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When you think of buying your favorite drink, you start considering how much it will cost you. But have you wondered how much it cost the firm to make that drink? All firms spend something to make the products they sell, whether directly or indirectly. This is because nobody has unlimited resources, so everything comes at a price! Whatever the firm spends to make the product you love so much is part of the total production cost. What does that include? Let's find out together. Read on!
Businesses are in the business of making things people want to buy. These things people want to buy are called goods (or outputs). To make these outputs, the firm must start with inputs and process or convert them. The inputs come at a cost, and the conversion of inputs into outputs also incurs a cost. All these costs make up the total production cost.
Firms must convert inputs into outputs.
Production cost refers to all the direct and indirect costs the firm incurs to make the products it sells.
But is it that simple? Of course not! (But it is also not complicated, don’t worry).
Firms want to make as much money as they can possibly make, and they do this by selling products. However, the quantity of products they can produce depends on the quantity of inputs they use. This relationship is referred to as the production function.
The production function shows the relationship between the quantity of inputs and the quantity of outputs.
Figure 1 illustrates a production function. It will typically be increasing because more inputs allow for the production of more goods. However, it will typically have a section that is still increasing but concave downward, which reflects diminishing marginal returns. This means that each additional unit of input contributes a positive but diminishing, or decreasing, marginal increase in production.
Figure 1. An illustrative production function curve, StudySmarter Original
Okay, now let's address the perfect competition model. You've been waiting to know what it is, let's get right into it!
The perfect competition model refers to a market where we assume that there are many, many firms that are making the same products or goods for many, many people to buy.
Firms make identical products.
In the perfect competition model, the product is assumed to be identical from one firm to the next. There are no differences between the products or brands.
There are a large number of firms and consumers.
This model assumes that each buyer and seller is a teeny, tiny part of the vast market. There are enough buyers demanding the product that the market can take any possible quantity level that a seller might choose to produce.
There is no market power.
All firms and consumers are so small and powerless that they must take the market price as a given. They have no market power with which to set their own price. Instead, they take the market price and choose only their output quantity.
New firms can easily enter the market without incurring costs, and old firms can easily leave the market without incurring costs.
Finally, firms can easily enter (new firms) and exit (existing firms) the market. Not much is stopping them, because there are no barriers to entry or exit.
You should keep in mind that the production function shows the relationship between the quantity of inputs and the quantity of outputs. Look at this example:
A coffee processing company produces coffee for sale. To produce the coffee, the company only uses land and labor. Land for planting the coffee, and labor to process the coffee for sale. The land of the company is 5 acres, and they have no extra land. Thus, they can’t change the size of the land they have through any means.
In the above example, economists refer to land as a fixed input. This is because its quantity cannot be changed for a given period of time.
A fixed input is an input whose quantity cannot be changed for a given period.
On the other hand, the labor hired by the company is a variable input. This means the company can hire more workers or lay off workers as needed.
A variable input is an input whose quantity can be changed for a given period.
You must note that given enough time, any input can be a variable input. Enough time is available in the long run. What distinguishes the long run from the short run? The short run is any period of time where at least one input is a fixed input.
In the long run, all inputs are variable inputs. The long run can be defined as the length of time it takes for all fixed costs to become variable in some way.
Since production cost refers to all the direct and indirect costs the firm incurs to make the products it sells, we can now say that the firm can have a long-run cost or a short-run cost.
Long-run production costs refer to all the direct and indirect costs the firm incurs to make the products it sells in the long run.
Short-run production costs refer to all the direct and indirect costs the firm incurs to make the products it sells in the short run.
Let's do some simple calculations now. Consider the following example:
A coffee processing company produces coffee for sale. To produce the coffee, the company only uses land and labor. Land is for planting the coffee, and the labor force processes the coffee for sale. The land owned by the company is 5 acres, and they have no extra land. Thus, they can’t change the size of the land they have through any means in the short run. However, they can increase or decrease the quantity of labor.
The total production cost (TC) is the total fixed cost (FC) and the total variable cost (VC) combined.
Mathematically:
Before the calculations, let's talk about diminishing marginal returns.
If the company has one worker, the production process will be slow. With additional workers, production increases. As the company adds more workers, the total amount of coffee they can produce increases due to each additional work having a positive marginal contribution.
However, at some point, the owner realizes that each additional worker increases the total output by a smaller amount than the worker before. That's diminishing marginal returns. Eventually, the process will be so crowded that adding an additional worker will actually decrease the total production! This happens because too many workers can get in each other's way.
Let's back up. Suppose that one worker produces 15 bags of coffee. Then, two workers are not quite able to double that. Instead, they can produce 28 bags of coffee together. Why 28 instead of 30, you ask? Well, the operation has only 5 acres of land, and that creates a limitation. With 5 acres, there is a limit to how much they can produce, even if they added the entire population of Nebraska!
With three workers, they can produce 39 units. This is more than they could produce with only two workers, but the new worker has a smaller additional contribution (11 units = 39 - 28) than the second worker (13 units = 28 - 15). As you add more workers without increasing the acres of land, total output will increase, but the contribution of each additional worker decreases.
The law of diminishing marginal returns states that the addition of additional inputs results in smaller marginal output.
So, what is marginal output? It is the additional output resulting from the addition of an extra unit of input.
Marginal output is the increase in total output as a result of the addition of an extra unit of input.
Since an output refers to the product being produced, marginal output is also referred to as marginal product. And the marginal product of an input, say, labor, is called the marginal product of labor.
This is calculated by dividing the change in the quantity of output by the change in the quantity of input. If the input is labor (L), the formula is:
With all the information we have now, let's look at the table below based on the provided example.
| Quantity of Labor (L) | Quantity of Coffee (Q) | Marginal Product of Labor (MPL) | Average Product |
| 0 | 0 | 0 | 0 |
| 1 | 15 | 15 | 15 |
| 2 | 28 | 13 | 14 |
| 3 | 39 | 11 | 13 |
| 4 | 48 | 9 | 12 |
| 5 | 55 | 7 | 11 |
| 6 | 60 | ? | 10 |
So what is the marginal product of labor when the sixth worker is added? Let's use the formula for MPL above.
Now, let's show the production function on a graph. Look at Figure 2 below.
Figure 2. Production function for coffee business, StudySmarter Original
Let's look at some examples of production and cost in perfect competition. In perfect competition, there are many firms producing the same product with many consumers buying them.
An example is an agricultural commodity exchange where many raw products (corn, lettuce, tomatoes) are essentially the same. Firms that produce coffee beans to sell on a commodity exchange are in perfect competition and must take the going market rate on the exchange as given. They must decide how much to plant and produce for the next season based on the cost of resources and the current market price for coffee beans.
Another example is online bookselling, since the internet provides platforms for people to buy and sell items that are often identical. A given book, if it's brand-new, is identical across any number of sellers. Thus, online sellers can find themselves in a very competitive market, where the quantity is high and the market price is quite low. Firms with higher costs of production are driven out of the online market.
Note that perfect competition is a theoretical extreme; often, products claim to have a specific quality level or other distinguishing feature that differentiates the product from that of another seller.
The main characteristic of production cost in perfect competition in the long-run is that all the producers (firms) are selling at their marginal cost of production. In the long run, all costs are variable, so the marginal cost equals both the variable cost of the next unit and the total cost of the next unit. Firms all produce at an efficient quantity for their given production function, and high-cost producers are driven out of the market in long-run equilibrium. Figure 3 depicts this!
Perfect! You've completed Production, Cost and the Perfect Competition Model. That was easy, right? You should definitely read our articles on Short-run Production Costs and Long-run Production Costs. They provide more detail after the introduction you just had!
Production cost refers to all the direct and indirect costs the firm incurs to make the products it sells. Indirect costs are called implicit costs; direct costs are called explicit costs. Production costs can be variable with the level of output, or fixed with respect to the level of output. The perfect competition model in economics is a setup where a large number of profit-maximizing firms compete with each other to produce and sell an identical good.
1. There are a very large number of buyers and sellers.
2. All firms are selling identical products.
3. All buyers and sellers are price-takers; no one has any market power.
4. Firms can leave and enter the market without incurring any cost.
In any market structure, a firm that is producing a good incurs both fixed costs of production and variable costs of production.
Production Cost = Fixed Cost + Variable Cost
If the marginal cost of production is increasing, the profit-maximizing firm in any market structure produces up to the point where the marginal benefit of producing an additional unit equals the marginal cost of production for that next unit. In perfect competition, each firm takes the market price as given. Thus, the marginal benefit of producing and selling one additional unit of the finished good is precisely the revenue earned on that unit, which is the price of the good. In short, in perfect competition, price equals marginal benefit. Therefore, MB = MC at the quantity level where P = MC.
Consider the alternative possibilities. If marginal cost is below the market price, then additional units can be produced at a positive profit, so profit is not maximized. Similarly, if marginal cost is above the market price, then some units were sold below their cost, so profit is not maximized.
Since firms in perfect competition have no market power, the equilibrium price and quantity are perfectly efficient. Stated another way, the outcome maximizes consumer plus producer surplus and is socially optimal. Compared to monopoly, firms in perfect competition collectively sell more units at a lower market price. This is the most efficient outcome possible.
A firm's cost function in any market structure is the relationship between the number of units produced and the total cost of producing those units. It is calculated as the sum of all fixed costs and all variable costs.
The perfectly competitive market environment affects the firm's revenue function, but not its cost function.
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