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Production Cost

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!

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Production Cost

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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!

Cost of production definition

The cost of production definition is all the costs incurred by a firm during production. 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 increase in production, but at a diminishing, or decreasing rate.

Production Cost Perfect competition function curve StudySmarterFig. 1 - An illustrative production function curve

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. There are no barriers to entry or exit, nothing is hindering them from either.

Costs of production in perfect Competition

To explain the costs of production in perfect competition, we will start by looking at the production function. 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.

Calculate the total cost of production in perfect competition

Here, we will calculate the total cost of production in perfect competition using the following example:

A coffee processing company produces coffee for sale. To produce the coffee, the company only uses land and labor. The 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:

\(Production\ cost=\ Total\ Fixed\ Cost+\ Total\ Variable\ Cost\)

\(TC={FC}+{VC}\)

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 the 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, the marginal output is also referred to as a 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:

\(\frac{\Delta\hbox{Q}}{\Delta\hbox{L}}\)

The ∆ symbol known as Delta refers to change, so ∆Q is the change in quantity.

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
0000
1151515
2281314
3391113
448912
555711
660?10

So what is the marginal product of labor when the sixth worker is added? Let's use the formula for MPL above.

\(\hbox{MPL}=\frac{\Delta\hbox{Q}}{\Delta\hbox{L}}=\frac{60-55}{6-5}=\frac{5}{1}=5\)

Now, let's show the production function on a graph! Look at Figure 2 below.

Production Cost Perfect competition production function coffee business curve StudySmarterFig. 2 - Production function for coffee business

Cost of a product formula

The formula for the cost of a product uses the total production cost and the quantity of the product produced. Economists may also refer to the cost of a product as the cost per unit or the average cost of production. It is the total production cost divided by the total quantity of goods produced.

The cost of a product or the cost per unit produced is the total production cost divided by the total quantity of goods produced.

Mathematically, this is written as:

\(Cost\ per\ unit=\frac{TC}{Q}\)

Shall we try an example?

Fred produced 50 candy bars and incurred a total cost of $25. What is the cost of producing a candy bar?

Solution:

Since the quantity of candy bars is 50 and the total production cost is $25, we can insert these into the formula for the cost of a product.

\(Cost\ per\ unit=\frac{TC}{Q}\)

We will have:

\(Cost\ per\ unit=\frac{$25}{50}\)

\(Cost\ per\ unit=$0.5\)

Examples of production in perfect competition

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.

Main characteristics of production cost in perfect competition

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 the 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 - Key Takeaways

  • Production cost refers to all the direct and indirect costs the firm incurs to make the products it sells.
  • The production function covers the relationship between the inputs and outputs of production.
  • The two types of production costs are fixed costs and variable costs.
  • In the short run, at least one input is fixed, which means that there is at least one fixed cost. In the long run, all inputs are variable inputs, and all costs are variable costs.
  • The marginal product is the additional product resulting from the addition of an extra unit of input.
  • The law of diminishing marginal returns states that adding additional inputs while keeping other resources constant results in progressively smaller increases in the total product; alternatively stated, marginal product decreases as additional units of the resource are used.

Frequently Asked Questions about Production Cost

Product cost, or cost per unit, is the cost of producing a unit of output.

The cost of a product or the cost per unit produced is the total production cost divided by the total quantity of goods produced.

Mathematically, this is:

Cost per unit = TC/Q

Cost of production directly affects supply as it affects the profit margin and therefore the quantity of the product that the firms decide to sell in the market.

Bulk production reduces costs by lowering the cost per unit as the same volume of resources per time unit is utilized to produce a greater output quantity.

Production cost is important because it helps firms determine whether their operations are profitable and whether to provide a good or a service in the market.

Final Production Cost Quiz

Production Cost Quiz - Teste dein Wissen

Question

What are some examples of fixed costs?

Show answer

Answer

Some examples of fixed costs include the maintenance costs of an office building, rent, salaries, interest on loans, advertising, and business rates.

Show question

Question

What are some examples of variable costs?

Show answer

Answer

 Some examples of variable costs include wage costs, basic raw materials (wood, metal, iron), energy costs, fuel costs, and packaging costs.

Show question

Question

What are total costs?

Show answer

Answer

The total costs (TC) of a company are the fixed costs (FC) and variable costs (VC) added together.

Show question

Question

What are average costs?


Show answer

Answer

The average cost (AC) or unit cost is calculated by dividing the firm’s total cost of production by the quantity (Q) of output produced.

Show question

Question

What is productivity?

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Answer

Productivity is a measure of effectiveness and efficiency on how a company or economy can transform resources into goods or services.

Show question

Question

How is productivity measured?

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Answer

Productivity is measured as a ratio of output to the input consumed.

Show question

Question

When does productivity increase?

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Answer

- The output produced increases while the amount of inputs remains the same.


Or


-When the same amount of output is produced with less input.

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Question

What is production? 

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Answer

Production is the process of converting raw materials into useful goods or services.

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Question

Are production and productivity the same?

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Answer

No.

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Question

What is the difference between production and productivity?

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Answer

Production is a process - the process of converting raw materials into useful outputs (goods or services)


Productivity is a measure -  the measure of effectiveness and efficiency in the process of production

Show question

Question

What are the types of productivity?

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Answer

- Labour productivity

- Land productivity

- Capital productivity

- Entrepreneurial productivity



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Question

What is labour productivity?

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Answer

Labour productivity is defined as output produced per unit of labour input.

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Question

Why is productivity important?

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Answer

It is the key source of economic growth and competitiveness.

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Question

How does productivity contribute to economic growth?

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Answer

Productivity contributes to:

- higher profits

- lower prices

- higher wages

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Question

How can firms improve productivity?

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Answer

By

- Selecting the proper workforce

- Selecting proper equipments and machines

-Carefully choosing the total area and its location

- Using renewable resources 

- Managing properly the production factors

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Question

What is economies of scale?

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Answer

As a firm’s output increases, its long-run average costs decrease.

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Question

What is diseconomies of scale?

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Answer

As the output of a firm increases, the long run average costs increase. 

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Question

What is short-run production?

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Answer

Short-run production in the microeconomic theory is the period where at least one of the factors of production (land, labour, capital, and technology) is fixed and cannot be changed.

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Question

What is long-run production?

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Answer

Long-run production in the microeconomic theory is the period where the scale of all factors of production is variable and can be changed.

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Question

What are the types of production costs?

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Answer

  • Fixed costs 
  • Variable costs
  • Total costs
  • Average cost
  • Long-run average cost 
  • Average fixed costs
  • Average variable costs
  • Average total costs

Show question

Question

What are fixed costs?

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Answer

Fixed costs are the costs that do not change when production output changes.

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Question

What are some examples of fixed costs?

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Answer

1. Maintenance costs of a factory or an office building.

2. Rent.

3. Interest on loans.

4. Advertising.

5. Business rates.

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Question

What are variable costs?

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Answer

Variable costs are the costs that change when production output changes. 

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Question

What are examples of variable costs?

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Answer

1. Wages.

2. Basic raw materials (such as wood, metal, iron.)

3. Energy costs.

4. Fuel costs.

5. packaging costs

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Question

What is the total cost?

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Answer

Total cost is the aggregate cost incurred by a company of producing a given level of output.

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Question

How can you reduce the costs of production?

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Answer

  1. Increase employees’ efficiency with training programs.
  2. Assign tasks to employees who are specialised to these particular tasks and fields.
  3. Reduce direct costs by utilising quotations from suppliers or offering cash payments to suppliers.

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Question

What is technological change?

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Answer

Technological change is improving existing technologies and developing new ones to improve the existing products and to create new products in the market.

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Question

What is an invention? 

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Answer

Anything that is created for the first time. 

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Question

Which century is considered the ‘Computer age’?

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Answer

Mid twentieth century onwards. 

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Question

What does productivity mean?

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Answer

It is the output produced per unit of input.

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Question

What is a monopolistic market structure?

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Answer

A market ruled by one company. 


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Question

What is disruptive innovation?

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Answer

Innovation is disruptive when it improves existing goods or creates new goods with which the existing market goods can not compete.

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Question

What does sustaining innovation mean? 

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Answer

Due to sustained innovation, no new markets are created. Companies within the existing markets compete by providing better value than their competitors. 

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Question

What is the definition of creative destruction?

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Answer

Capitalism evolving and renewing itself over time through new technologies and innovations by replacing older technologies and innovations. 

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Question

When did the agricultural and industrial revolutions begin? 

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Answer

 In the eighteenth century. 

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Question

In which century did steel replace iron in infrastructure development and manufacturing?

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Answer

In the nineteenth century. 

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Question

What does the cost of production mean?

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Answer

A cost that is incurred while producing a unit of a good. 

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Question

What is innovation?

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Answer

Anything that improves an invention is called innovation. 

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Question

What is a duopolistic market structure?

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Answer

A market ruled by two companies. 

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What is a competitive market structure?

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Answer

A market where not one or two companies are ruling it. Every company has equal chance of progressing. 

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Question

Who came up with the term ‘creative destruction’? 

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Answer

An Austrian American economist named Joseph Schumpeter. 

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Question

What is an example of the law of diminishing returns?

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Answer

Extraction of fish, chocolate production, a software company, etc.

Show question

Question

What is the law of diminishing returns?

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Answer

The Law of diminishing returns states that when you have a fixed variable in a production process and add more of the other variable, the total output produced by the other variable will fall.

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Question

What is the significance of the law of diminishing returns?


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Answer

It helps companies maximise their profit and plan their production ahead.

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Question

What are the three stages of the law of diminishing returns? 


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Answer

Increasing returns, constant returns, and diminishing returns.

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Question

Where can you observe the law of diminishing returns?

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Answer

In production processes.

Show question

Question

Are inputs homogenous or heterogenous in the law of diminishing returns?

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Answer

Homogenous.

Show question

Question

Can you observe the law of diminishing returns in the long run?

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Answer

No, the law of diminishing returns can only be observed in the short run.

Show question

Question

Why can't you observe the law of diminishing returns in the long run?

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Answer

Because other dynamics will start affecting the production process.

Show question

Question

What is the marginal return of labour?

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Answer

The marginal return of labour is the output generated by having the firm hire an additional worker.

Show question

Test your knowledge with multiple choice flashcards

How many types of returns to scale are there?

Is there a difference between diminishing returns to scale and diminishing marginal returns?

Do returns to scale occur in the long run or short run?

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Flashcards in Production Cost757

Start learning

What are some examples of fixed costs?

Some examples of fixed costs include the maintenance costs of an office building, rent, salaries, interest on loans, advertising, and business rates.

What are some examples of variable costs?

 Some examples of variable costs include wage costs, basic raw materials (wood, metal, iron), energy costs, fuel costs, and packaging costs.

What are total costs?

The total costs (TC) of a company are the fixed costs (FC) and variable costs (VC) added together.

What are average costs?


The average cost (AC) or unit cost is calculated by dividing the firm’s total cost of production by the quantity (Q) of output produced.

What is productivity?

Productivity is a measure of effectiveness and efficiency on how a company or economy can transform resources into goods or services.

How is productivity measured?

Productivity is measured as a ratio of output to the input consumed.

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