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Costs, Revenues and Production Decisions - Essay Example

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Costs, Revenues and Production Decisions Introduction A firm’s production decision is critically dependent upon its revenue and costs. In particular, the firm’s objective is to maximize its profits. This involves identifying the level of output that maximizes its profits…
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Costs, Revenues and Production Decisions Introduction A firm’s production decision is critically dependent upon its revenue and costs. In particular, the firm’s objective is to maximize its profits. This involves identifying the level of output that maximizes its profits. The profits of a firm in essence are the total revenue net of total costs. Both these variables, total revenues and total costs depend upon the level of output produced. Additionally, the price charged per unit of the product influences the total revenue. Therefore, whenever a firm tries to maximize its profits, it is trying to identify the level of output and the price per unit to be charged so that the revenue is maximized and the costs are minimized so that profits are maximized. In the following, this paper shall elaborate upon how cost curves and revenues play into the production decisions. The discussion will initiate by reviewing the notions of costs and revenues and how these are related to the production decision of the firm. Then the discussion shall move on to show how considerations of costs and revenues impact the production decision. Finally, the paper will conclude with a summary of the findings. Costs and output The primary decision that a producer has to take is to choose its input mix. Each possible input combination given the factor prices, is associated with a particular cost. The firm’s challenge is to identify the combination of inputs that is most efficient, i.e., the combination of inputs that yields the maximum output at some given level of cost, or for some given level of output the efficient input combination minimizes the total cost. Thus, the least cost combination of inputs is known as efficient. Production in the short run involves some fixed costs, i.e., costs that do not depend upon the level of output as well as variable costs, i.e., costs that vary with the level of output. The efficient combination of inputs minimizes these variable costs. To keep things simple typically only two factors of production, capital (K) and Labour (L), are assumed. Capital is assumed to be fixed in the short run and the variable costs are due to varying labour input. Due to the law of variable proportions, the productivity of labour initially increases and then after a certain extent decreases. As a result, the amount of labour required to produce an additional unit of output first falls at a declining rate, slows down and then starts rising at a rising rate. Hence the total variable cost curve is shaped like a tilted “s”. The fixed cost is simply a horizontal straight line and adding these two, the firm’s total cost curve is obtained. It is shown in the diagram below. Figure 1: Variable, Fixed and Total Costs Revenue and output A firm’s total revenue is simple equal to the number of units sold times the price of the product. If P be the per-unit price and q be the number of units sold, then the total revenue (TR) is simply pq. Now, quantity of output, q has two channels of affecting the revenue. First, if q rises, given p, total revenue rises. However, as q rises, by the law of demand, the market price, p falls. Therefore, TR tends to drop. Whether a price change results in a rise or fall in total revenue actually depends upon the price elasticity of demand of that product. However, that topic is beyond the scope of the present discussion. We proceed by making the simplifying assumption that the producer operates in a competitive market so that the market price does not depend upon changes in q (recall that a perfectly competitive producer is a price taker). Thus, with given p, total revenue becomes proportional to quantity of output and therefore can be represented by a straight line with a positive slope and zero intercept. Figure 2: The total revenue curve The production decision As briefly mentioned in the introduction, the producer’s objective is to maximize its profits, i.e., the difference between total revenue and total costs. The discussion above implies that this boils down to identifying the level of output that leads to the biggest gap between total revenue and total costs. The analysis is carried out graphically in figure 3. Observe that initially, as output starts rising, total costs lie above total revenue. Therefore in this phase the producer makes losses. As he increases production, TR rises, and the increased productivity leads to a drop in per unit costs. Consequently, the losses start falling, come down to zero, and then profits start becoming positive. Evidently, the profits are maximized at the level of output where the vertical distance between TR and TC is maximum, and this happens for the level of output where the slopes of these curves are equal. Since the slopes represent the marginals, the profit maximizing output is thus identified by the condition: Marginal Revenue = Marginal Cost or MR=MC. For all output levels where MR>MC, the firm can expand production and increase its profits. For all output levels when MR Read More
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