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Production Cost

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When you think of buying your favorite drink, you start considering how much it will cost you. But have you wondered how much it cost the firm to make that drink? All firms spend something to make the products they sell, whether directly or indirectly. This is because nobody has unlimited resources, so everything comes at a price! Whatever the firm spends to make the product you love so much is part of the total production cost. What does that include? Let's find out together. Read on!

Cost of production definition

The cost of production definition is all the costs incurred by a firm during production. Businesses are in the business of making things people want to buy. These things people want to buy are called goods (or outputs). To make these outputs, the firm must start with inputs and process or convert them. The inputs come at a cost, and the conversion of inputs into outputs also incurs a cost. All these costs make up the total production cost.

Firms must convert inputs into outputs.

Production cost refers to all the direct and indirect costs the firm incurs to make the products it sells.

But is it that simple? Of course not! (But it is also not complicated, don’t worry).

Firms want to make as much money as they can possibly make, and they do this by selling products. However, the quantity of products they can produce depends on the quantity of inputs they use. This relationship is referred to as the production function.

The production function shows the relationship between the quantity of inputs and the quantity of outputs.

Figure 1 illustrates a production function. It will typically be increasing because more inputs allow for the production of more goods. However, it will typically have a section that is still increasing but concave downward, which reflects diminishing marginal returns. This means that each additional unit of input contributes a positive increase in production, but at a diminishing, or decreasing rate.

Fig. 1 - An illustrative production function curve

Okay, now let's address the perfect competition model. You've been waiting to know what it is, let's get right into it!

The perfect competition model refers to a market where we assume that there are many, many firms that are making the same products or goods for many, many people to buy.

Firms make identical products.

In the perfect competition model, the product is assumed to be identical from one firm to the next. There are no differences between the products or brands.

There are a large number of firms and consumers.

This model assumes that each buyer and seller is a teeny, tiny part of the vast market. There are enough buyers demanding the product that the market can take any possible quantity level that a seller might choose to produce.

There is no market power.

All firms and consumers are so small and powerless that they must take the market price as a given. They have no market power with which to set their own price. Instead, they take the market price and choose only their output quantity.

New firms can easily enter the market without incurring costs, and old firms can easily leave the market without incurring costs.

Finally, firms can easily enter (new firms) and exit (existing firms) the market. There are no barriers to entry or exit, nothing is hindering them from either.

Costs of production in perfect Competition

To explain the costs of production in perfect competition, we will start by looking at the production function. You should keep in mind that the production function shows the relationship between the quantity of inputs and the quantity of outputs. Look at this example:

A coffee processing company produces coffee for sale. To produce the coffee, the company only uses land and labor. Land for planting the coffee, and labor to process the coffee for sale. The land of the company is 5 acres, and they have no extra land. Thus, they can’t change the size of the land they have through any means.

In the above example, economists refer to land as a fixed input. This is because its quantity cannot be changed for a given period of time.

A fixed input is an input whose quantity cannot be changed for a given period.

On the other hand, the labor hired by the company is a variable input. This means the company can hire more workers or lay off workers as needed.

A variable input is an input whose quantity can be changed for a given period.

You must note that given enough time, any input can be a variable input. Enough time is available in the long run. What distinguishes the long run from the short run? The short-run is any period of time where at least one input is a fixed input.

In the long run, all inputs are variable inputs. The long run can be defined as the length of time it takes for all fixed costs to become variable in some way.

Since production cost refers to all the direct and indirect costs the firm incurs to make the products it sells, we can now say that the firm can have a long-run cost or a short-run cost.

Long-run production costs refer to all the direct and indirect costs the firm incurs to make the products it sells in the long run.

Short-run production costs refer to all the direct and indirect costs the firm incurs to make the products it sells in the short run.

Calculate the total cost of production in perfect competition

Here, we will calculate the total cost of production in perfect competition using the following example:

A coffee processing company produces coffee for sale. To produce the coffee, the company only uses land and labor. The land is for planting the coffee, and the labor force processes the coffee for sale. The land owned by the company is 5 acres, and they have no extra land. Thus, they can’t change the size of the land they have through any means in the short run. However, they can increase or decrease the quantity of labor.

The total production cost (TC) is the total fixed cost (FC) and the total variable cost (VC) combined.

Mathematically:

$$Production\ cost=\ Total\ Fixed\ Cost+\ Total\ Variable\ Cost$$

$$TC={FC}+{VC}$$

Before the calculations, let's talk about diminishing marginal returns.

If the company has one worker, the production process will be slow. With additional workers, production increases. As the company adds more workers, the total amount of coffee they can produce increases due to each additional work having a positive marginal contribution.

However, at some point, the owner realizes that each additional worker increases the total output by a smaller amount than the worker before. That's diminishing marginal returns. Eventually, the process will be so crowded that adding an additional worker will actually decrease the total production! This happens because too many workers can get in each other's way.

Let's back up. Suppose that one worker produces 15 bags of coffee. Then, two workers are not quite able to double that. Instead, they can produce 28 bags of coffee together. Why 28 instead of 30, you ask? Well, the operation has only 5 acres of land, and that creates a limitation. With 5 acres, there is a limit to how much they can produce, even if they added the entire population of Nebraska!

With three workers, they can produce 39 units. This is more than they could produce with only two workers, but the new worker has a smaller additional contribution (11 units = 39 - 28) than the second worker (13 units = 28 - 15). As you add more workers without increasing the acres of land, total output will increase, but the contribution of each additional worker decreases.

The law of diminishing marginal returns states that the addition of additional inputs results in smaller marginal output.

So, what is the marginal output? It is the additional output resulting from the addition of an extra unit of input.

Marginal output is the increase in total output as a result of the addition of an extra unit of input.

Since an output refers to the product being produced, the marginal output is also referred to as a marginal product. And the marginal product of an input, say, labor, is called the marginal product of labor.

This is calculated by dividing the change in the quantity of output by the change in the quantity of input. If the input is labor (L), the formula is:

$$\frac{\Delta\hbox{Q}}{\Delta\hbox{L}}$$

The ∆ symbol known as Delta refers to change, so ∆Q is the change in quantity.

With all the information we have now, let's look at the table below based on the provided example.

 Quantity of Labor (L) Quantity of Coffee (Q) Marginal Product of Labor (MPL) Average Product 0 0 0 0 1 15 15 15 2 28 13 14 3 39 11 13 4 48 9 12 5 55 7 11 6 60 ? 10

So what is the marginal product of labor when the sixth worker is added? Let's use the formula for MPL above.

$$\hbox{MPL}=\frac{\Delta\hbox{Q}}{\Delta\hbox{L}}=\frac{60-55}{6-5}=\frac{5}{1}=5$$

Now, let's show the production function on a graph! Look at Figure 2 below.

Fig. 2 - Production function for coffee business

Cost of a product formula

The formula for the cost of a product uses the total production cost and the quantity of the product produced. Economists may also refer to the cost of a product as the cost per unit or the average cost of production. It is the total production cost divided by the total quantity of goods produced.

The cost of a product or the cost per unit produced is the total production cost divided by the total quantity of goods produced.

Mathematically, this is written as:

$$Cost\ per\ unit=\frac{TC}{Q}$$

Shall we try an example?

Fred produced 50 candy bars and incurred a total cost of $25. What is the cost of producing a candy bar? Solution: Since the quantity of candy bars is 50 and the total production cost is$25, we can insert these into the formula for the cost of a product.

$$Cost\ per\ unit=\frac{TC}{Q}$$

We will have:

$$Cost\ per\ unit=\frac{25}{50}$$

$$Cost\ per\ unit=0.5$$

Examples of production in perfect competition

Let's look at some examples of production and cost in perfect competition. In perfect competition, there are many firms producing the same product with many consumers buying them.

An example is an agricultural commodity exchange where many raw products (corn, lettuce, tomatoes) are essentially the same. Firms that produce coffee beans to sell on a commodity exchange are in perfect competition and must take the going market rate on the exchange as given. They must decide how much to plant and produce for the next season based on the cost of resources and the current market price for coffee beans.

Another example is online bookselling since the internet provides platforms for people to buy and sell items that are often identical. A given book, if it's brand-new, is identical across any number of sellers. Thus, online sellers can find themselves in a very competitive market, where the quantity is high, and the market price is quite low. Firms with higher costs of production are driven out of the online market.

Note that perfect competition is a theoretical extreme; often, products claim to have a specific quality level or other distinguishing feature that differentiates the product from that of another seller.

Main characteristics of production cost in perfect competition

The main characteristic of production cost in perfect competition in the long-run is that all the producers (firms) are selling at their marginal cost of production. In the long run, all costs are variable, so the marginal cost equals both the variable cost of the next unit and the total cost of the next unit. Firms all produce at an efficient quantity for their given production function, and high-cost producers are driven out of the market in long-run equilibrium. Figure 3 depicts this!

Perfect! You've completed the Production, Cost, and the Perfect Competition Model. That was easy, right? You should definitely read our articles on Short-run Production Costs and Long-run Production Costs. They provide more detail after the introduction you just had!

Production Cost - Key Takeaways

• Production cost refers to all the direct and indirect costs the firm incurs to make the products it sells.
• The production function covers the relationship between the inputs and outputs of production.
• The two types of production costs are fixed costs and variable costs.
• In the short run, at least one input is fixed, which means that there is at least one fixed cost. In the long run, all inputs are variable inputs, and all costs are variable costs.
• The marginal product is the additional product resulting from the addition of an extra unit of input.
• The law of diminishing marginal returns states that adding additional inputs while keeping other resources constant results in progressively smaller increases in the total product; alternatively stated, marginal product decreases as additional units of the resource are used.

Product cost, or cost per unit, is the cost of producing a unit of output.

The cost of a product or the cost per unit produced is the total production cost divided by the total quantity of goods produced.

Mathematically, this is:

Cost per unit = TC/Q

Cost of production directly affects supply as it affects the profit margin and therefore the quantity of the product that the firms decide to sell in the market.

Bulk production reduces costs by lowering the cost per unit as the same volume of resources per time unit is utilized to produce a greater output quantity.

Production cost is important because it helps firms determine whether their operations are profitable and whether to provide a good or a service in the market.

Production Cost Quiz - Teste dein Wissen

Question

What is the law of supply?

The law of supply states that as the price of a good or service increases, the quantity of that good or service that producers are willing to offer will increase.

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Question

What is the law of demand?

The law of demand states that as the price of a good or service increases, the quantity of that good or service that consumers are willing to seek will decrease.

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What determines price elasticity of demand?

Price elasticity of demand is determined by how responsive the quantity demanded of a good is to changes in its price.

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Question

Which of the following is NOT a type of elasticity of demand?

Marginal elasticity

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Question

How does the law of diminishing marginal utility affect demand?

The more of a good or service is consumed, the utility derived from each additional unit will decrease, which means that consumers will be less willing to pay more as quantity of a good or service consumed increases.

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Question

What is income elasticity of demand?

Income elasticity of demand measures the responsiveness to changes in consumers' income in terms of the quantity of a good or service sought out by consumers.

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Question

Name three tools that the government may use to influence the economy.

• Regulations and policies
• Subsidies
• Taxes

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Question

Where can equilibrium be found in a supply and demand model?

Equilibrium is the point of intersection between the supply and demand functions.

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What is equilibrium?

Equilibrium is the quantity-price point where quantity demanded equals quantity supplied, and thus produce a stabilized balance between the price and quantity of a resource in the market.

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Question

Which of the following examples represent inelastic demand best?

Emerging trend for a technology equipment the producer of which owns a patent on.

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Question

What is a demand schedule?

Demand schedule is a table of various quantities of a good or service that consumers are willing to seek out at various price levels.

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Question

Which of the following factors may affect price elasticity of supply?

There are numerous factors that can affect price elasticity of supply, such as availability of resources needed for production, changes in demand for the product that the firm produces, and innovations in technology.

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Question

Which of the following is NOT a factor that may cause.a shift in demand for a good or service?

Price of the good or service

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Question

An increase in quantity demanded at every price level will translate on a graph as:

Rightward shift of the demand curve

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Question

A leftward shift of the demand curve means:

Decrease in quantity demanded at each price level

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Question

Shifts of the demand curve are described as:

Leftward / rightward

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Question

When the demand curve shifts rightward, all else held constant the price of the equilibrium point:

Increases

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Question

Which of the following is not an example of normal goods?

Luxury cars

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If consumers' income falls, quantity demanded of normal goods will:

Decrease

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Which of the following is NOT a category of related goods?

Dependent goods

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Question

If the price of a complement increases, the demand curve for a good that it complements will:

Shift leftward

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What are substitute goods?

Substitute goods or substitutes are goods that satisfy the same desires or needs for consumers as another good, thus serving as an alternative to the latter.

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Question

Product B is a substitute for product A. Suppose that the price of product B falls below the price of product A. How will this affect the demand curve for product A?

The demand curve for product A will shift leftward as the quantity demanded will decrease, since consumers will be more inclined to purchase product B instead.

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Which of the following is the best example of consumers' taste influencing a rightward shift in demand for a product?

Fans of a popular celebrity purchasing a product after an endorsement by the celebrity

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If consumers expect prices for a certain product to decrease due to promises of future subsidies, the demand curve for that product will likely...

Shift leftward, as consumers may prefer to postpone the purchase of that product in hopes to save money.

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Suppose a college experiences a sharp decrease in the number of students regularly attending classes in person in favor of online learning. Due to this decrease in population, the demand curve for parking spots on campus will:

Shift leftward

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The extent to which quantity of any good or service demanded will fluctuate due to changes in any factors of influence depends on the measure of:

Elasticity of demand

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Market disequilibrium occurs when...

Quantity of a product or service demanded exceeds quantity supplied, or quantity supplied exceeds quantity demanded

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A shortage occurs when...

Quantity demanded exceeds quantity supplied

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Question

What does price elasticity of supply measure?

PES measures the responsiveness of quantity of a good or service supplied to changes in market price.

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How do you calculate PES?

PES is calculated by dividing percentage change in quantity supplied by the percentage change in price.

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When calculating price elasticity of supply, what would the result of your calculations have to be in order for supply to be considered price elastic?

Price elasticity of supply would have to be greater than 1.

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Question

What does it mean when supply is unit-elastic?

Supply is unit elastic when PES equals 1, which means that quantity supplied changes proportionately to changes in price.

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Suppose you determine supply to be perfectly inelastic. What would the supply function look like on a graph?

The function is a vertical line.

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Question

Does the supply curve shift as a result of changes in price or quantity supplied?

Supply curve does not shift when the price of a good changes. Supply curve shifts only if the economic factors other than the price change.

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If the supply curve shifts _____, quantity supplied at every price level will increase.

Rightward

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If the supply curve for a certain product/service shifts leftward, this means that the quantity supplied...

Decreases

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True or false: price of the product or service is one of the factors that directly cause sideward shifts of its' supply curve.

False. Changes in price of the product/service do not reflect in sideward shifts of the supply curve.

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Which of the following is NOT one of the economic factors that may cause the supply curve to shift?

Consumers' preferences

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Suppose there is a significant increase in the price of steel, which is one of the inputs that producers of cars use in their production. This increase in price of steel would likely shift the supply curve for cars...

Leftward

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Question

Suppose that the latest advances in technology allow producers of certain physical products to reduce their energy expenses in the production process. As a result, the supply curve of such producers would shift...

Rightward

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Question

When the price of a complementary good increases, quantity supplied of the complemented good will likely...

Increase

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Question

When the price of a substitute in production decreases, the supply curve for the original will likely shift...

Rightward

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Question

Since a higher number of producers in the market results in higher quantities of a good or service supplied, a decrease in the number of producers would shift the supply curve...

Leftward

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Question

If producers expect unfavorable market conditions for their good or service in the near future, what may happen to the quantity they supply and the respective supply curve?

Supply curve will shift leftward causing the quantity supplied at every price level to decrease.

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Suppose producers have a reason to believe that the price for their good or service may increase in the near future. How will this affect the supply curve?

Favorable market conditions would result in supply curve shifting rightward, resulting in more quantity supplied at every price level.

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Question

If producers experience a raise in taxes on some of their inputs, the supply curve for their ultimate product will likely shift...

Leftward

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If producers begin to receive subsidies for their product, this will likely compel them to...

Increase quantity supplied

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Question

If a supply curve shifts rightward, how will the shift affect the price value that corresponds to the market equilibrium, all other things held constant?

The new equilibrium price will decrease from the initial value before the shift.

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Question

Suppose you were to calculate price elasticity for a certain product and your result came out to be 1.2, what does this say about how price elastic the given supply is?

Supply of the given product is price elastic.

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