Economics Micro & Macro (CliffsAP)

Production Costs

In previous chapters, we’ve explored the behavior of consumers; let’s now turn our attention to the behavior of producers.
Variety and selection are factors that help businesses succeed in a market economy. Businesses offer a selection of goods
to appeal to the various tastes and preferences of consumers. When producing goods, firms use a range of resources, such
as labor, land, and capital. The price of these resources affects the price of the finished product. The monetary payments
and opportunity costs firms experience comprise a firm’s production costs. This chapter focuses on the production costs
of a firm and how firms continually try to reduce their production costs to increase revenue. Our main goal in this chapter
is to examine the way firms attempt to achieve economic efficiency.

A simple circular flow diagram (see Figure 9-1) shows how money flows from the household sector to the business sec-
tor in payment for goods and services. The flow of money to businesses represents that sector’s total revenue. In turn,
money flows from the business sector to households as payment for the use of their resources—land, labor, and capital.
After the resources have been paid off, the owner of the firm receives or gets to retain what is called a profit. The profit
ultimately depends on what the firm paid for its resources and how much the firm received in revenue. A firm’s goal is to
produce its units at the lowest possible cost without compromising the value or quality of its product. Doing so requires a
firm to compare all combinations of inputs that can be used to produce output.

Figure 9-1

Diminishing Marginal Returns

The relationship between quantities of a variable resource and quantities of output is called the law of diminishing
marginal returns. According to this law, when successive equal amounts of a variable resource are combined with
a fixed amount of another resource, output will initially accelerate, then decelerate, and eventually decline.

Implicit and Explicit Costs

Explicit costsare monetary payments a firm makes for its costs. Labor, raw materials, rent, and power are all explicit
costs. Firms make these payments for resources owned by another person or entity. Although explicit costs are used to
determine a profit, they are not the onlycosts to be considered.

Implicit costsare trade-offs and opportunity costs that arise from a firm’s decision to pay for its own resources. When
firms have implicit costs, they forgo resources owned by other entities. The decision to use self-employed resources cre-
ates a trade-off. Implicit costs are anything external resources could have generated in monetary and nonmonetary value.

Land, Labor, Capital

Goods and Services

Costs of Production

Total Revenue

Households Firms