6 - Production and Cost

Abstract

Firms exist because they can increase efficiency in production. Firms are organized in many different ways according to the size of the firm and the number of owners that a firm might have. The principal motive of the firm is to earn profits, although several other motives might also affect business decisions. Firms encounter fixed and variable costs in production in the short run. In the long run, all costs are variable. The firm bears the explicit costs of fixed and variable inputs and the opportunity costs of production decisions foregone. As production increases, the total cost of production increases. The marginal cost of output rises showing that greater levels of production can be obtained, in the short run, at ever increasing costs. Rising marginal costs mean that average costs display a “U-shaped” relationship, first falling as production increases, and then rising with greater levels of output. In the short run, with some variables fixed, rising production means rising marginal and average costs. In the long run, all inputs can be viewed as variable and rising average costs are not the case, depending upon the nature of returns to scale for the individual firm.