Firm Production and Costs

The allocation of economic resources is determined by economic profit, which in turn depends on how much consumers are willing to pay for particular products (or services) and how much it costs for firms to produce those products. If consumers are unwilling to pay enough for suppliers to make an economic profit, then the product will not be produced.

The economics of firm behavior is first examined by showing the production function, which is the relationship between the firm's output and its input, which are all the factors of production necessary to produce the product. Obviously, for a firm to be profitable, the cost of its inputs must be less than the revenue received for its output. But even if there is an accounting profit, there must also be an economic profit, which is the amount of the accounting profit that is over and above the opportunity cost of producing the product. Opportunity cost is the amount that the suppliers would receive if they had produced the next most profitable product or did something else to earn money.

To be competitive, a firm must also achieve productive efficiency, converting inputs into outputs for the least cost.

Total, Average, and Marginal Product

To examine production in greater detail, we first look at short-run production, where only variable costs, such as labor, are varied according to market demand — there is no change in fixed assets, such as buildings. In such a case, only a few economic characteristics of short-run production pertain to output. Total product (TP) is the total quantity of a product produced. Marginal product (MP) is the additional output created by an additional unit of input, such as labor.

So, for instance, if a firm adds 1 worker, then the marginal product is the additional product that the firm can produce because of that additional worker. If the additional worker produces 7 extra widgets, then that is the marginal product for that worker.

Average product (AP) is the total product divided by the number of units of input, which is usually labor.

So if 10 workers can produce 50 widgets, then the average product = 5 widgets per worker.

One aspect of the production function is that, over the short run, increasing the number of inputs at first results in increasing marginal product, where the marginal product increases more than the number of input units added, but the output over input ratio eventually declines as the firm reaches its limit of production in terms of its fixed assets. For instance, a factory usually has assembly lines that require a minimum number of workers for its efficient operation. Hence, as a factory adds more workers to fill the assembly line positions, the marginal product increases faster than the inputs. Although the factory can increase its number of workers further to satisfy increased demand, the factory has only so much space, limiting the number of workers that can be added, unless it is willing to spend a lot more money for more space and equipment. Even within the factory, many more workers will interfere with each other and will compete for the available resources within the factory. Thus, increasing short-run inputs eventually leads to a diminishing marginal product, where the marginal product declines for each incremental increase in inputs.

Fixed and Variable Costs

A firm's cost of production consists of fixed and variable costs. Fixed costs are costs that do not vary with output quantity. A firm cannot produce anything until the capital investment is made to buy or rent space, buy equipment, get any necessary licenses, and to buy insurance, but once it makes this capital investment, then it becomes a sunk cost that can only be recouped if the firm can produce and sell its products. This is also true if an existing firm wants to increase its capital investment. Hence, most fixed costs are in the form of sunk costs. However, some fixed costs, such as rent, are paid periodically, but they are fixed in the sense that there is either a contractual obligation to pay a fixed amount or the amount paid cannot be varied according to production.

Variable costs are costs directly proportional to the quantity of output, with labor and materials being the most common type of variable input. Hence, variable costs can be adjusted in real-time to market demand for the product.

Total Cost, Average Total Cost, Average Fixed Cost, and Average Variable Cost

Several types of costs relate cost to output. Total cost (TC) is the cost to produce a firm's entire output. Therefore:

Total Cost = Fixed Costs + Variable Costs

The average total cost (ATC) equals the total cost divided by the quantity of product produced.

The average fixed cost (AFC) equals total fixed costs divided by total product:

Likewise, the average variable cost (AVC) equals the total variable cost divided by the total product.

Marginal Cost and Average Total Cost

The marginal cost (MC) is the increase in total cost that results when an input is increased by one unit, such as adding an additional worker.

So if it costs $1000 to make 100 widgets, and $1800 to make 200 widgets, then the marginal cost = ($1800 - $1000)/(200 - 100) = $800/100 = $8 per widget.

For instance, suppose that the average of 3 numbers is 5. If you add another number that is less than 5, then the average will decline; if the number is larger, then the average will increase. Likewise for average total costs and marginal costs. Since the marginal cost is the cost of an additional unit of output, ATC will continually decline as long as the marginal cost is less than the ATC; ATC starts to increase when the marginal cost exceeds the ATC. When ATC is graphed with the marginal cost, then the marginal cost curve crosses the ATC curve when the marginal cost = ATC, as can be seen in the diagram below, which is based on the following table:

Average Total Costs in the Long Run

The difference between fixed and variable costs depends on the time period and the type of business. A small business can probably change fixed assets relatively quickly, while products that require large factories, such as those used to produce integrated chips, may take several years and cost billions of dollars.

The shape of the ATC curve over the long-run is also U-shaped, although it is generally flatter in the middle. As the first inputs are added, average total costs decline because of the distribution of fixed costs over more units of output, specialization of labor, the increased know-how of management, and a more efficient organization that comes from increased experience. These factors allow economies of scale, which is the reduction of average total costs as production increases. Economies of scale exist because all firms have fixed costs, so increasing the number of widgets sold reduces the fixed cost per unit, which lowers average total costs until diseconomies of scale set in, where the productivity of fixed assets reach their limit.

Firms may also have economies of scope, where the cost of producing several products using the same fixed assets is reduced.

Eventually, the long-run ATC curve flattens, as more companies enter the competition to produce the product. This yields a constant return to scale, where ATC remains the same as production increases further. At some point, a further increase in production will cause the ATC to increase, causing diseconomies of scale.

Diseconomies of scale are caused primarily by competition for the inputs necessary to produce the product, such as labor or materials. Diseconomies of scale are also caused by multiple companies producing the same product, since there is a lack of organization within the industry and because of different levels of efficiency within each company. Even individual companies may experience diseconomies of scale because large enterprises become difficult to manage, which is evident by the fact that most large companies eventually stop growing, and many eventually break apart, such as when more profitable units are spun off into separate companies. Diseconomies also result from individual groups within the company competing for resources, and often those resources are allocated to the more powerful groups, even if they are not the most profitable or have the best potential. Furthermore, large enterprises tend to stifle innovation, by promoting people most simpatico with their bosses over those best qualified for the job.

A natural monopoly business, however, is generally not subject to diseconomies of scale, at least in regards to its natural monopoly product. A natural monopoly exists when the average total cost for a product continually declines over the entire market demand quantity. One of the best examples of a natural monopoly business are software companies. Once the software is produced, it can easily be copied and distributed at little cost, regardless of the quantities, especially over the Internet. Likewise, for digital information in the form of digital music, books, TV, and movies. For a natural monopoly business, ATC would be steep for the first few products, but would then drop dramatically as production increased, asymptotically approaching zero for millions of copies, which is why many founders of software companies or Internet firms become wealthy.