Chapter 6: Costs, Profits, Revenues : Part 1

Felix Losch

Mr. Eschrich

IB2 Economics

Chapter 6: Costs, Profits, Revenues : Part 1

Cost Theory

What is cost theory?

Cost theory is the analysis of the firm in order to evaluate the quantity of production that maximizes profit or minimizes cost. The costs in this calculation include opportunity cost, Fixed costs, and variable costs; which lead into the overarching concept of short run and long run costs. Following is an explanation of each individual term and their relationship to the firms cost theory.

Opportunity cost

Opportunity cost is one of the most basic concepts in economics. It is often neglected to be considered when making a purchase, but it is a very real cost that companies and individuals face. Opportunity cost is anything one could do instead of the considered decision. For example if an individual purchases candy worth 5$, the opportunity cost is composed of all the other things the individual could have purchased with said 5$. This could be a pizza that costs 5$, a book, or anything else that the money could have been used for. However opportunity cost does not always have to be of monetary nature. The opportunity cost of taking the dog out to walk for an hour can be that one can't do homework or watch a movie during that time. Almost every decision has an opportunity cost.

For companies opportunity cost plays a very important role when trying to decide what to produce. For example the opportunity cost of Firm A to produce five thousand calculators might be the production of five hundred laptops because the resources are limited and can only be devoted to one of the two. This is how opportunity cost weaves in with cost theory, because a company has to make the critical decision about producing the right amount of each product in order to maximize profit or minimize losses.

Fixed Costs

Fixed costs are a company's costs of operation that are not dependent on the level of output and that the firm cannot eliminate by shutting down temporarily. These costs can be composed of property taxes, machine maintenance, and advertisement. These costs are only considered “fixed” in relation to the level of output. In relation to time, fixed costs can fluctuate. For example the rent for a building does not increase if the company produces more, but the landlord can demand more rent upon the renewal of the contract. Fixed costs are one of the two components of total cost, with variable costs being the other.

Variable Costs

Variable Costs are a company's costs of operation that are dependent on the level of output and that a firm can eliminate by shutting down temporarily. These costs can be composed of raw material costs or utility expenses. If a firm shuts down, the variable costs are eliminated since there are no more resources required and the company does not need any more utilities such as electricity or water. The variable costs are dependent on the level of output because as a company produces more it will in effect need more resources, which will therefore increases the costs for the company. Variable costs and Fixed costs make up the total cost for a company.

Long run vs. Short run

Factors of Production

Factors of production are any input considered during production in a company. These factors are categorized between fixed and variable factors.

Fixed factors are made up of any factors that cannot be changed in the time period under consideration. A good example of a fixed factor is machinery. For example if Firm A produces cars and wants to increase production, they might need more robots. The robots have to be produced and shipped, which takes approximately 3 to 4 weeks. In this time frame machinery is therefore a fixed factor.

Variable factors, as said by the name, can be changed by the company in the considered time frame. For example most raw materials are considered a variable factor of production because their input quantity can easily be changed. As one can conclude, the only way to change output in the short run is to change the variable factors of production.

Short Run in Production

Many companies consider the short run for a single factor of production to be the time frame in which at least one factor of production is fixed. While all factors of production can be modified by the company in the long-term, there is fixed factors which, as previously explained need time to be adjusted.

Total, Average and Marginal Product

All of the output within a given time period make up the total product. The average product(AP) is calculated by taking the total product(TP) and dividing it by the the amount of variable factors that have been used in production(V). This is portrayed by the formula: AP = tp/v . The term marginal refers to “the next one” and therefore Marginal product is the change in total product(∆TP) per change of Variable factor(∆V); as portrayed by the formula MP=∆TP/∆V. The following table explains the relationship between Total Product, Average Product and Marginal Product further:

Electricity / Pens / Average Product / Marginal Product
0
30
1 / 30 / 30
40
2 / 70 / 35
50
3 / 120 / 40
40
4 / 160 / 40
30
5 / 190 / 38
20
6 / 210 / 35

Electricity being the variable factor is increased, therefore making the machines produce more pens. The marginal product initially increases but in the end it decreases. This introduces the law of diminishing returns.

Diminishing Returns

The law of diminishing returns explains the theory that when one introduces more and more variable factors of production, at some point there will be a fixed factor of production that starts to limit the marginal product. To make this concept easier to understand one can consider this example: A company orders more copper in order to produce more computers. As the demand increases they want to produce even more computers, but the company will not be able to achieve this by just purchasing more copper all the time if the machinery can only produce so much. Another limiting factor could be the size of the facility in which production takes place.

Short and Long Run Costs

When looking at short run costs, economists separate them into several categories. Total Costs and Average costs. Total costs are made up of total variable costs(TVC) and total fixed costs(TFC). Total variable costs are the addition of all of the variable costs faced during production while total fixed costs are the addition of all the fixed costs. The Average fixed(AFC)and variable costs(AVC) are calculated by the following formulas: AFC= TFC/q AVC= TVC/q in which q is the level of output.

To simplify the relationship between all of these costs consider the following graph:

As seen in the graph, Average Total cost(ATC) troughs at the intersection with marginal cost(MC). This can be explained by logic, because if the next item costs more than the average cost of the items, the average will go up.

The average cost curve

The average cost curve is a more complex curve than it seems at first. The lowest point of the average cost curve is the point of productive efficiency (the production of the most output from the least input). The average cost curve also portrays the short and long term. The long run average cost curve(LRAC) is made up of infinitely many short run average cost curves(SRAC) as explained in the following paragraphs.

SRAC

As previously explained, there is fixed factors and variable factors in the short run. A firm always operates in the short run and can therefore not modify the level of output greatly without experiencing increased costs.

LRAC

In the long run, a company is able to plan and modify both its fixed and variable factors. Therefore the long run average cost curve is an envelope curve that is a representation of many Short run average cost curves as portrayed in the diagram below.

The long run average cost curve is also a representation of the levels during which a company experiences increasing, constant, or decreasing returns to scale; which are also known as economies and diseconomies of scale. On its most basic level, the area above the LRAC curve is attainable for the company, meaning it will be able to produce at the given costs. Anything below the LRAC curve is unattainable.

Economies and Diseconomies of Scale

Internal Economies of Scale

Economies of scale is a term economists use to describe a decrease in long term average costs as a company increases the level of output. There are several reasons as to why companies experience economies of scale. Specialization: As firms grow bigger, workers can specialize on what they are best at, may this be marketing, finance, or production. Division of Labor: Instead of having one person complete the whole process on a product, each person takes one step in the process and does this repeatedly. Bulk Buying: As a company buys great amounts of raw materials they might be able to agree on discounts with the suppliers Financial Economies: Large firms are considered less of a risk and therefore banks are more willing to lend to them. Large firms have easier access to money Transport Economies: The more products a firm ships the less cost there will be per unit Large Machines: As a firm invests in larger machines the machines will also be more productive and efficient Promotional Economies: Advertisement is considered a fixed cost, and therefore the cost per unit will fall as more units are produced.

Internal Diseconomies of Scale

Diseconomies of scale is a term economists use to describe an increase in long term average costs as a company increases the level of output. Diseconomies of scale theoretically happen because of control and communications problems as the company expands and management is not able to control every aspect of production anymore. Also as the firm grows individuals tend to lose the sense of loyalty to the company and act much more for their own good. The term theoretically is used because no no company has been seen to grow big enough to experience this phenomena.

External Economies and Diseconomies of Scale

External Economies of scale can be caused by the creation of universities and other places of education that increase the productivity of the workers without adding extra costs to the company. External diseconomies of scale could be cause by an increase in competition as others see the firm being successful.