The Relationship between Costs in Production - Coursework Example

01 December 2008 Production and Cost Relationships Outline I. II. The Economics of Profits III.Average Total Cost IV. Marginal Cost V. Marginal Product VI. Conclusion VII. Bibliography I. Abstract This paper explores the relationship between costs in production. Utilizing numerical example and graphical representations, this paper provides a simplistic view of different costs incurred by a firm. In more detail, this paper first turns in identifying the major goal of a firm—that is profit maximization and offers solution in term of cost minimization. The body of the paper expounds three microeconomics concept namely average total cost, marginal cost, and marginal product. II. The Economics of Profit It is irrefutable that the goal of a firm is profit maximization (Brue and McConnel 2005). Economically speaking, all business organizations would want to maximize the use of its resources in order to make the maximum return possible given its limited resources (Brue and McConnel 2005). Profit is measured as the difference between the revenue generated deducted with the costs incurred. Thus, in order to maximize profits, the company could either ensure that it is generating the highest revenue possible by increasing price and quantity demanded or minimize the costs that it incurs (Pindyck and Rubinfeld 2005). This paper will focus on the latter. The following chapters will look at the relationship of average cost, marginal cost, and marginal product in the aim of helping a business organization attain its goal of profit maximization. III. Average Total Cost In the course of its operation, a business organization incurs various costs in order to ensure that products are designed, manufactured, and distributed to customers (Cepeda 2005). In order to understand average total cost, it is best to have a comprehension of what comprises the total cost that a business organization faces. In general, the company is faced with two different costs which make up its total cost namely fixed cost and variable cost (Brue and McConnell 2005). Fixed cost, as the name implies is fixed and does not vary with the level of production. An example of fixed cost is the payment for rent of production plant or retailing store. On the other hand, variable costs are those costs which changes when the quantity of production is changed (Cepeda 2005). Examples of these are the cost of materials and labor which are needed in the production of one unit of a product. The sum of the total fixed cost and the total variable cost is the total cost. Dividing the total cost with the number of quantity produced by the business organization will yield the average total cost (Brue and McConnell 2005). Table 1. Numerical Example for Average Total Cost Quantity Total Fixed Cost Total Variable Cost Total Cost Average Total Cost 50 $600 $1250 $1850 $37 100 $600 $2500 $3100 $31 150 $600 $3750 $4350 $29 200 $600 $5000 $5600 $28 250 $600 $6250 $6850 $27.4 300 $600 $7500 $8100 $27 In order to illustrate fixed cost, it is best to come up with a numerical example. Suppose that a company manufactures figurines and incurs fixed cost as follows in a month: $200 for building rent; $300 for administrative expense; and $100 for utilities. On the hand, it incurs the following variable cost per unit: $10 direct material and $15 direct labor. The company’s production capacity is 300 units per month. Table 1 shows the company’s variable cost and fixed cost at each level of quantity produced. On the other hand, Figure 1 shows the short run average total cost curve. It should be noted that as the quantity produced is increased, ATC declines because of economies of scale, managerial specialization, and use of more efficient labor. Figure 1. ATC Curve in the Short-run However, in the long run, ATC curve will begin to inflect because of the diseconomies of scale as production expands further (Pindyck and Rubinfeld 2005). Thus, the long run ATC curve will tend to slope downward at first and begin to rise the moment that more fixed cost should be injected in the firm in order to support higher quantities of production (Brue and McConnell 2005). IV. Marginal Cost Marginal cost refers to the increase in total cost as a result of producing an additional unit of product (Cepeda 2005). Using the above figures, we can calculate the marginal cost of producing additional outputs as follows: Table 2. Numerical Example for Marginal Cost Quantity Total Cost Change in Quantity Change in Total Cost Marginal Cost 100 $3100 50 $1250 $25 150 $4350 50 $1250 $25 200 $5600 50 $1250 $25 250 $6850 50 $1250 $25 300 $8100 50 $1250 $25 Since our example assumes a short-run operation, marginal cost remains unchanged because the total fixed cost does not vary with the level of production. Thus, it can be shown that in the short-run, the MC curve is a horizontal line (Cepeda 2005). However, in the long run, MC slopes downward at first and then after reaching its lowest point begins to slope upward (Brue and McConnell 2005). This can be explained by the additional capital and equipment required in the long run (Brue and McConnell 2005). Figure 2 shows a typical MC curve in the long-run. Figure 2. A Typical Marginal Cost Curve in the Long-run There is a significant relationship between MC and ATC. In the long run, when marginal cost is greater than average total cost, the latter is increasing (Brue and McConnell 2005). However, when marginal cost is less than average total cost, the latter is declining (Brue and McConnell 2005). V. Marginal Product Similar with the explanation for the marginal cost, marginal product refers to the additional product that each unit of labor contributes to the total product (Brue and McConnell 2005). In this context, the marginal product is the number of product which is generated by the addition of a unit of worker into the pool of resources that the business organization has. Theoretically speaking, when new workers are introduced in the plant or working areas, the marginal product will increase at each addition as each resource is utilized more efficiently (Pindyck and Rubinfeld 2005). However, the law of diminishing marginal returns will take hold at some point when the workplace is saturated and the addition of new workers will contribute to crowding out (Pindyck and Rubinfeld 2005). The law of diminishing marginal returns state that the addition of additional worker in a manufacturing plant without changing the level of other input will generate lesser output than the previous workers (Cepeda 2005). Thus, as more workers are introduced the average output that they produce becomes less because of the declining marginal product (Brue and McConnell 2005). Table 3 shows a numerical example of this: Table 3: Numerical Example of Marginal Product Inputs Labor Total Product Marginal Product 0 0 1 15 15 2 34 19 3 51 17 4 65 14 5 74 9 6 80 6 Through this numerical example, it can be seen that the addition of one employee from one to twp and even three will tend to increase the marginal product and consequently the average product produced. However, for the following additions of unit labor, the marginal product` begins to decline until it reaches only six marginal products at the sixth units. VI. Conclusion In conclusion, the ability of a company to maximize its resources firm hinges in its ability of understanding its cost structure and capability of applying economical theories in its operation. The above discussion looked at how average total cost, marginal cost, and marginal products behave in the long-run and short-run. Knowledge of this will enable firm to choose the optimal quantity that they should produce in order to maximize total profits. Works Cited Cepeda, Ricardo. “Production, costs and their relationships.” 2005. 30 November 2008 Mc Connel, Campell and Stanley Brue. “Microeconomics: Principles, Problems, and Policies.” 16th edition. 2005. Mc Graw-Hill: New Jersey Pindyck, Robert and Daniel Rubinfeld. “Microeconomics.” 6th edition. 2005. Pearson: New York Read More