Cost of Production The Production Function A relationship between the number of units of inputs that a firm employs and the corresponding units of output produced. Production Function embodies an economic principle that is critical to our understanding of the cost of production. These Three phases are reflected in the marginal product, MP. This is defined as the change in total product resulting from a unit change in a variable input. Hence, marginal product can be calculated by the formula. MP = change in total product change in variable input Average product, AP, is simply the ratio of total product to the amount of variable input needed to produce that product: AP = total product variable input COST Understanding Cost Cost is a sacrifice that must be made in order to do or to acquire something. Outlay Costs versus Opportunity (Alternative) Costs Outlay cost is the moneys expended in order to carry on a particular activity. Examples of outlay cost to business are wages and salaries of its employees and expenditures on plant and equipment or payments for raw materials, power, light, and transportation; disbursements for rent, advertising and insurance; and taxes paid to the government. Opportunity cost defined as the value of the benefit that is forgone by choosing one alternative rather than another. This is an extremely important concept because the true cost of any activity is measured by its opportunity cost. Explicit Cost and Implicit Cost Explicit cost (accounting cost) is a cost that is incurred when an actual (monetary) payment is made. Implicit cost is a cost that represents the value of resources used in production for which no actual (monetary) payment is made; it is a cost incurred as a result of a firm using resources that it owns of that the owners of the firm contribute to it. Economic Profit and Accounting Profit Economic Profit is the difference between total revenue and total opportunity cost, including both its explicit and implicit components. Economic profit = Total Revenue - Total Opportunity Cost or Economic profit = Total Revenue - (explicit + implicit cost) Accounting profit is the difference between total revenue and explicit cost. Normal Profit is the least payment the owner of the enterprise would be willing to accept for performing the entrepreneurial function, including risk taking, management, and the like. Economic Costs these are payments that must be made to persuade the owners of the factors of production to supply the factors for a particular activity. The sum of the firms economic costs is therefore its total cost. Thus: Economic costs = Total cost = explicit costs + implicit cost Normal profit is part of a firms total cost because normal profit is the measure of implicit costs. As a result, any receipts that a firm may get over and above its total cost may be thought of as pure profit. Another name for pure profit is economic profit. Periods of Production Short Run and Long Run These refer not to clock or calendar time but to the time necessary for resources to adjust fully to new conditions. This is true regardless of how many weeks, months, or even years the adjustment may take. Market Period Short Run is a period in time in which some inputs are fixed. Long Run is a period of time in which all inputs can be varied (no inputs are fixed) Type of Cost Total Fixed Cost (TFC )represents those costs that do not vary with output. Examples include rental payments, interest payments on debt, property taxes, and depreciation of plant and equipment. Total Variable Cost (TVC) consist of those costs that vary directly with output. A firms total variable cost consists of payments for materials, labor, fuel, power, and the likes. These costs rise with increase in production. Total Cost (TC) represents the sum of total fixed cost and total variable cost. Basic Equations TC = TFC + TVCTVC = TC - TFC TFC = TC TVC Average Fixed Cost (AFC )is the ratio of total fixed cost to quantity AFC = TFC Q Average Variable Cost (AVC) is the ratio of total variable cost to quantity produced AVC = TVC Q Average Total Cost (ATC) is the ratio of total cost to quantity ATC = TC Q ATC is also equal to the sum of AFC and AVC: ATC = AFC + AVC (1)(2)(3)(4)(5)(6)(7)(8)(9) Units of Variable factor, F* Quantity of output per day, Q* Total fixed cost, TFC Total variable cost, TVC $50x(1) Total cost, TC (3)+ (4) Average fixed cost, AFC (3) (2) Average variable cost, AVC (4) (2) Average total cost, ATC (5) (2) or (6) (7) Marginal cost, MC change in(5) change in(2) 00$1000 $ $5.00$2.50$