
Key detail: starting business vs.
continuing it!
Fixed
Costs
Start-Up Annual
Operation
fixed al Fixed
costs Costs
Element #1: Start-Up fixed costs – costs you have to pay immediately to launch your business:
- Land and building
- Essential equipment
- Vehicle(s)
- Promotional expenses (initial)
- Furniture, fixtures, office supplies (if there is a physical location)
- Initial inventory/raw materials.
- Salary for each employee (just to launch your business)
Attention: VERY INDIVIDUAL!!!
Attention: the issue of
sustainability… and costs
you`ll have to pay upfront!
In determining where to locate production facilities=> variables to consider:
• Logistics and related expenses:
- Locations of major customers
- Transportation costs to deliver finished products
- Geographic locations of suppliers of parts and raw materials
Example: Wal-Mart. The wave-like patterns associated with Wal-Mart’s growth strategy and
the monetary savings related to distribution costs afforded by having a dense network of store
locations. Pattern similar to dropping a rock into a pond and watching the ripples radiate
outward.
• Availability + cost of skilled and unskilled labor
• The cost of land to build and/or run a new production facility
Element #2: Annual Operational Fixed Costs=> to be payed on an annual/rolling
basis that stay the same regardless the level of output/sales:
- Rent
- Internet/communication
- Banking fees
- Insurance
- Bills
- Promotional expenses
- Raw materials
- Maintenance
B. Variable costs=> change as the firm alters the quantity of output produced.
Example: your employee earns commissions. The more they sell, the higher the
amount you owe them=> their wages are a variable cost because they depend on
sales.
Formula: Total Variable Costs = Products Sold X Variable Cost Per Unit
Example: you sold 5,000 cell phone cases. It costs you $5 to make each case=> total
variable costs are $25,000.
Total Costs = Fixed Costs + Variable Costs
Total Cost Per Unit = (Fixed Costs + Variable Costs) / Total Units Produced
(2) Average Total
and Marginal Cost
Average Total Cost (ATC)=> the total cost per unit
produced within an organization inclusive of both fixed
costs and variable costs.
Formula: ATC = Total cost (TC)/Quantity (Q)
Example: if the firm produces 2 cups of coffee per hour,
its total cost is $3.80, and the cost of the typical cup is
$3.80/2, or $1.90.
Importance of ATC?
• It helps managers identify cost-effective
production methods.
• It assists in making decisions about pricing.
• Businesses can use ATC to determine the
minimum price needed to cover costs (BEP) and
make a profit.
Marginal cost: the increase in total cost that arises from an extra unit of production
Formula: Marginal cost (MC) = Change in total cost (ΔTC)/Change in quantity (ΔQ)
Attention:
• ATC=> tells us the cost of a typical unit of output if total cost is divided evenly over all the units
produced.
• MC=> tells us the increase in total cost that arises from producing an additional unit of output.
Example: if production increases from 2 to 3 cups, total cost rises from $3.80 to $4.50, so the
marginal cost of the third cup of coffee is $0.70.
Importance of MC?
1. Marginal cost helps determine pricing strategies: by calculating the marginal cost of
producing one more unit, businesses can set prices that cover their costs + generate
profits.
Example: if a company's marginal cost of producing one more unit of a product is $1…
it would be unwise to sell the product for less than $1.
2. Marginal cost helps optimize production levels: MC can help businesses determine
how much to produce to maximize profits.
Example: if a company's marginal cost of producing one more unit is $1, and it can sell
each unit for $1.5, it would make sense to produce more units until the marginal cost
exceeds $1.5.
3. Marginal cost helps evaluate investment opportunities: by comparing the marginal cost of a
potential investment with the potential returns, businesses can determine whether the investment is
worth pursuing.
Example: if a company is considering investing in a new production line, it would calculate the
marginal cost of producing one more unit with the new line and compare it with the potential
profits.
4. Marginal cost helps identify cost-saving opportunities: by analyzing their production processes
and identifying areas where the marginal cost can be reduced, businesses can increase their
profitability.
Example: if a company's marginal cost of producing one more unit is high due to inefficient
production processes, it could invest in new equipment or restructure its processes to reduce the
marginal cost.
Part #4. Costs in the
Short and in the Long
run
The Relationship between Short-Run and Long-Run Average
Total Cost
Attention: for many firms, the division of total costs between fixed and variable
costs depends on the time horizon.
Example: Ford Motor Company. Over a short period of time (several months),
Ford cannot adjust the number/sizes of its car factories. The only way it can
produce additional cars is to hire more workers at the factories it already has. The
cost of these factories is a fixed cost in the short run. By contrast, over a period
of several years, Ford can expand the size of its factories, build new factories, or
close old ones=> the cost of its factories is a variable cost in the long run.
Reasons:
• Many decisions are fixed in the short run but variable in the
long run… firms have greater flexibility in the long run.
• In the long run, the firm gets to choose which short-run curve
it wants to use.
• In the short run, the firm has to use whatever short-run curve
it has, based on decisions it has made in the past.
Analysis:
1. Short run: when Ford wants to increase production from 1,000 to 1,200 cars per day, it has no
choice but to hire more workers at its existing medium-sized factory. Because of diminishing
marginal productivity – a production scenario where adding more of a variable input (like labor) to
a fixed input (like capital) eventually leads to smaller and smaller increases in output; each
additional unit of the variable input contributes less to total production than the previous unit –
average total cost rises from $10,000 to $12,000 per car.
2. Long run: Ford can expand both the size of the factory and its workforce, and average total cost
returns to $10,000.
Key question: how long does it take a firm to get to the long run?
Answer: this depends on the firm, its resources and/or external support.
Economies and
Diseconomies of
Scale…
Economies of scale=> occur when an increase in output quantity reduces the per unit total cost of production.
Key condition: when production is optimized when being spread over a larger amount of goods=> larger
companies are more likely to achieve economies of scale due to more cost savings and higher production levels.
Sources:
• Purchasing in bulk
• Improved management quality
• Utilization of technologies that increase efficiency
Case study: Australia, LNG
exports, and economies of
scale
1. Sensing the opportunity
1989=> LNG’s economic impact was recognized=> LNG exports… would surpass metallurgical coal as Australia’s
second biggest resource and energy-export earner.
Malcolm Roberts (chief executive of the industry lobby, the Australian Petroleum, Production and Exploration
Association (APPEA): “Australia’s LNG projects will deliver decades of economic growth, jobs and exports”
2. Logistics
3. Strategic long-term partnerships
1. Purchasing=> firms might be able to lower average costs by buying the inputs
required for the production process in bulk or from special wholesalers. By
negotiating with suppliers for volume discounts, the purchasing firm takes
advantage of economies of scale.
2. Managerial=> firms might be able to lower average costs by improving the
management structure within the firm. The firm might hire better skilled or more
experienced managers.
3. Technological=> a technological advancement might drastically change the
production process. However, only large firms that could afford to invest in
expensive equipment could take advantage of the new technology.
Companies and
countries?
1. Walmart: This retail giant benefits from bulk purchasing, securing lower prices from suppliers. With over
11,000 stores worldwide, Walmart leverages its size to negotiate favorable terms, passing savings on to customers
and maintaining competitive pricing.
2. Toyota: Known for its just-in-time manufacturing system, Toyota achieves economies of scale by streamlining
production processes. By automating tasks and optimizing supply chains, the company reduces costs per vehicle
while improving quality.
3. Costco: Costco’s membership model enables bulk buying at discounted rates. The company’s focus on high-
volume sales allows it to keep prices low while offering a wide range of products to members.
4. Amazon: Through advanced logistics and fulfillment centers, Amazon maximizes efficiency as it scales
operations. Its vast network enables rapid delivery times and cost reductions in shipping expenses.
5. Coca-Cola: Coca-Cola’s global distribution system exemplifies external economies of scale. By utilizing
established supplier networks and skilled labor pools worldwide, the company minimizes costs associated with
production and distribution.
Diseconomies of Scale=> the increase in per-unit cost of production as the scale of production increases. Occur when the per-
unit costs for running a company increase as the company’s size increases… when a company’s cost per unit increases as the
number of units produced increases.
Examples:
• The cost of running a restaurant increases as the number of customers increase.
• When a company has too many employees and not enough work to do.
• When the cost of renting or buying property goes up as more people want it.
• When there are so many products or services that they all compete with each other for customers.
• Poor communication as a firm grows.
• Inefficient management when firms grow quickly.
• Motivation issues.
• When a product is made up of two components, diseconomies of scale might occur if one component is produced at a slower
rate than the other.