Chapter 12: Production Costs

Breakeven level of output

the level of output which, if completely sold, the total revenue would be exactly equal to the total cost of its production. Break-even is the point at which the business is neither making a profit nor a loss.

Abnormal profit can be earned in three different market structures:

1. By firms in the perfect competition market structure in the short-run, before the new firms entering the market will wear down the profit down to a normal level (normal profit). 2. By firms which are in less competitive markets, such as firms operating in the monopolistic competition, through innovation or reduction of costs, and generating head start profits. Such profits will eventually be eaten away, providing further incentive for innovation and even to be more cost efficient. 3. By firms which are in very low competitive markets, such as monopolies. These firms can create barriers to entry to protect themselves from the competition in the long-run and earn persistent abnormal profits.

The break-even level of output can be found by:

1. Constructing a table and/or a graph. The level of output where TC is equal to TR and profit is zero. 2. By using the breakeven output formula: Break-even output = Total Fixed Costs / Selling price per unit - Variable costs per unit

Production costs

Payments that the firm pays during the production process. Eg. wages and salaries paid to the employees, cost of raw materials, advertising expenses, rent paid and utility bills.

Marginal cost (MC)

The change in Total Cost when output is increased by 1 unit. Marginal Cost (MC) = ∆ Total cost(TC) / ∆ Total output (Q)

Average total costs (ATC)

The cost per unit of output. It is the total cost of making one product. Average Total Costs (ATC) = Total cost(TC) / Total output (Q)

Fixed costs (FC)

The costs of production that do not vary as output changes. FC exists only in the short-run. Eg. rent, rates, insurance, interest on loans

Variable costs (VC)

The costs of production that vary as output changes. These costs are the variable factor/s of production. Eg. wages, costs of raw materials, fuel, and power

Profit or loss

The difference between the TR and the TC received from the sale of outputs

Average fixed cost (AFC)

The fixed cost per unit of output. The AFC is the only average that is always decreasing since we are dividing a constant figure by an ever-increasing level of output. Average Fixed Costs (AFC) = Fixed cost (FC) / Total output (Q)

Production function

The relationship of how the level output varies when the level of inputs varies. This relationship states the quantity of output (q) that a firm can produce as a function of the quantity of inputs to production

Total costs (TC)

The summation of fixed costs and variable costs of production. TC = FC + VC

Momentary Run (very short run)

The time period where all factors of production are fixed and the firm cannot increase its production

Short Run

The time period where at least one factor of production (input) is fixed. Usually, it is assumed that land and capital are fixed, and labour is variable.

Long Run

The time period which the factors of production, the land, the capital and the quantity of labour are all variable. Therefore, the firm can increase its output by employing more labour, more capital, and more land. In the long-run, the employment of more factors of production will always increase output.

Average variable costs (AVC)

The variable cost of production per unit of output. The selling price must always be greater than the AVC, otherwise the firm closes down. Average Variable Costs (AVC) = Variable cost (VC) / Total output (Q)

Revenue

Total amount of money received by a business from selling the goods and/or services it produces. Sales revenue, total revenue, and sales turnover are used interchangeably. Total Revenue (TR) = Selling Price (P) x Quantity Sold (Q)

Supernormal profit / economic profit / abnormal profit

When the firm's profit is over and above the normal profit. This is learned when the total revenue (TR) is greater than the total costs (TC), whereby the total costs (TC) includes the normal profit.

Normal profit

a minimum reward that is sufficient enough to keep the entrepreneur supplying their enterprise. This reward is covering the opportunity cost of the entrepreneurship

Returns to scale

compare the percentage increase in the output of the firm to the percentage increase in the size of the firm when the firm employs more of all the factors of production.

Marginal product (MP)

measures the change in the Total Product (TP) resulting from a change in the factors of production. MarginalProduct = ∆Total Product (TP) in units / ∆ Units of factors of production

Average product (AP)

measures the product produced per worker or the output per unit of capital Average Product = Total Product (TP)in units / Units of factors of production

Law of Diminishing Returns

states that as more units of the variable factor (labour) are added to the fixed factors (land/capital), the change in total output will at first increase and then decrease.