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Cost and Short Run Production Decisions

Ultimately, we want to be able to understand production so that we can understand the production and supply decisions of sellers.
Sellers' decisions are based on the cost of producing goods or services. Cost, in turn, is based on the ability to produce.

Counting the Cost

The opportunity costs associated with using resources that are owned by a firm (producer), and which don’t involve a money payment, are called implicit costs.

Costs of using resources that must be purchased, and thus require monetary payment are explicit costs.

The implicit (normal) rate of return that must be earned by investors to continue to supply capital to a firm is called the opportunity cost of capital, equal to the amount that could be earned on alternative investments. This is roughly the interest that could be earned if the capital asset owned by the firm were sold, and the funds invested in some other way.

We call the costs that cannot be (or don't need to be) changed in the short run fixed costs.
Fixed costs are the costs associated with capital and similarly fixed inputs (in the short run)

We call the costs that can be changed in the short run when more output is produced variable costs.
Variable costs are the costs associtated with labor and other variable inputs in the short run.

Since only variable costs can change in the short run, all short run decisions are made based solely on variable costs.


But we have different kinds of variable cost which we might want to consider, depending upon the decision we are trying to make.

Suppose a seller is trying to decide whether she can afford to sell a unit of a good at a particular price. If the price a buyer will pay is the only benefit she will receive for selling the good, then she will compare the price to her cost of selling one unit of the good to that buyer.
We call the cost of making and selling one unit of a good the marginal cost.
Marginal cost tells us how much to make. If the price of the good is at least as big as the marginal cost of making one more of the good, then it's worth making and selling that one more unit.

Marginal Cost and Marginal Product

The marginal cost is determined by the marginal product.

For example, if one more unit of labor costs $10 to hire and will make 10 units of output, each of those units of output costs $1. We can thus calculate the cost of each individual (additional) unit of output.

The wage of hiring one more worker divided by the amount of product made by that particular worker will tell us the money cost of one more unit of ouput, or the marginal cost.

wage/marginal product = marginal cost

Another way of looking at this is to say that the marginal cost is the change in spending on labor divided by the change in output that results when one more unit of labor is hired.

Technically, the spending on labor is called the variable cost, if labor is the only variable input.

So, the marginal cost could also be defined as the change in variable cost divided by the change in output.

Using MC for marginal cost, MP for marginal product, and VC for variable cost, we get the following relationships:
or

A Bit Broader View

Suppose a seller is trying to decide whether to make any product at all. If the seller decides not to make anything today (or this week or this month) the seller will still have his fixed costs, but can avoid the variable costs in the short run. He can do this by having his workers stay home and by not ordering any materials.
To make this decision the seller will weigh the revenue he would get from today's production against the variable cost of making output today. This is still a short run decision, but it is a bit bigger than the decision of whether or not to make one more unit of the product.

When considering today’s variable cost against today’s revenue:

If Revenue is greater than or equal to Variable Cost, then open (produce), or
If PxQ ≥ Variable Cost, then open, or (dividing by the amount of output, Q)
We call the variable cost per unit of output...

average variable cost (AVC). So if
P ≥ AVC (Average Variable Cost), then open up

AVC will depend on the level of output we produce, but as long as the price is greater than AVC at even its lowest point (its minimum), it will pay to open.

Average Variable Cost and Average Product




But

is called the average product, so


The average product is the amount of output produced per worker. It is not the same as the marginal product, because it does not measure the output of a particular unit of variable input, but the average output of all the units of variable input being used. However, like the marginal product, it will change as different amounts of variable input are used.

Summing Up
A producer in the short run can make two kinds of decisions.
1. To produce or not to produce...

First, the producer must decide whether to produce anything at all or not (to open up or shut down). The cost that helps it make this decision is the average variable cost. If the price of the product is at least as big as the minimum average variable cost, then the producer will produce (open up). Otherwise, it will produce nothing (also called a shut down).
The average variable cost is inversely related to the average product, which is the output divided by the amount of variable input used.

P≥ AVC means the producer should produce something.


2. How much to produce...

Second, the producer must decide how much to produce. The cost that helps it make this decision is the marginal cost. If the price of a particular unit of the product is at least as big as the marginal cost of producing that unit, then the producer will gain more by producing the unit than it costs. The seller will thus want to produce every unit that costs less (in terms of marginal cost) than the price. If the marginal cost just equals the price, then it doesn't matter if that particular unit is made or not.
The marginal cost is inversely related to the marginal product; the marginal product is the change in output output divided by the change in the amount of variable input used to produce the additional product.

P≥ MC means the producer should produce a particular unit.

Copyright 2006 by Ray Bromley. Permission to copy for educational use is granted, provided this notice is retained. All other rights reserved.
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