Cost and Production Concepts
At the center of economic analysis is the model of choices and in microeconomics we will examine the choices made by individuals and firms. Before we are done with our analysis of firms, we will have looked at an array of choices that they will need to make including decisions about what mix of inputs to use in production, what level of output to produce, and what means of financing the operation should be used. If you are running a university for example, you will need to determine how many computers to buy and how many faculty to hire, how many students to accept, a how to raise the revenue needed to keep in business.
In this course we will follow the lead of most economics texts and focus our attention on the relationship between profit maximization and behavior. "If you are a profit maximizing firm, then you should...." What you should recognize at the outset is that the conditions which we derive are ONLY valid when we are talking about this narrow objective. Stated somewhat differently, what is good for a profit maximizer is not necessarily good for a firm attempting to maximize market share.
The place to start is with the concept of Profit. Profit is defined as the difference between revenues and costs [Profit = Total Revenues - Total Costs]. If it costs you $57,000 to run your T-shirt shop and you bring in revenues of $81,000, then the profit is $24,000.
At this time we will be focusing our attention on the cost side of the equation. To fully understand the relationship between output and cost, we will need to decompose our analysis into two parts - production relationships that define the link between inputs and outputs and cost relationships that link output and cost. These important relationships will be described in the Concepts section. You will also find a section in which the graphical representation of the concepts are presented and an example of the concepts based on the operation of the university RIU.
One thing to keep in mind as you work through the analysis of the firm is the importance of the time horizon. Here we will be making the distinction between the short-run and the long-run and ignoring the very long-run. The difference between short-run and long-run is based on the ability to alter inputs and thus varies across industries. When we talk about short-run we are not allowing enough time for the level of all inputs to vary and thus we focus on the relationships between one input and output and cost. In long-run analysis, meanwhile, all inputs are allowed to vary and we examine what happens to output and cost when all of the inputs change. At this time we will not discuss the very long-run which is a time-frame that allows for the technology to change.
Production Relationships
The analysis of production describes the process by which a firm transforms inputs (ex. labor and machines) into outputs (haircuts, automobiles, education). Here we will be introducing some important productivity concepts (marginal productivity) and discussing the link between the production and cost concepts. It is also a time where you will be introduced to the concept of diminishing marginal product. In the long-run analysis we will discuss the concept of returns to scale which provides us with an answer to the question: what happens to output if we double all of our inputs? This is one of the key places that technology, or more specifically, technological change, affects the market system by affecting the individual firms.
Cost Relationships
After the discussion of production, we will shift to a discussion of a variety of cost concepts. As we proceed through this section, however, it is essential that you realize that we are talking about economic cost and not accounting costs. One place where you would see a difference between economic and accounting cost would be in the cost of capital. When you run a business you need to keep some funds in cash or a checking account which earns little or no interest. This costs you nothing in an accounting sense so it would not even enter into the profit calculations. There is, however, a cost to tying that money up since it could be used in other ways that would make money. If you tie up $10,000 in cash in running the business and you could earn 5 percent on your money if you invested it, then using the $10,000 would cost you $500 (.05*$10,000) and this $500 would show up as a cost. In this case the economic cost would be $500 higher than the accounting cost. An understanding of the economic cost concept is the only way that you will be able to understand the concept of zero profit which is so important to economists.
In this component of the course you will also examine the division of costs between fixed costs and variable cost. These concepts will be extremely important in a later discussion of the rules governing the choices of firms. Another concept that we will discuss, one that will enter into the calculations of profit maximizing behavior, will be marginal cost.