13The Costs of Production.docx
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13The Costs of Production.docx
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13TheCostsofProduction
THECOSTSOFPRODUCTION
INTHISCHAPTERYOUWILL...
Examinewhatitemsareincludedina
firm’scostsofproduction
Analyzethelinkbetweenafirm’s
productionprocessanditstotalcosts
Learnthemeaningofaveragetotal
costandmarginalcostandhowtheyarerelated
Theeconomyismadeupofthousandsoffirmsthatproducethegoodsandser-vicesyouenjoyeveryday:
GeneralMotorsproducesautomobiles,GeneralElectricproduceslightbulbs,andGeneralMillsproducesbreakfastcereals.Somefirms,suchasthesethree,arelarge;theyemploythousandsofworkersandhavethou-sandsofstockholderswhoshareinthefirms’profits.Otherfirms,suchasthelocalbarbershoporcandystore,aresmall;theyemployonlyafewworkersandareownedbyasinglepersonorfamily.
Inpreviouschaptersweusedthesupplycurvetosummarizefirms’produc-tiondecisions.Accordingtothelawofsupply,firmsarewillingtoproduceandsellagreaterquantityofagoodwhenthepriceofthegoodishigher,andthisresponseleadstoasupplycurvethatslopesupward.Foranalyzingmanyquestions,thelawofsupplyisallyouneedtoknowaboutfirmbehavior.
Inthischapterandtheonesthatfollow,weexaminefirmbehaviorinmorede-tail.Thistopicwillgiveyouabetterunderstandingofwhatdecisionsliebehind
Considertheshapeofatypicalfirm’scostcurves
Examinetherelationship
betweenshort-runandlong-runcosts
269
thesupplycurveinamarket.Inaddition,itwillintroduceyoutoapartofeco-nomicscalledindustrialorganization—thestudyofhowfirms’decisionsregardingpricesandquantitiesdependonthemarketconditionstheyface.Thetowninwhichyoulive,forinstance,mayhaveseveralpizzeriasbutonlyonecabletelevi-sioncompany.Howdoesthisdifferenceinthenumberoffirmsaffectthepricesinthesemarketsandtheefficiencyofthemarketoutcomes?
Thefieldofindustrialor-ganizationaddressesexactlythisquestion.
Asastartingpointforthestudyofindustrialorganization,thischapterexam-inesthecostsofproduction.Allfirms,fromDeltaAirLinestoyourlocaldeli,in-curcostsastheymakethegoodsandservicesthattheysell.Aswewillseeinthecomingchapters,afirm’scostsareakeydeterminantofitsproductionandpricingdecisions.Establishingwhatafirm’scostsare,however,isnotasstraightforwardasitmightseem.
WHATARECOSTS?
WebeginourdiscussionofcostsatHungryHelen’sCookieFactory.Helen,theownerofthefirm,buysflour,sugar,flavorings,andothercookieingredients.Shealsobuysthemixersandovensandhiresworkerstorunthisequipment.Shethensellstheresultingcookiestoconsumers.ByexaminingsomeoftheissuesthatHe-lenfacesinherbusiness,wecanlearnsomelessonsthatapplytoallfirmsintheeconomy.
TOTALREVENUE,TOTALCOST,ANDPROFIT
totalrevenue
theamountafirmreceivesforthesaleofitsoutput
totalcost
themarketvalueoftheinputsafirmusesinproduction
profit
totalrevenueminustotalcost
Webeginwiththefirm’sobjective.Tounderstandwhatdecisionsafirmmakes,wemustunderstandwhatitistryingtodo.ItisconceivablethatHelenstartedherfirmbecauseofanaltruisticdesiretoprovidetheworldwithcookiesor,perhaps,outofloveforthecookiebusiness.Morelikely,however,Helenstartedherbusi-nesstomakemoney.Economistsnormallyassumethatthegoalofafirmistomax-imizeprofit,andtheyfindthatthisassumptionworkswellinmostcases.
Whatisafirm’sprofit?
Theamountthatthefirmreceivesforthesaleofitsout-put(cookies)iscalleditstotalrevenue.Theamountthatthefirmpaystobuyin-puts(flour,sugar,workers,ovens,etc.)iscalleditstotalcost.Helengetstokeepanyrevenuethatisnotneededtocovercosts.Wedefineprofitasafirm’stotalrev-enueminusitstotalcost.Thatis,
ProfitTotalrevenueTotalcost.Helen’sobjectiveistomakeherfirm’sprofitaslargeaspossible.
Toseehowafirmgoesaboutmaximizingprofit,wemustconsiderfullyhow
tomeasureitstotalrevenueanditstotalcost.Totalrevenueistheeasypart:
It
equalsthequantityofoutputthefirmproducestimesthepriceatwhichitsellsits
output.IfHelenproduces10,000cookiesandsellsthemat$2acookie,hertotal
revenueis$20,000.Bycontrast,themeasurementofafirm’stotalcostismore
subtle.
COSTSASOPPORTUNITYCOSTS
WhenmeasuringcostsatHungryHelen’sCookieFactoryoranyotherfirm,itisimportanttokeepinmindoneoftheTenPrinciplesofEconomicsfromChapter1:
Thecostofsomethingiswhatyougiveuptogetit.Recallthattheopportunitycostofanitemreferstoallthosethingsthatmustbeforgonetoacquirethatitem.Wheneconomistsspeakofafirm’scostofproduction,theyincludealltheopportunitycostsofmakingitsoutputofgoodsandservices.
Afirm’sopportunitycostsofproductionaresometimesobviousandsometimeslessso.WhenHelenpays$1,000forflour,that$1,000isanopportunitycostbecauseHelencannolongerusethat$1,000tobuysomethingelse.Similarly,whenHelenhiresworkerstomakethecookies,thewagesshepaysarepartofthefirm’scosts.Theseareexplicitcosts.Bycontrast,someofafirm’sopportunitycostsareimplicitcosts.ImaginethatHelenisskilledwithcomputersandcouldearn$100perhourworkingasaprogrammer.ForeveryhourthatHelenworksathercookiefactory,shegivesup$100inincome,andthisforgoneincomeisalsopartofhercosts.
Thisdistinctionbetweenexplicitandimplicitcostshighlightsanimportantdifferencebetweenhoweconomistsandaccountantsanalyzeabusiness.Econo-mistsareinterestedinstudyinghowfirmsmakeproductionandpricingdecisions.Becausethesedecisionsarebasedonbothexplicitandimplicitcosts,economistsincludebothwhenmeasuringafirm’scosts.Bycontrast,accountantshavethejobofkeepingtrackofthemoneythatflowsintoandoutoffirms.Asaresult,theymeasuretheexplicitcostsbutoftenignoretheimplicitcosts.
ThedifferencebetweeneconomistsandaccountantsiseasytoseeinthecaseofHungryHelen’sCookieFactory.WhenHelengivesuptheopportunitytoearnmoneyasacomputerprogrammer,heraccountantwillnotcountthisasacostofhercookiebusiness.Becausenomoneyflowsoutofthebusinesstopayforthiscost,itnevershowsupontheaccountant’sfinancialstatements.Aneconomist,however,willcounttheforgoneincomeasacostbecauseitwillaffectthedecisionsthatHelenmakesinhercookiebusiness.Forexample,ifHelen’swageasacom-puterprogrammerrisesfrom$100to$500perhour,shemightdecidethatrunninghercookiebusinessistoocostlyandchoosetoshutdownthefactoryinordertobecomeafull-timecomputerprogrammer.
THECOSTOFCAPITALASANOPPORTUNITYCOST
Animportantimplicitcostofalmosteverybusinessistheopportunitycostofthefi-nancialcapitalthathasbeeninvestedinthebusiness.Suppose,forinstance,thatHe-lenused$300,000ofhersavingstobuyhercookiefactoryfromthepreviousowner.IfHelenhadinsteadleftthismoneydepositedinasavingsaccountthatpaysanin-terestrateof5percent,shewouldhaveearned$15,000peryear.Toownhercookiefactory,therefore,Helenhasgivenup$15,000ayearininterestincome.Thisforgone
$15,000isoneoftheimplicitopportunitycostsofHelen’sbusiness.
Aswehavealreadynoted,economistsandaccountantstreatcostsdifferently,
andthisisespeciallytrueintheirtreatmentofthecostofcapital.Aneconomist
viewsthe$15,000ininterestincomethatHelengivesupeveryyearasacostofher
business,eventhoughitisanimplicitcost.Helen’saccountant,however,willnot
showthis$15,000asacostbecausenomoneyflowsoutofthebusinesstopayforit.
Tofurtherexplorethedifferencebetweeneconomistsandaccountants,let’s
changetheexampleslightly.SupposenowthatHelendidnothavetheentire
explicitcosts
inputcoststhatrequireanoutlayofmoneybythefirm
implicitcosts
inputcoststhatdonotrequireanoutlayofmoneybythefirm
$300,000tobuythefactorybut,instead,used$100,000ofherownsavingsandbor-rowed$200,000fromabankataninterestrateof5percent.Helen’saccountant,whoonlymeasuresexplicitcosts,willnowcountthe$10,000interestpaidonthebankloaneveryyearasacostbecausethisamountofmoneynowflowsoutofthefirm.Bycontrast,accordingtoaneconomist,theopportunitycostofowningthebusinessisstill$15,000.Theopportunitycostequalstheinterestonthebankloan(anexplicitcostof$10,000)plustheforgoneinterestonsavings(animplicitcostof$5,000).
ECONOMICPROFITVERSUSACCOUNTINGPROFIT
economicprofit
totalrevenueminustotalcost,includingbothexplicitandimplicitcosts
accountingprofittotalrevenueminustotalexplicitcost
Nowlet’sreturntothefirm’sobjective—profit.Becauseeconomistsandaccoun-tantsmeasurecostsdifferently,theyalsomeasureprofitdifferently.Aneconomistmeasuresafirm’seconomicprofitasthefirm’stotalrevenueminusalltheoppor-tunitycosts(explicitandimplicit)ofproducingthegoodsandservicessold.Anac-countantmeasuresthefirm’saccountingprofitasthefirm’stotalrevenueminusonlythefirm’sexplicitcosts.
Figure13-1summarizesthisdifference.Noticethatbecausetheaccountantig-norestheimplicitcosts,accountingprofitislargerthaneconomicprofit.Forabusi-nesstobeprofitablefromaneconom
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