Chapter 05 _Production Costs_

Chapter 05 _Production Costs_ - Chapter 5 Production Costs...

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135 Chapter 5 Production Costs Introduction and Review We now move to analyze the supply side of the market. Business firms supply to the market the goods and services that they produce. Therefore, we start off by looking into the operations of a single business firm. In this chapter we will study the cost side of production. We will leave the benefit side of making production decisions to later chapters. Firms do not produce output simply out of the goodness of their hearts. They do so to make money. In economics, this money is called profit , which is the total revenue firms receive from selling their products minus the cost of producing those products. A typical firm incurs costs because it has to pay its production inputs. We denote the profit made by a firm during a certain period of time by the Greek letter Π , the total revenue by TR and total cost by TC. Thus, Π = TR – TC To make our story simple, we will assume that there are only two kinds of production inputs: labor and capital. One more time we confront scarcity. The firm has to pay for labor and capital since these resources are scarce. All the firms in the economy are competing against each other to acquire these resources. Therefore, if our firm does not pay enough to hire a worker, the worker will work for some other firm. Similarly, the firm has to pay for the use of capital goods. If it does not, other firms will, and our firm will be left without them. A firm’s objective is to maximize profit. It will compare the marginal benefit and the marginal cost of producing each unit of the good. Revenues add to profit and so they are the benefit of production. The marginal benefit is the revenue that the additional unit of production will bring in. We call this marginal revenue (MR) . Input payments reduce profits and so they are the cost side of the decision. The marginal cost (MC) is the cost of producing an additional unit of output. If the revenue from the next unit of output exceeds its cost of production, production of that unit will increase profit and the firm will produce that unit. The firm will produce additional units for as long as their MR exceeds their MC and will stop when MR = MC. What if marginal revenue is less than marginal cost? Then if the firm reduces output the cost saving will be larger than the loss of revenue and, as a result, profit will increase. Therefore, profit will be maximized when the marginal revenue equals marginal cost. MR > MC Increase production to increase profit MR < MC Decrease production to increase profit MR = MC Keep the production level unchanged, profit is maximized
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136 From Inputs to Costs A firm hires labor and uses capital to produce output. It acquires the inputs in the input markets and sells the output in the output market. Production takes place over a certain period of time. Both labor and capital costs should be calculated over this period of time.
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Chapter 05 _Production Costs_ - Chapter 5 Production Costs...

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