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!

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.

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.

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.

Fig. 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.

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.

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.

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.

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:

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.

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.

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.

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.

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:

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.

So, what is the marginal output? It is the additional output resulting from the addition of an extra unit of input.

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

With all the information we have now, let's look at the table below based on the provided example.

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.

Fig. 2 - Production function for coffee business

Shall we try an example?

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.

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!