Cost in Business Overview

Cost in Business

• In a business, costs represent half of the picture, with revenue/sales the other half.
• The key equation for any business is: Profit = Total Revenue - Total Cost

Types of Costs

• Fixed Costs: Remain constant regardless of output changes. Examples include rent, insurance, employee salaries, property taxes, and interest payments. These costs are sometimes referred to as sunk costs, as the money is already spent, regardless of output.
• Variable Costs: Change with the level of output. When output rises, variable costs increase; when output falls, they decrease. Examples include wages (if you cut back output, you lay off some people), fuel (when output changes, you vary your fuel bill), and raw materials.

Mixed Costs

• Some costs have both fixed and variable components. Examples include electricity and phone bills.

Total Cost

• Total cost is the sum of fixed cost and variable cost.
• The increase in total cost is due to changes in variable costs.

Marginal Cost

• This is the cost of producing one more unit of output.
• Each additional unit added affects the overall cost.

Short Run vs. Long Run

• Short Run: The length of time in which fixed costs remain fixed.

• Long Run: All costs are variable.

• The present situation is always the short run.

Average Cost

• Average cost is the total cost divided by the total output.
• Your Case Study: A business wants to sell hotdogs on the beach. Costs are: cart rent, ingredients, etc. If total cost is 250andexpecteddailysalesare200hotdogs,averagecostperhotdogis:250 and expected daily sales are 200 hotdogs, average cost per hotdog is: 250andexpecteddailysalesare200hotdogs,averagecostperhotdogis:250/200 = $1.25.
• If total cost changes to 300,theaveragecostincreasesto300, the average cost increases to 300,theaveragecostincreasesto1.50.

Average Fixed Cost (AFC)

• AFC gets progressively smaller as output increases because the fixed cost is shared by more and more output.

Average Variable Cost (AVC)

• AVC declines initially with output increase, but then rises.

Average Total Cost (ATC)

• ATC declines initially with the output increase and then rises. This mirrors AVC.

The Production Function and the Law of Diminishing Returns

• The production function illustrates the relationship between the maximum amounts of output a firm can produce and various quantities of inputs.

• Businesses try to keep production and costs down by optimizing factors of production, like labor (L, La) or capital (k) in the best combinations. The law of diminishing returns explains how, once sufficient resources have been applied to production, addition outputs will start to slow down considerably or even decrease as more resources are used.

• Example: A farm with a fixed amount of land (fixed resource) adding more workers will lead to decreasing marginal returns after a certain point.

Economies of Scale

• Large scale production creates economies for enterprises, making them operate more efficiently. Benefits include advantages in pricing, lower fixed costs spreading out over more output, and improved brand recognition (e.g., Smith's Pin Factory).

Diseconomies of Scale

• Inefficiencies that occur in larger corporations.

Decision Making in the Short Run

• Decide to operate, or shut down.

Decision Making in the Long Run

• Decide to stay in business, or go out of business.

Theory of Consumer Behavior

• Consumers weigh the benefit (utility) against the cost (price)
• Consumers will pay the price they feel is justified; you do not have to pay outrageous prices but you can make your own choice.
• Consumers will continue buying goods and services until the marginal utility equals the price.

Marginal Utility

• The satisfaction a buyer gets from one additional unit of a good/service. Utility will reach a limit and then diminish as the good is consumed more and more.
• Example - A consumer is hungry enough to buy 4 hot dogs at the price of 2.He′sstillhungry,butiswillingtopayonly2. He's still hungry, but is willing to pay only 2.He′sstillhungry,butiswillingtopayonly1 for a 5th hot dog.

Total Utility

• The total satisfaction derived from consuming a fixed number of units of a good or a service.

Maximizing Utility

• In almost all real-world situations, consumers maximize utility by spending their money according to marginal utility.

What determines market price?

• Supply and demand (at the equilibrium point).

Perfect Competition

• Characteristics include many sellers and buyers (no dominant sellers), identical products, and no barriers for new firms to enter or exit the market.
• A seller that increases its prices will lose all sales; a seller that decreases its prices will have no additional sales because others will follow.
• A firm operating in a perfectly competitive market has no control over price.
• The firm in the market will only operate if it reaches a breakpoint/equilibrium point where its marginal cost equals its marginal revenue. Any lower, the firm suffers a loss and should no longer be in the market, and exit/leave.

Efficiency

• This occurs at the minimum point of the average total cost (ATC). This is the breakeven point.