Production and Costs

Production

Key Terms

Factors of Production
Short Run
Long Run
Fixed Resources
Variable Resources
Total Product
Average Product
Marginal Product

Factors of Production

In order to produce (output), a firm requires factors of production (inputs). As we know already, these are Land, Labour, Capital & Enterprise.

Land - This is the natural land or resources of the land, such as raw materials. This is sometimes referred to as Natural Capital.
Labour - This is the workers or people who work for a firm. This is sometimes referred to as Human Capital
Capital - This refers to the machinery or technology that is used in the production process. This is sometimes referred to as Physical Capital.
Enterprise - This refers to the ideas or ownership of firms and produce profits.

These factors of production can be either fixed (a limited amount) or variable (an unlimited amount Understanding this concept is important to help us distinguish between the Short Run and the Long Run.

In Economics, we define the Short Run as at least one Factor of Production is fixed. If a firm wanted to increase its output in the Short run it could hire more workers (labour) or buy more materials (capital) but it couldn't change the size of its factory or number of expensive heavy machines. Therefore in this example the number of workers and materials are the variable inputs but the building and heavy machinery is a fixed input.

In the Long Run, all Factors of Production are variable. Using the same example as above, over the longer term, the firm is able to also increase the size of its building or invest in more expensive machinery, therefore making all factors of production (inputs) variable.

Short Run Production and The Law of Diminishing Returns

As mentioned above, in the short run, at least one factor of production is fixed. The video below will explain the Law of Diminishing Returns.

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Understanding how firms produce is the first important step to understanding a firms costs, revenues and profits. However in a particular moment in time, the firm will have a fixed amount of at least one factor of production. This means that the firm has a maximum amount it can efficiently produce in the short run if it continues to add variable FOP to its fixed FOP. For example, a delivery firm has 5 vans. If the firm add more labour to these vans, initally the output (how much they deliever), will increase. However, after a certain point, more workers won't increase the amount of deliveries as there is a fixed number of vans. This is called the Law of Diminishing returns and is explained in more detail in the video.

Short Run Costs

Understanding Economic Costs

When a firm uses inputs/resources to produce they incur a costs of production. When a firm uses a resource it does not own, it must buy them from outside the firm and makes a payment for them. It could pay rent on a building, salaries for workers, purchase materials etc. All of these costs of production are called explicit costs.

On the other hand, when a firm uses a resource they own, it still has a cost. For example, if a firm owns an a factory and uses it to produce, the cost for the firm is the rent it could achieve renting out the office instead of using it. Similarly, if a person was to give up their job as a teacher in order to open their own chain of coffee shops, that person still has a cost of the salary or hours they could get paid working as a teacher. These examples are opportunity costs and in economics we refer to these as implicit costs.

In economics we consider both of these types of costs in the cost of production.

Types of Costs

Total Fixed Costs (TFC) - Sum of all fixed costs

Total Variable Costs (TVC) - Sum of all variable costs or Variable cost per unit x number of units

Total Costs (TC) - This is the sum of all costs of production for the firm or TVC+TFC

Average Total Costs - This is the total costs divided by the total output. TC/Q

Average Fixed Costs = TFC/Q or the average fixed cost per unit produced

Average Variable Costs = TVC/Q or the average variable cost per unit produced

Marginal Costs - This is the extra costs of producing one additional unit of output. It is calculated by taking the = Change in Total costs divided by Change in Output.

Marginal Product, Marginal Costs and the firm's Supply Curve (Assumption of the Law of Supply)

When we looked at competitive markets, we introduced the idea that the Supply curve also represented the Marginal Cost Curve for the firm. Below is the assumptions that underpin the Law of Supply. To go to the Law of Supply page, click here.

To understand why this is, let's look at the data in the table on the left. As we can see, the table contains the production (TP,AP & MP) and costs (TC,MC,AC).

If we were to plot the data for both the Marginal Product and Marginal Cost, we would have the two curves shown to the left. As we can see, at the peak of the MP curve, the law of diminishing returns sets in and the additional product each additional input add begins to diminish. We can also see this in the change in the total product from the table above.

Total Product also represents Quantity.

Therefore, as the law of diminishing returns sets in (in the data we can see this is after 2 units of variable input) and each additional variable input adds less to than the previous unit of variable input.

At the same time, we can see the total cost is rising by a constant amount of $100 (the cost of hiring an additional variable input i.e. worker) each time a worker is added. As the marginal cost is equal to the change in total cost / change in quantity (MP), the constant increase in TC is being divided by a lowering increase in TP, due to the law of diminishing returns. Therefore, as output rising, so too does the firms Marginal Cost.

This means that firms will require a higher price in the market to produce a higher quantity, therefore the law of supply: at a higher price, more fims are willing and able to produce due to being able to cover the higher marginal cost of production.

Relationship between Marginal Product, Average Product, Average Cost & Marginal Cost

Long Run Costs

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Long-Run Costs in Economics is considering the outcome of scaling a firm. When a firm's scales its production, this means it increases its production capabilities (and factors of production) which is why we consider the long run as all FOP as variable.

As we have learnt above, if a firm does not increase its FOPs, then it will face the law of diminishing returns and therefore rising costs. So to be able to increase its output, whilst lowering its costs, the firm needs to invest in additional FOPs. When a firm's costs decrease in the long run with increased output, this is called Economies of scale. When a firm's costs rise in the long run with an increase in output, this is called Diseconomies of scale.

Minimum Efficient Scale (MES)

In the long run, all factors of production are variable, and firms can expand or contract their scale of output. As output increases, firms may benefit from lower average costs due to economies of scale. However, beyond a certain point, these cost reductions stop. The Minimum Efficient Scale (MES) is the lowest level of output at which a firm can produce at the lowest point on its long-run average cost (LRAC) curve. This point represents productive efficiency, where the firm is operating with the lowest average total cost possible.

Why MES Matters

Firms that produce below the MES face higher per-unit costs, which may make it difficult to compete with larger, more efficient producers. On the other hand, firms that operate at or beyond MES can take advantage of full economies of scale, enabling them to lower prices or earn higher profit margins.

The size of the MES relative to market demand also has significant implications for the structure of an industry. If the MES is small relative to the total market, then many firms can coexist efficiently, resulting in a more competitive market structure. However, if MES is large relative to market demand, only a few firms can achieve it, often leading to oligopoly or natural monopoly.

MES in Competitive Industries: Bakeries

In industries with low MES, such as local bakeries, the scale needed to reach the lowest average cost is relatively small. This means many firms can operate efficiently without needing a large share of the market. These industries tend to be highly competitive.

Diagram – MES in Small-Scale Industry (e.g. Bakeries)

MES in Medium-Scale Industry: Car Manufacturing

In car manufacturing, the MES is moderate. Firms need significant capital investment and output to lower their average costs, but they don’t need to serve the entire market. Several car companies can coexist in the global or regional market and still reach MES.

Diagram – MES in Medium-Scale Industry (e.g. Car Production)

MES in High MES Industry: Electricity Distribution

In industries like electricity or water supply, the MES is very large. A single firm must produce at a high level of output to minimize costs, often making it inefficient to have multiple firms. These industries may become natural monopolies, where one firm can supply the entire market more efficiently than many small ones.

Diagram – MES in Natural Monopoly (e.g. Electricity)

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