Macroeconomics: Production Costs - Term Paper Example

Nasser Al Thani Microeconomics: Production Costs Fall - Econ 202 – 002 Sabo Macroeconomics: Production Costs Production is the creation of goods through transformation of inputs into finished products that satisfy consumer needs and wants. Every business organizations engaged in transformation of inputs into finished products incurs certain specific costs. Costs of producing a commodity is influenced by the cost of technology used, resources applied, as well as the costs of inputs employed in the production process. These costs are inevitable and usually included within commodity prices. The following is a discussion of production costs that business organizations incur in the process of creating goods for consumption. Introduction Indeed production process is the beginning of business cycle and has various effects on inputs. With consumption being the last stage in the production process, the latter increases ability of various inputs that would otherwise not be useful to satisfy the former’s wants in a number of ways. Some these ways include changing physical characteristics of inputs, changing location and time of various inputs, changing location, as well as changing the ownership of inputs from producers to consumers (Nicholson & Snyder 15). In this regards, production creates various utilities that include possession, form, place, and ownership. In this paper, I will discuss various costs associated with the production process. This discussion includes the broad categories of production costs, subdivisions, as well as examples of each category and subdivision. Production Costs Overview Costs are very vital in assisting business organizations that are engaged in conversion of inputs to finished products to understand profitability of a firm. Profitability of a firm is found by getting the difference between total revenue and total production costs. According to Weerapana (9), when the total revenues of a firm are more that the total costs then the firm is actually making profits whereas when the total revenues are less than total costs a loss arises. In this regards therefore it is important for organization to understand and check on their costs keeping them far much below the total revenues with an aim of maximizing profits. In any case, business organizations’ microeconomic objective is to minimize costs and maximize profit. Opportunity, explicit, and implicit costs are vital aspects of costs that organizations should be aware of while getting involved in business functions. Opportunity costs refer to the benefits foregone for not using an economic resource in its next best alternative form (Rittenberg and Tregarthen 38). In other words, an opportunity cost may be defined as the value of the next best alternative that a given resource can be put to but has not owing to concept of scarcity and choice. Implicit costs on the other hand are those non-monetary sacrifices that an organization makes in the event of producing finished goods for purposes of consumptions (Nicholson & Snyder 19). Explicit costs are the monetary expenditures that organizations incur in the process of providing finished goods. Making of profitability decisions within business organizations requires consideration of all costs; opportunity, implicit, and explicit. Economic analysis of firms therefore with respect to profit viability with an aim of fulfilling microeconomic principle of maximizing revenues and minimizing costs heavily relies on all the three costs; opportunity, explicit, and implicit (Weerapana 18). Other than this category, classification of costs can be based on the behavior of a given cost. Such classification may end up with fixed, variable, and semi-fixed costs. Short-Run Production Costs Economically, an organization’s performance can be evaluated both in short-run and in the long run less than two periods. In each period, the production function differs hence differences in the type and amount of costs incurred. In the short-run economic period production functions of organizations is a function of fixed input and technology that is, the employed level of technology and input remains unchanged. This can be represented as; Q = f (L); given fixed technology and input at fixed known prices In addition to fixed amount of employed technology and input, prices of various inputs are known and are unlikely to change over this period (Nicholson & Snyder 21). The following are some of the production costs incurred during the short-run. Fixed Costs: Fixed costs represent the total amount of fixed input applied in the production process. For instance, rent, salaries, and insurance charges that organizations incur. Such costs do not change with changing amounts of outputs and inputs. In this case, it can be referred to as total fixed costs that organizations incur in producing outputs irrespective of the amount (TFC). Variable Costs: Variable costs on the other hand refer to various expenses incurred by business organizations that vary with quantity or volume of inputs and outputs. With variable costs as the volume of inputs increases so do the costs (Weerapana 22). Examples include costs of raw materials, transportation costs, and utilities costs amongst others. Average Costs: This cost represents an average amount of costs that is incurred in producing one unit of a commodity. Average costs are obtained when number of output produced divides total costs. For instance, And, Marginal Costs: When an organization decides to produce additional output, there are additional costs incurred. Marginal costs are the additional costs incurred by an organization in producing additional one unit. Marginal Costs (MC) are calculated when change in total costs incurred in divided by change in total output. The following figure shows graphical representation of production and cost that a firm incurs in the short run. From the figure below, TP represents the Total Production function that a firm follows in order to produce output in the short run. L represents the amount of labour employed by the firm along the production function (Weerapana 29). TP increases incrementally from 0 to LA since the Marginal Product is also increasing and the Variable Cost is increasing at a decreasing rate. Between points LA and LB the Marginal Costs increases hence the increasing TP at a decreasing rate despite the increase in amount of labor employed by the firm. After LB maximum Marginal Product has been attained. With increase of labor between LA and LB, the output increases from QA to QB hence the incremental increase in Variable Costs (Rittenberg & Tregarthen 61). Once the addition of Variable Costs without significant increase in the number of outputs, business organizations, or producers will cease to produce and rather concentrate on other aspects of enhancing profitability. Figure 1: Representation of Costs of Production courtesy of Reynolds (6) On the other hand there is a strong correlation between variable costs and average variable costs with respect to Marginal Costs that defines the point at which a firm attains maximum profits. A firm obtains maximum profits when the value of Marginal Cost equals the value of Marginal Revenue hence the need to understand concept of Marginal Costs (Rittenberg & Tregarthen 72). This is represented by the following graph. Figure 2: Relationship between various Costs of Production Courtesy of Reynolds (7) In the above graph, at minimum Marginal Costs, QA units of output are produced whereas at maximum Marginal Cost QB ­ units of output are produced. At that point the Variable Cost is higher with a decreasing level of output. From earlier discussions it is identified that once additional Variable Costs do not increase the Output then production should be stopped. In this regards, such a firm will stop producing at QC where MC=AVC and there are no additional variable inputs that cause increase in costs without increasing the output level. Relationship between ATC, AVC, MC, and AFC Any producer engaged in manufacturing of products must understand the relationship between Average Total Cost (ATC), Average Variable Costs (AVC), Marginal Cost (MC), and Average Fixed Costs (AFC). The following formulas provided calculations of these four levels of production costs incurred within short-run production period. The above relationship can be represented by the following graph; Figure 3: Relationship between MC, ATC, AVC, and AFC courtesy of Reynolds (7) From the above graph, the vertical distance between Average Total Cost and Average Variable Cost is the Average Fixed Costs hence the declining nature of the graph. As the volume of quantity produced increases the Average Fixed Costs will decreases from the above formula of AFC since it is constant while the denominator, Q keeps enlarging. Relationship between MC and AVC to MPL and APL The relationship between Marginal Cost and Average Variable Cost to Marginal Product of labour as an input and Average Product of labor can be represented in the following panels of graphs. Figure 4: Relationship between MC and AVC to MPL and APL Courtesy of Reynolds (8) From the above graph, several positions of input are indicated in the first panel that provides total production function. These levels are LA, LH, and LB that produce different levels of outputs QA, QB, and QC in that order. At LA the MP is at maximum point and at LH the Marginal Product equals the Average Product. From the following formula, it therefore follows that at maximum MP, the Marginal Product of labor as an input is at minimum; Therefore, when MP > AP, then AP increases and when MC < AVC, then AVC will be experiencing a decrease. On a different perspective, at point LH Average Product is at the maximum level making the produced QH to have the minimum of AVC with the MC being equal to MP. This is the best point at which a firm can ever produce since it will derive the maximum profits associated with producing various goods and services (Rittenberg & Tregarthen 88). This is an important concept that organizations should employed in order to derive the best out of their production process. Nevertheless, it is important to note that at the farthest end, LB the amount of variable cost incurred is just too high hence higher variable costs associated with the same. Consequently, an organization producing at this level will definitely make a loss since the additional inputs do not add any value or volume of the quantity of output produced by the firm in question. Microeconomic principle of profit maximization from minimization of costs arises from the fact that business organizations that produce output should avoid scenarios where additional input has not effect on volume of the output (Rittenberg & Tregarthen 98). Long-Run Production Costs Other than short-run, businesses also undergo long-run production hence incurring costs associated with long-run production. Long-run production costs are associated with long-run production functions, which in most cases are multidimensional. Multidimensional production function refers to a situation where several inputs are used in production processes such as labour, capital, and entrepreneurship (Mankiw 44). In addition, the output produced may be two or more. Long-run production function is also associated with differential in pricing of inputs that are bound to change in the process of production. Consequently, long-run production functions are represented on isoquants embodied on topographical maps. This follows that long-run production costs will be derived from long-run production functions that are represented in isoquants. Since long-run production functions are characterized by various prices of inputs then long-run production costs will be a combination of different costs incurred in bringing on board all the inputs used in the production process. In long-run production process there are no fixed inputs. All inputs are bound to change with regards to pricing and quantity as well (Mankiw 57). In any case, long-run production process can be considered as a combination of short run production processes. The following graph gives a pictorial understanding of various isoquants of different classifications of costs that make up long-run production costs that a firm is likely to incur in the event that it produces a given level of product. Figure 5: Long-run Production Costs Courtesy of Reynolds (10) From the graph above, there is an isoquant showing the long-run average cost with other smaller isoquants that indicate AC of different periods incurred by a firm producing a given level of output. The smaller isoquants represent a series of short-run production average costs associated with production within the firm in question. In addition, each of the isoquant representing series of short-run production process is for different plant sizes that make up the whole firm (Mankiw 69). When a plant is large then average costs associated with them are smaller. For instance, from the graph Plant D is the largest since it has the lowest level of average costs. The range in plant sizes experienced in a firm during production is referred to as the economies of scale, which has benefits and disadvantages associated with the same. Conclusion From the ongoing discussion it is evident that all firms manufacturing products incur some production costs. Since production is a process of enhancing utility of a product there is no way that manufacturers can evade such costs. Therefore, there is need for adequate understanding of concepts of production costs where a firm identifies when to produce. From my own understanding, firms should produce at the level where MC=MP. I also propose that there should be various measures within firms to maximize total revenue whilst minimizing total costs since this is the only sure way of attaining maximum profits. I therefore conclude by saying that managerial divisions and departments should have the necessary information with regards to production costs. Works Cited Mankiw, Gregory. Principles of Microeconomics. Mason, OH: Southern-Cengage, 2010. Print. Nicholson, Walter & Snyder, Christopher. Intermediate Microeconomics and its Applications. . Mason, OH: Southern-Cengage, 2010. Print. Reynolds, Larry. Principles of microeconomics: Production and costs. Web. Accessed on November 16, 2011. Rittenberg, Libby & Tregarthen, Timothy. Principles of Microeconomics. Nyack, NY: Flat World Knowledge, Inc, 2008. Print. Weerapana, Taylor. Principles of Microeconomics: Global Financial Crisis Edition. Mason, OH: Southern-Cengage, 2010. Print. Read More