“Cost of Production”
> Explanatory Article by Marios Kyriakou, MSc Economics
About the author: Marios Kyriakou has a bachelor’s degree in Economics from the University of Cyprus and a master’s degree in Economics from the University of Warwick. He is also a holder of CySEC’s Advanced Certificate in Financial Services Legal Framework and a professional in Online Trading, Forex and CFDs with more than 7 years of experience.
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<Last updated 11.04.2020>
Hi! If you are interested in Economics, I’ve prepared the below so you can find useful information that will help you in your studies and life in general. You should take a look at this short article in which I show the Costs associated with Production in a model example of an individual business.
A business wants to minimize the cost (and in doing so maximizing its profit). The business must buy factors of production: their price are the Payments/rewards , i.e. wage (for Labor), rent (for land, buildings and offices), interest (for capital or funds). To produce more, more quantities of factors of production are needed leading to higher cost.
There are two types of costs regarding production:
> Explicit Cost: It includes the expenditure of a business on factors of production that belong to others, third-parties (i.e. on labor, on raw materials, on buildings and offices).
> Implicit Cost: It includes the expenditure of a business on factors of production that belong to the entrepreneur. (i.e. interest on own capital, rent on own buildings and offices, his/her remuneration > Normal profit). Economists are interested how businesses take decisions regarding production and this needs to take into account all costs (including implicit costs which is similar to opportunity cost).
The difference between Accountants and Economists is that accountants observe money flows, money in and out (cash flows) taking into account only the explicit cost, the one that “can be seen”. while economists take the opportunity cost also into account.
As you can see, the Economic Cost is higher than the Accounting Cost due to implicit cost. Economic Profit is lower than the accounting profit due to this reason. Opportunity cost, in this example, is the amount of other goods given up in order to produce the good (real cost).
How does cost change when output changes? Just like production, we have both fixed factors and variable factors that contribute to the cost function of the business (at least in the short-run). When there are indeed also fixed factors we call this period the Short-Run.
Fixed Cost: It’s the cost that does not change when output changes. These are all expenses that are attributed to fixed factors of production (rent, wages of permanent employees, insurance, depreciation etc.). Even if production is zero fixed cost will be a positive amount in businesses expenses.
Variable Cost: It’s the cost that experiences a change when output changes. It includes all expenses that are attributed to variable factors of production (expenses for raw materials, wage, fuel etc.). Costs changes are not always analogous to output changes.
> Total Cost = Fixed + Variable Cost
Example: Variable Cost = Labor (L, number of workers) x Wage (W)
As you can see, as more units are produced the total cost per extra unit increases due to variable cost increase.
A business wants to maximize profits or minimize costs. To do that the Total Revenue curve can be compared to the Total Cost curve, in order for the business to take the decision on what quantity to produce. However, businesses find more convenient to use averages of the variables of interest.
> Average Fixed Cost (AFC): Fixed Cost per unit of Output = FC / Q
> Average Variable Cost (AVC): Fixed Cost per unit of Output = VC / Q
> Average Total Cost (ATC): Fixed Cost per unit of Output = TC / Q
AFC: It lowers as production increases since higher production means increase of Quantity Q in equation Fixed Cost (FC)/Quantity (Q).
AVC: It lowers as production increases since we have decreasing expenses and then increases with increasing expenses due to the law of diminishing return.
ATC: When Q=4, ATC is at is lowest level and then it starts to increase since the increase in AVC is higher than the decrease in AFC.
Marginal cost is the change/increase in the total cost amount when the business is increasing production by one unit.
> MC = ΔΤC/Q > Because Fixed Cost does not change, the extra cost is due to the Variable Cost.
> MC = ΔVC/Q in this case.
Marginal Cost plays an important role in business decision because the business must compare the extra cost from hiring another worker (in order to increase production) with the extra revenue generated > so comparing MC with Marginal Revenue (MR).
At quantity Q = 3, the AMC = AVC This is the level of production that is produced with the lowest cost. It shows the optimum level of production. At that level the costs per unit of output are minimized (the profit per unit of output is maximized).
Example of business producing furniture: Factors of Production which are variable are workers and raw materials. Then the Variable Cost will take the form:
VC = (L x W) + (RM x Q) : L= Number of Workers,
W= Wage, RM = Cost of Raw Materials, Q = quantity of chairs produced. In this example we have Q in the variable cost equation.
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