7.1 Building Producer Theory
Learning Objectives
By the end of this section, you will be able to:
- Understand the relationship between marginal product of labour and marginal cost
- Derive average cost from marginal costs
- Represent a firm’s short run costs on a producer theory diagram
Different firms face different kinds of costs. A list of the costs involved in producing cars will look very different from the costs involved in producing fast-food meals. However, the cost structure of all firms can be broken down into some common types.
To start, we want to look at the costs of a single firm in the short run. These costs come from the different inputs required to produce a good, whether that is machines, labour, ingredients, rent, etc. By short run, we mean that there is at least one input that cannot be changed. This input (or inputs) is classified as a fixed cost since in the short term there is nothing we can do to avoid this cost except quit producing altogether.
When a firm looks at its total costs of production in the short run, a useful starting point is to divide total costs into two categories: fixed costs (ones that cannot change) and variable costs (ones that can change).
To guide our understanding of fixed and variable costs, consider Henry Ford once more. When Ford was opening his first factory, he had to consider different categories of costs.
Fixed Costs
Ford’s fixed costs are his expenditures that do not change regardless of his level of production. Whether he produced a lot or a little, his fixed costs are the same.
The first step for Ford to open his factory is finding the factory space. Ford must find someone who is willing to sell or rent him space. His first offer comes from Tom, who will only rent to Ford if Ford signs a 1-year lease for $20,000. Ford, with little negotiating power, agrees and signs the lease.
Once Ford signs the lease, the rent for the year costs him $20,000 regardless of how much he produces. This lease has now become a sunk cost since there is nothing Ford can do to get his money back. Fixed costs can take many other forms: for example, the cost of machinery or equipment to produce the product, research and development costs, even an expense like advertising to popularize a brand name. The level of fixed costs varies according to the specific line of business. For instance, manufacturing computer chips requires an expensive factory, but a local moving and hauling business can get by with almost no fixed costs at all if it rents trucks by the day when needed. Since Fords cost is fixed for a whole year, this is the length of his ‘short-run.’ During that period, since the lease expense is sunk, it should not affect his decision making.
Variable Costs
Ford’s variable costs are incurred in the act of producing—the more he produces, the greater the variable cost.
After signing the lease for the factory and purchasing machines, Ford now has to buy the raw materials and find workers to produce his cars. The mo