Cost of Production

The economy is made up of thousands of firms that produce the goods and services you enjoy every day. General Motors produces automobiles, General Electric produces light bulbs, and General Mills produces breakfast cereals. Some firms, such as these three, are large they employ thousands of workers and have thousands of stockholders who share in the firm’s profits. Other firms, such as the load barbershop or candy store, are small. They employ only a few workers and are owned by a single person of study.

We used the supply curve to summarize a firms’ production decisions. According to the law of supply, firms are willing  to produce and sell a greater  quantity of a good when the price of the good is higher and this response leads to a supply curve that slopes upward. For analysing many questions the law of supply is all you need to know about firm behaviour.

We examine firm behaviour in more detail. This topic will give you a better understanding of what decisions lie behind the supply curve in a market. In addition, it will introduce you to part a part of economics that is called industrial organization —  the study of how any firms’ decision on prices  and quantities depend on the market  conditions they face. The place where you live, for instance may have several pizzerias but only one cable television company. It raises a few key questions. How does the number of firms affect the prices  in a market and the efficiency of the market outcome? The field of industrial organization addresses exactly this question.

Before we turn to those issues, however, we need to discuss the cost of production. All firms, from Delta Airlines to your local delivery, incur costs as they make the goods and services that they sell. Firm’s costs are a key determinant of its production and pricing decisions. In this article we define some of the variables that economists use to measure a firm’s costs and we consider the relationships among these variables.

A word of warning: This topic is dry and technical. To be brutally honest,   one might even call it boring. But this material provides a crucial foundation for the fascinating topics that follow.

What are costs?

We begin our discussions of costs at Hungry Helen’s Cookie  Factory. Helen, the owner of the firm buys flour, sugar, chocolate chips and other cookie ingredients. She also buys the mixers and ovens and hires workers to run this equipment. She then sells the cookies to consumers. By examining some of the issues that Helen faces in her business we can learn some lessons about costs that apply to all firms in the economy.

Total Revenue, Total Cost, and Profit:

We begin with the firm’s objective. To understand the decisions a firm makes, we must understand what it is trying to do.  It is conceivable that Helen started her firm because of an altruistic desire to provide the world  with cooking or, perhaps, out of love  for the cookie business. More likely Helen started her business to make money. Economists normally assume that the goal of a firm is to maximize profit, and they find that this assumption works well in most cases.

What adds to a firm’s profit? The amount that the firm receives for the sale of its output (cookies) is called its total revenues. The amount that the firm pays to buy  inputs (flour, sugar, workers, ovens and so forth) is called its total   cost. Helen gets to keep any revenue that is not needed to cover costs.  Profit is a firm’s total revenue minus its total cost. That is,

Profit = Total revenue — Total cost

Helen’s objective is to make her firm’s profit as large as possible.

To see how a firm goes  about maximizing profit, we must consider fully how to measure its total revenue and its total cost. Total revenue is the easy part; it equals the quantity of output the firm produces times the price at which it sells its output. If Helen produces 10,000 cookies and sells them at $2 a cookie, her total revenue is $ 20,000. By contrast the measurement of a firm’s total cost is more subtle.

Costs as opportunity costs:

When measuring costs at Hungry Helen’s Cookie factory or any other firm, it is important to keep in mind one of the Ten Principles of Economics.  The cost  of something is what you give up to get it. Recall that the opportunity cost of an item refers to all those things that must be forgone to acquire that item.

When economists speak of a firm’s cost of production, they include all the opportunity costs of making its output of goods and services.

Explicit costs: Input costs that require an outlay of money by the firm.

Implicit costs: Input costs that do not require an outlay of money by the firm.

A firm’s opportunity cost of production is sometimes obvious but sometimes less on. When Helen  pays $1,000 for flour, that $1000 is an opportunity cost because Helen can no longer use that $1000 to buy something else. Similarly, when Helen hires workers who make the cookies, the wages  she pays are  part of the firm’s costs. Because these costs require the firm  to pay out some money, they are called explicit costs. By contrast some of a firm’s  opportunity costs are called  implicit cost, as they do not require  cash outlay. Imagine that, Helen, is skilled at computers and could earn $100 per hour working as a programmer. For every hour that Helen works at her cookie factory she gives up $100 in income, and this forgone income is also   part of her costs. The total cost of Helen’s businesses is the sum of the explicit costs and the implicit costs.

The distinction between explicit and implicit costs highlights an important difference between how economists and accountants analyse a business. Economists are interested in studying how firms make production and pricing decisions. Because these decisions are based on both explicit and implicit costs, that economists  include when measuring a firm’s costs. In contrast accountants have the job of keeping track of the money that flows in and out of firms. As a result, they measure the explicit costs but often ignore the implicit costs.

The difference  between economists and accountants is easy to see in the case of Hungry Helen’s Cookie Factory. When Helen gives up the opportunity to earn money as a computer programmer, her accountant will not count this as a cost of cookies business. Because no money flows out of the business to pay for this cost, as it never shows up on the accountant’s financial statements. An economist however, will count the forgone income as a cost  because it will affect  the decision that Helen makes in her cookie business. For example if Helen’s wage as a computer programmer rises from $100 to $500 per hour, she might decide that running her cookie business is too costly and choose to shut down the factory to become a full time computer  programmer.

The cost of capital as an opportunity  cost:

An important  implicit cost of almost every business is the opportunity, cost of the financial capital that has been invested in the business. Suppose, for instance, that Helen used $300,000 of her savings to buy her cookie factory from the previous owner. If Helen had instead left this money deposited in a savings account that pays an interest rate of 5 per cent she would have earned $15,000 per year. To own her cookie factory, therefore Helen has given up $15,000 a year in interest income. This forgone $15,000 is one of the implicit opportunity costs of Helen’s business.

As we have already noted, economists and accountants treat cost differently, and this is especially true in their treatment of the cost of capital. An economist views the $15,000 in interest income that Helen gives up every year as a cost of her business event though it is an implicit cost. Helen’s  accountant however will not show this $15,000  as a cost because no money flows out of the business to pay for it.

To further explore the difference between economists and accountants let’s change the example, slightly. Suppose  now that Helen did not have the entire $300,000 to buy the factory but, instead used $100,000 of her savings  and borrowed $200,000 from a bank at an interests rate of 5 per cent. Helen’s  accountant, who only measures explicit costs, will now count the $10,000 interest paid on the bank loan every year as a cost because this amount of money now flows out of the firm. By contrast according to an economist, the opportunity cost of owning the business is still 15,000. The opportunity cost equals the interests on the bank loans (an explicit cost of $10,000 plus forgone interests on savings (an implicit cost of $5,000).

Now let’s return to the firm’s objective profit. Because economists and accountants measure costs differently, they also measure profit differently.  An economist measures a firm’s economic profit as the firm’s total revenue minus all the opportunity cost (explicit and implicit) of producing the goods and services sold.

Excerpts from Principles of Economics

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