Costs of production affect the decision an individual firm makes about how much to produce. They also affect how many firms will be in an industry.

To illustrate the concepts of cost of production, consider a pizza shop that makes pizzas and delivers them to customers where they live.

–Fixed Costs are costs that the firm must incur even if it produces no output. The pizza shop must pay rent, it has to obtain ovens and other equipment, it must obtain a license, pay for advertising, etc. Fixed costs include the opportunity cost of the business owner, who spends time tending to the pizza shop that otherwise could be spent doing other things.

–Variable Costs are costs that vary with the amount of output. Each pizza requires flour, tomato sauce, cheese, additional labor effort, etc. Since our shop delivers the pizza, variable cost includes the driver’s time and the cost of gasoline.

–Marginal Cost is the cost of increasing output by one unit. To increase sales, our pizza shop must deliver pizzas to customers farther and farther away from our location. This costs more in gas mileage and driver’s time. So we say that there are increasing marginal costs.

When we decide how much to expand production, we compare the price we can sell output to our marginal cost.

Suppose that the price we can get for a pizza is $10. If the marginal cost of producing a pizza and delivering it to nearby customers is $8, we earn a profit on an additional pizza and we should expand output. As we try to serve a larger market with customers farther away, the marginal cost might rise to $11. That is too high relative to a price of $10, so we should not expand output that far. We should only expand output to where the point where the marginal cost of making and delivering the pizza is just equal to the price.

–Average Variable Cost is the sum of all variable costs divided by the number of units sold. If the total cost of pizza ingredients, gasoline, and labor time for delivering 10,000 pizzas is $80,000, then average variable cost is $80,000/10,000 = $8. As long as the price at which we can sell a pizza is above average variable cost, it pays to keep continue operations. But if the price were below average variable cost, then we should stop buying ingredients and paying for labor. We would still be stuck with fixed costs, until we can exit the business.

–Average Total Cost is the sum of all variable costs plus fixed costs, divided by the number of units sold. If the total variable cost for delivering 10,000 pizzas is $80,000 and the fixed cost of our shop is $20,000, then total cost is $100,000. So average total cost is $100,000/10,000 = $10. If the price we can sell pizzas is $10 each, then we are just breaking even. If the price is $9, then we should keep selling pizzas to cover variable cost, but we should be trying to exit the business by selling the equipment and getting out of our rental agreement as soon as possible.

To decide whether to enter an industry or exit an industry, an entrepreneur will assess the prospects for selling output above average total cost. Once in an industry, the entrepreneur will keep producing output as long as the price is above average variable cost, but if the price is below average total cost the entrepreneur will look to exit the industry.

The decision of how much to produce is based on comparing marginal cost to marginal revenue. When marginal revenue is above marginal cost, that suggests producing more. When marginal revenue is below marginal cost, that suggests producing less. When marginal revenue and marginal cost are equal, that suggests that the right amount is being produced.

When the firm is making these marginal decisions, fixed costs do not matter. But for the industry as a whole, fixed costs affect the number of firms that a market can support. Other things equal, when fixed costs are high, there will be only a few firms. When fixed costs are low, there will tend to be many firms. When the Internet reduced the fixed cost of becoming a publisher, because you no longer need a printing press, the number of providers of written content skyrocketed.

–by Arnold Kling

Definitions and Basics

Spatial Economics, by Wolfgang Kasper. Concise Encyclopedia of Economics.

Producers and buyers are dispersed in space, and overcoming the distances between them can be costly. Much commercial activity is concerned with “space bridging,” and much entrepreneurship is aimed at making good use of locational opportunities and cutting the costs of transport and communication….

Michael Munger on Sharing, Transaction Costs, and Tomorrow 3.0. Podcast episode on EconTalk.

… I think the three categories of transactions costs are: First, triangulation–the people who want to cooperate or buy and sell have to be able to find each other. And they have to be able to identify each other as possessing something that the other wants. Usually in economics we start with this idea that A has a widget; B has some money and wants a widget; and then they negotiate on price. Well, how did they meet? How did they know that they have a widget? Do they speak the same language? Do they have a currency that they can use to consummate the exchange?…

Advertising, by George Bittlingmayer. Concise Encyclopedia of Economics.

Economic analysis of advertising dates to the 1930s and 1940s, when critics attacked it as a monopolistic and wasteful practice. Defenders soon emerged who argued that advertising promotes competition and lowers the costs of providing information to consumers and distributing goods. Today, most economists side with the defenders most of the time….

Liability, by W. Kip Viscusi. Concise Encyclopedia of Economics.

Until the 1980s, property and liability insurance was a small cost of doing business. But the substantial expansion in what legally constitutes liability has greatly increased the cost of liability insurance for personal injuries….

In the News and Examples

Elizabeth Pape on Manufacturing and Selling Women’s Clothing and Elizabeth Suzann. Podcast episode on EconTalk.

… Most fabrics shrink 10-20% in length. So, we’re using probably about 15% more fabric than the H&M tunic, because we’ve accounted for shrinkage. If you throw that tunic in the wash, I can almost guarantee you that it’s going to shrink to an unwearable size. So, shrinkage ends up being a pretty big factor in our bottom line. So, we’ve got fabric. And then we’ve got trim, which is pretty minimal–thread. We’ve got the garment tag, the care tag, the hang tag. So, all those go into the material cost. And we end up at about $30–I think $31 dollars…. for the material cost going into that shirt.

… Then we’ve got the labor cost. So, all of our garments are, as we said, cut and sewn in the building. So, we’ve got a gal over there who, she creates a marker, which is essentially a template that’s laid out over various plies of fabric. Those have been cut through with a kind of electric knife–she cuts through the big stacks and then she pairs together the garment pieces that go together….

Mitch Weiss on the Business of Broadway. Podcast episode on EconTalk.

… Every theater is slightly different and has its own characteristic. So the designers–in addition, let me throw in a very important feature. New York City has the most stringent fire code in the world. When, if you light a cigarette on stage, there are two stage hands who have been specially trained and licensed, standing with fire extinguishers on each side of the stage, for that particular moment. Then they go back and do whatever else they are doing. So, when you see, fire or any sort of thing on stage, there is a lot going on backstage. And New York has never had a fire that the audience had to worry about. So, whether it’s right or wrong–of course, you can go to Chicago, and you can do what you want….

Wally Thurman on Bees, Beekeeping, and Coase. Podcast episode on EconTalk.

… If you take bees into an almond orchard, you might rent them for a 10-day service while the trees are blooming, for $150, $175, maybe $200 per colony. You might put two colonies per acre. So $300, $350 an acre is how much the almond grower would pay the beekeeper. A little perspective on that is that’s going to work out to be not huge in the spreadsheet of an almond-grower, maybe a 5-7% cost share. So among all the seed and land–well, per anything. Of all his costs–labor, chemicals, fertilizer, land, etc.–renting pollination services is going to be 5, 10, 7% of his costs….

Michael Munger on Milk. Podcast episode on EconTalk.

… if you want to know the markup on something–and a lot of times people say, oh, the liquor is so expensive, that’s where they make all their money; they lose money on everything else but they get it back on the liquor. Or, they make it up on the desserts. Or whatever it is. And one of the things that ignores–it ignores a couple of things. It ignores the fixed and sometimes not so fixed cost of a liquor license, which makes the actual profit of the item different from what the markup is. I think people think, I know what a bottle of wine costs, and this is so much more than that in the restaurant. But of course the steak is a lot more, too. You say, well, okay, but there are labor costs; there’s not much labor cost in a bottle of wine. How could that be the legitimate, competitive markup?…

Keith Smith on Free Market Health Care. Podcast episode on EconTalk.

… Yeah. Yeah, so much for the spiraling cost of healthcare. And, I’d like to point out that some of the prices on our website may actually look higher than when we first started. And the reason for that is that the actual bundle of services that we are providing that initially maybe were not inside of the bundle of care, are….

Corruption, by Fran├žois Melese. Concise Encyclopedia of Economics.

… Corruption hurts investment in at least three ways. First, it increases the cost of doing business, which then raises the threshold revenues required for businesses to break even….

Advanced Resources

Michael Munger on the Nature of the Firm. Podcast episode on EconTalk.

… It’s not free to use the price system. Firms exist when it’s too expensive to use the price system. Home repair or home improvement: invite someone into your house, their bid never turns out to be what you pay, always surprises. Some you pay by the hour; but that gives them an incentive to go slowly. Maybe best way is flat rate; but you rejected the high bidder who may have anticipated that and now you are stuck with uncomfortable situation and maybe having to pay more. …

L.S.E. Essays on Cost, by James M. Buchanan and George F. Thirlby.

… In his paper, ‘Economics and Knowledge’, included in this volume, Hayek scarcely mentioned ‘cost’. Nonetheless he provides indirectly the strongest argument for attempting, through the publication of this collection of essays, to focus the attention of modern economists on the elementary meaning of cost. Hayek emphasized the differences, in principle, between the equilibrium position attained by a single rational decision-maker in his own behavioural adjustments, given his preference function and the constraints that he confronts, and the equilibrium potentially attainable through the interaction of many persons….

The Theory of Interest, by Irving Fisher.

… But even if we change the orchard to machines, houses, tools, ships (that is, “produced means to further production”) the principle that the value of anything is the discounted value of its expected income stands unrefuted. This is not to say cost of production does not have an influence. But past costs have no influence on the present value of a capital good, except as those costs affect the value of the future services it renders and the future costs….

Related Topics

Margins and Thinking at the Margin

Competition and Market Structures