Understanding Production Costs

Production Costs

• Production cost refers to the total expenses a company incurs to produce goods or services.
• It includes all costs, from raw materials to machinery used in the final product's manufacturing.
• Companies use factors of production: capital (K), labor (L), electricity, and raw materials.
• Explicit costs are costs that result in an outflow of money for the firm, such as wages, rent, and materials.
• Implicit costs do not result in an outflow of money for the firm, such as the owner's time or capital invested.
• Explicit costs are actual payments made, like wages or office rent.
• Implicit costs represent the opportunity cost of using resources the firm already owns.
• Opportunity cost is the benefit or profit an individual loses by choosing one alternative over another; the value of the next-highest-valued alternative use of a resource.
• Economists consider both explicit and implicit costs.
• A firm transforms inputs into output, creating added value.
• Companies use capital (K) and labor (L) to produce products or services. In the short term, capital is fixed.
• Electricity and raw materials are also used (intermediate consumption).
• The process of a firm includes turning labor, capital, and materials into goods/services.
• This is bound by technological and market constraints.

Fixed Costs (FC)

• Fixed costs are expenses that do not change with production levels.
• They remain constant regardless of how much a company produces or sells, such as rent, property tax, and insurance.
• Total cost: Fixed costs (FC) + Variable costs (VC)
• Total fixed costs are independent of the quantity produced.
• Average fixed costs (AFC) are the fixed costs per unit of output.
• It's calculated by dividing total fixed costs by the quantity of output.
• As production increases, fixed costs are distributed across more units, causing average fixed cost to decrease.
• As total fixed cost (TFC) is a constant, the average fixed cost (AFC) always falls as output increases.

Variable Costs (VC)

• Variable cost expenses that change in direct proportion to the level of production or business activity.
• As production increases, variable costs rise, and vice versa. Examples include wages, raw materials, and energy.
• Average variable cost (AVC) represents the variable cost per unit of output.
• Calculated by dividing total variable costs (VC) by the quantity of output produced.
• The average variable cost curve initially decreases, reaches a minimum, then increases.
• The AVC tends to fall as output increases but it will eventually start to rise again.
• This is explained by the law of diminishing marginal returns, where, as more variable input units (labor or raw materials) are added to a fixed amount of other inputs (capital or land), additional output (marginal product) eventually decreases if all other factors are constant.
• The law of diminishing marginal returns states that after an optimal level of capacity is reached, adding an additional production factor results in smaller output increases.
• Under diminishing returns, output remains positive, but productivity decreases.
• The marginal return (or productivity) from an additional production factor (labor) decreases, all other things being equal.
• As an example, a company that operates at an optimal level and manufactures its products with consistency of production can reduce its efficiency by adding more workers.

Marginal product (MP)

• Marginal product (MP) refers to the additional output produced by adding one more unit of a variable input (like labor or raw materials) while keeping other inputs constant.
• It measures the change in total output resulting from a change in the quantity of a specific input.
• Marginal Product (MP) is calculated using the formula: ΔQ / ΔL, where ΔQ represents the change in total output and ΔL represents the change in the amount of the variable input being used.

Total Cost (TC)

• The total product increases rapidly but can slow down at a certain point.
• Labor productivity increases through specialization, learning, and fixed factor utilization, leading to rising marginal returns.
• From the 4th worker, the marginal product decreases, and labor productivity falls.
• Fixed production factors cannot accommodate more than 3 workers.
• Total cost (TC) is the sum of all costs incurred in producing goods or services, including both fixed (FC) and variable costs (VC).
• Total Cost (TC) = f(Q) = Fixed Costs (FC) + Variable Costs (VC).
• Average total cost (ATC) is the total cost per unit of output.
• It is calculated by dividing the total cost (TC) by the quantity of output produced.
• TC = FC + VC
• ATC = FC/Q + VC/Q
• ATC = AFC + AVC and AVC = ATC - AFC
• ATC tends to fall as output increases and then starts to rise again as output continues to increase, a trend similar to AVC.

Marginal Cost (MC)

• Marginal cost (MC) is the additional cost of producing one more unit (the cost of the last unit produced).
• It measures the change in total cost from a one-unit increase in production.
• Marginal Cost (MC) can be determined by analyzing the change.
• MC tends to fall as output increases, then rises as the output increases; the more a firm produces, the more it costs to produce an additional unit.
• This phenomenon is explained by the hypothesis of diminishing marginal returns.
• The MC increases because of the decreasing marginal productivity of a production factor (Labor in the SR).
• The average cost takes a U form.
• Economies and subsequent diseconomies of scale happen when a business grows so large that costs per unit increase due to technical or organizational issues.
• The MC and AC intersect at the minimum of the AC:
  • AC is neither increasing or decreasing if MC = AC, which puts AC at its minimum.
  • AC decreases if MC < AC.
  • AC grows if MC > AC, because the cost of producing the last unit is higher than the average cost of all units produced.
• Average cost per unit is the average cost for one unit (AC).

Cost Curve Links

• MC cuts the ATC and the AVC right at their minimum.
• The AC increases when MC gets bigger then it (ATC or AVC).

Exercise 1 - Netoivite

• Netoivite is a company that produces brooms. The following table describes the relationship between the number of workers at Netoivite and the daily production level:
  • Marginal Product (MP) is increased by each additional worker.
  • As more workers are added, they can divide tasks and become specialized.
  • The total product increases at an increasing rate when the marginal product is increasing.
  • The marginal product begins to decrease and there are diminishing returns.
  • The amount of capital available in the factory is limited.
• The Total Cost is used to fill out the rest of the information:
  • A worker costs 100 euros a day and the firm has fixed costs of 200 euros. Use this information to fill in total costs.
    • Output with marginal product, fixed costs, and variable costs.
  • Marginal Cost (MC)=∆TP/ ∆Q
• Average Total Cost:
  • ATC = TC/Q
  • The curve of average total cost has a U-shape.
  • When the quantity is low, the average total cost decreases.
• Marginal cost results when the curve also has a U shape.
• With no employees, the firm has 200 euros fixed. Upon hiring its first employee, total costs increase 100 euros, and the number of brooms produced jumps by 20, so the marginal cost per broom is 5 euros.
• Upon adding a second worker the firm produced can produce another 30 brooms at a marginal cost of 3,33 euros each. As more workers are added beyond the third worker, the firm's marginal cost starts to increase.
• The marginal product (MP) increases with the marginal cost (MC).
• It means that the cost of the last produced unit leads to the reduction of Average Total Cost (ATC).

Cost Curve Links

• The MC cuts the ATC and the AVC right in their minimum.
• When the MC gets bigger then the AC (ATC or AVC) then the AC increases.
• If MC = AC then AC gets its minimum value.

Exercise 3

TC= 15 q²+4 q+ 1000:

• Give the expression of the variable cost (VC) and fixed cost (FC).
• The variable cost (VC) is the part of the total cost which varies according to the produced quantities. The fixed cost (FC) is the constant part of the total cost.
• Give the expression of the average variable cost (AVC) and average total cost (ATC).
• The average marginal cost means cost/unit =variable cost/unit and the marginal product of average cost is Total cost/unit.
• The expression of the marginal cost (MC) corresponds to the cost of the last produced unit. It is necessary to derivate the total cost.
• The efficient scale corresponds to the intersection point between the marginal cost (MC) and the average cost (AC)
• The Marginal cost (MC) = price (P)
• The curve of average cost in its minimum determines efficient scale.

Checkpoint

• Is what can explain the usual U shape of the average cost.
  • The U-shape of the average cost curve reflects the interplay between economies of scale and diseconomies of scale.
  • Initially, as production increases, average costs tend to fall due to spreading fixed costs over more units (economies of scale).
  • Beyond a high level of production the average cost will increase.

Long- Term Costs

• Long-term costs are when a firm adjusts all their fixed and variable inputs.
• Companies can change all their resources to find the most efficient way to produce, unlike in the short term, where some resources are fixed.
• In the long term, all fixed assets can change.
• Relationship of long term costs.
• The firm will continue to grow its business so that costs per unit increase due to technical or organizational issues.

Economies of Scale

• Economies of scale provide cost advantages when output increases.
• As goods or services increase, the average cost per unit decreases because fixed costs are spread across more units, leading to increased efficiency.
• Production becomes more efficient as the quality of output increases.
• This is an advantage for companies that are large.
• Examples: production of steel, aluminum, electricity, cars, oil refining, gas distribution.

Diseconomies of Scale

• Diseconomies of scale occur when a company's average cost per unit of output increases because of its size.
• The benefits of growing larger are exceeded through inefficiencies.
• Companies need to make new investments to expand production.
• This leads to a marginal cost of production and average cost increase.

The minimum efficient Size

• The minimum efficient size refers to the lowest level of production when a production can produce goods or service at long term.
• At this point, the company has maximized economies of scale, and increasing size further no longer reduces costs per unit.

Conclusion

• Marginal product is the additional output generated by an additional worker : ∆ TP/ ∆L.
• Is the average cost for one unit or unit cost of production.
• Fixed cost is the sum of all costs that are independent of the level of production.
• Average cost per unit: profits are maximized when marginal revenue equals marginal cost (MR = MC).
• The company can maximize output potential by affecting costs.