Unit 4: Production Decisions

Jim’s Guide for Unit 4:  Production and Costs

Adam Smith
Division of labour is the great cause of its increased powers , as may be better understood from a particular example, such as pin making…The effect is similar in all trade and also in the division of employments…The advantage is due to three circumstances. (1) improved dexterity, (2) saving of time, (3) application of machinery, invented by workmen, or by machine-makers and philosophers.

– Adam Smith, The Wealth of Nations


In the last two units we focused on demand, supply and their interaction in markets to determine the quantities or goods actually sold and the prices of those goods.  But in those units, you, like most students first being introduced to economics, probably thought most often about what economists call “final goods markets”.  In other words, you probably tried to relate the concepts to your own experiences buying and shopping for goods everyday.  In most cases, you’re a consumer – you’re one of the buyers that makes up the market demand curve.  Of course, in reality, you are often also a seller – particularly if you have a job. If you have a job you’re a seller and part of a supply curve.  But normally students relate easiest to buying goods and the demand for goods.

Now, in this chapter we switch our focus. Instead of looking at consumption & consumers, we are going to look at production & the firms that do it. In some ways, the analysis appears to get a little more complex at this point, but the essential thinking of firms is actually very similar to what consumers do.

Rational Choices: Marginal Decision-Making

The models and theories that underlie both the law of demand and the law of supply are based on the assumption that decision-makers (consumers and firms) make rational choices about how many units of a good to buy or how many units to make based on marginal decision-making.  Basically, we assume that everybody wants to make themselves better off and to make themselves as well-off as they can given the constraints of the real world. Constraints are things like our budget, available resources, and the prices that others charge. Given these constraints we try to maximize our benefit or utility or satisfaction (consumers) or maximize our profits (firms).

To rationally maximize benefit requires the decision-maker (consumer OR firm) to engage in marginal decision-making. Among non-economists, rational choices are often called “cost-benefit analysis”, but not all forms of cost-benefit analysis are marginal decision-making.  The key is understanding that we all make decisions or choices “at the margin” – that is, we don’t make grand plans for how much in total to consume or produce, instead we make a series of small decisions like “should I have another one?”.

The Magic Ingredient: Marginal Decision-Making

Bluntly put, consumers don’t really choose the total quantities they want to consume of each product, so much as they make an unending series of little choices to have “a little bit more of this” and a “little bit less of that”. These are marginal decisions. When make these incremental choices, we are constantly comparing the marginal benefit to be gained from that incremental increase in consumption versus the marginal cost of what it takes to acquire the incremental amount.

Examples of Marginal Decision-Making

 Let’s suppose you go out with your friends to some establishment that sells beverages and provides a nice atmosphere to watch talk and watch large-screen televisions – it could be coffee shop or a bar or somewhere else. Use your imagination.  Chances are rate that you don’t go  there with a pre-determined plan of exactly how many total units of beverage you will consume that evening.  Instead, you order one when you get there. As the evening wears on, you are asked repeatedly “Would you like another?”.  Each time you are asked, you  imagine or consider (often very quickly and unconsciously) the costs vs. benefits of one more unit – the next glass. If the benefit of one more appears to outweigh the costs of one more, then you say “Yes, I’ll have another”. Once you get to a point where the costs of the next one outweigh the benefits of that next one, you say no.  Your total consumption is based on adding up all the marginal choices where you said yes.

Similarly, consider your annual consumption of hamburger.  Odds are, unless you’re really weird, that you didn’t start the new year with a plan for your total consumption of hamburger this year.  Instead, you make a series of marginal choices.  Each day, at each mealtime, you ask “would increasing my consumption of hamburger this year by one more 1/4 pounder yield more satisfaction than the cost of paying for it”.  OK, you probably phrased it more like “do I feel like a burger?”, but it’s the same process.  Only at the end of the year when we add up all the times when you said yes to the marginal burger (one more unit of hamburger) can we get your total annual consumption.

 Do We Really Make Choices This Way?

It’s useful to keep in mind that the optimizing and choosing behavior described in this unit isn’t necessarily conscious decision-making by people. What economists have developed here is a model of how people make choices that maximize utility. People may or may not be consciously thinking this way, but the end results of their decisions are the same as if they were. One reason we introduce this concept with business firms is because they do make more conscious marginal cost-benefit decisions and thus it’s easier to illustrate.

This choice and constrained maximization area of economic theory is one of the strongest areas in economics. It’s also one area where there’s been some experimental “testing” of theories. The Law of Demand and the utility maximizing models presented in this unit reliably predict people’s behavior. In fact, they also reliably predict the behavior of other animals. Experimental tests have shown that birds, rats, mice, and other lab animals all behave as if these incredible utility-maximizing comparisons were being analyzed by them. If you’re curious, go to Wikipedia here.

An economist is a man who states the
obvious in terms of the incomprehensible.

– Alfred A. Knopf (publisher, 1892-1984)

Marginal Choices: Firms Just Want to Make Profits – Maximize Profits, Actually

A business firm’s decision-making is somewhat similar. The differences largely arise because the objective is different. Consumers try to maximize utility. Firms, however, try to maximize profits for the firm’s owners & investors. Some people mistakenly believe that firms try to maximize sales. Others (often employees) think the firm just tries to minimize costs. Most firms do neither. Instead the behavior of firms can be understood by assuming that they try to maximize profits. Profits are the difference between Total Revenue (money collected from customers by selling them products) and Total Costs (monies paid to produce the goods sold).

To produce goods, sell those goods,and maximize profits, firms must make three decisions.

  1. It must make a long-run decision: Commit to what industry to be in, what product(s) to make, and what technology or size of plant to use. This is the long-term strategic decision. It will commit the firm to certain kinds of spending and costs. Once the firm makes this decision, it is contractually committed to paying certain costs. Most firms make this decision at the beginning and only rarely do they ever re-consider the decision.
  2. The short-run production decision: Given the long-run decision in number 1, the firm is limited in it’s range of choices. Basically, it can choose how much to produce. In the context of economic models, this is described as choosing what Q (quantity) of output to produce.Given that it has already committed to a certain technology (long-run decision), the choice of how much to produce dictates how much short-term, or variable costs, must be incurred.
  3. Finally, the firm decides what price to charge. Of course, the firm is limited by what consumers are willing to pay and what price competitors charge.
  4. The last step isn’t really a decision, it’s a calculation of how much profit was made given the quantity buyers purchased at the firm’s selected price.

We will focus primarily on the how decision #1 is made in this unit. Most of this unit focuses on two issues: what is a cost? and how do costs vary in the short-run when we produce more (or less) output? By analyzing costs in the short-run, we can develop the firm’s short-run supply curve. First, though, we need to look at what is (and isn’t a cost). Economists are agreed on what’s a cost, but accountants seem to have a different view.

Economic Profits: Economists and Accountants Look At Costs Differently

Accountants and economists both spend a lot of time analyzing and measuring costs. But, the two groups look at costs somewhat differently, largely because accountants and economists have different objectives and different reasons for studying costs. (of course, personally, I rather like the economists)

Accountants keep track of actual, exact transactions. So, when accountants add up costs, they like to see actual transactions – you know, receipts, money spent, and all that. If accountants can’t establish a good rationale and paper trail for what something costs, they tend to not count it. Accountants try very hard to be exact. In effect, accountants think of costs as “purchased resources”. Since there is a clear, explicit dollar amount attached to each purchased cost, the costs accountants record are referred to as explicit costs of production.

Economists, however, are much more comfortable with approximations. Economists want to make sure the all resources used in production are counted, even if we can’t establish good, exact numbers for it. Economists think of costs as “all resources used, whether it was purchased or not”. That makes for a significant difference. Economists also realize that the best measure of cost is opportunity cost, not necessarily the price that was paid. Economists look for hidden costs. These hidden opportunity costs are called implicit costs. An example of an implicit cost is the time of the business owner who operates a business and doesn’t pay themselves a fixed salary. The owner’s time is valuable. It has an opportunity cost, so the economist tries to estimate the value of that opportunity cost and include it in any models of firm decision-making. So economists include both the explicit costs (same as the accountant) and implicit costs (which isn’t shown in accounting statements).

Profit, of course, is what’s left after take Total Revenue and subtract the firm’s costs. Since an accountant only subtracts explicit costs, an accountant gets a different number for profit than the economists calculates. An economist is subtracting both explicit and implicit costs, so the economist gets a smaller profit number. This number is called economic profit. Economic profit is always lower than accounting profit.

There are other differences between accountants and economists, too. Personally, I find economists to be sexier, smarter, more honest, more loving, more desirable, more charismatic, more exciting, better role models,……………………. (but then I’m an economist!).

TIP: From here on in this course, anytime you encounter the term “profit”, it will refer to “economic profit”. This is especially important when thinking about the models in the coming units that describe various market structures.

Fixed vs. Variable Costs: Does Producing More Mean Spending More?

Once we have calculated all the costs, explicit and implicit, that are involved in production, we need to divide these costs into two groups: Fixed and Variable. The reason we want to categorize different costs as either fixed or variable is because we will eventually build a model of how firms decide what quantity to produce and offer for sale. So, economists separate all costs into these two groups based on whether or not the cost increases when the firm decides to increase Q (produce more output). The firm must spend more on variable costs when the firm decides to produce more output. Variable costs increase directly when Q increases, and variable costs go down when Q is decreased. Fixed costs, though, don’t increase when the firm increases Q. Fixed costs also don’t change when Q is decreased. Fixed costs simply don’t change when Q changes — that’s why they’re called “fixed”.

In reality, even fixed costs can be changed by the firm’s management, if they wait long enough to re-write some contracts. Economists distinguish two time periods: the “long run” and the “short run”.  How long is “short-run” depends on contracts.

How Long is the “Short-Run”? – It’s All About Commitment

A common difficulty in this unit is understanding what “short run” vs. “long run” means. Unfortunately, there is no way to give a fixed answer — it doesn’t refer to some fixed amount of calendar time. Instead, “short run” vs. “long run” is all about commitment (or the lack of it). A period of time is “short run” IF a firm is committed (legally) to some particular cost or expenditure, regardless of what production decisions they might make. On the other hand, “long-term” means a period of time long enough that a firm can stop or get out of any and all commitments.

It may be easiest to understand by imagining the cost of renting a building. If there is a 2-year lease, then the amount of the rent payment is fixed for 2 years and the firm is committed to paying it. The firm cannot avoid paying the rent (without penalty) — it’s committed, even if the firm doesn’t need or use the building. So, anything during that two-year period is short-run with respect to the rent.  After 2 years, the lease expires and the firm could renew it, change it, increase it, eliminate it, or whatever. There’s no commitment in the long-term. As long as the lease is in effect, the cost of the rent is considered a fixed cost. If the analysis is dealing with a period of time beyond when the lease expires, that is long-run.

Some technologies just naturally require long periods of commitment. Some don’t. How flexible an industry is often has to do with how long it’s cost commitments are.  For example, let’s compare two very different businesses.  The first one (business A) is a small business that takes used goods on consignment from individuals and then sells them on e-Bay for a commission.  The second business is a giant integrated paper-and-forest products firm (business B).  A, the e-Bay seller, probably has some fixed commitments but they are very short in calendar terms. Let’s suppose the owner runs the business out of their own home & garage.  No commitment there. Maybe they have a 6-month commitment to a web-hosting business to pay monthly for a website.  Maybe they bought a computer just for the business.  If so, then “short-run” is anything less than the time it would take to get out of these two commitments  Obviously business A can be free and clear of any existing cost commitments in 6 months or less – that’s their “short-run”. Anything longer than 6 months is “long-term” for business A.

In contrast, consider Business A, a giant integrated forest-products-and-paper company.  They have long-term leases (10 years) with tree farmers to provide a source of trees to make into pulp.  They have a giant mill that cost $500 build. It will last 20 years and is financed with money borrowed over the next 10 years.  The mill is scrap if it isn’t used for making paper and nobody else would want to buy it.  For this paper company, Business B, anything less than 10 years should probably be considered “short-term”.  ”Long-term” is longer than 10 years.  So the exact calendar time that corresponds to “short” vs “long” term depends on your contractual commitments.

“Economist: Someone who sees something in
practice and wonders if it would work in theory.”
– former Senator Ernest “Fritz” Hollings

Reading Guide – Assigned Readings

In addition to the Jim’s Guide (above), you should read and study in your Mandel Economics: The Basics textbook:

Chapter 4 – How Businesses Work
JIm’s Comment: This is another very important chapter packed with some heavy-duty analytical material.  The most critical sections are Nature of Business pg.57, Cost pp 64-67, Revenue pp 68-70, and Profit Maximization pp. 70-73.  The tables and graphs in the first part of the chapter are less important than the later tables and graphs.  Be sure you understand and are comfortable with the tables 4.5, 4.6, 4.7, and 4.8 and graphs 4.5.

Practice Quiz

Click here for the Unit 4  practice quiz.  The practice quiz will open in a new tab/window.


The data, directions, and a description of the problem are here at the Unit 4 Worksheet. Answers to the questions can be entered and graded in the learning mgt system (Moodlerooms at HFCC). Go there to complete them.

Closer Look

Professor Nelson’s (another LCC Professor) Tutorials on Micro that are relevant to this unit:

  1. Costs in the short run

Other Video Tutorials

Dr. Mary McGlasson of Chandler Community College in Phoenix, AZ (known as mjmfoodie on YouTube) has numerous videos which are pretty decent. Here are the ones relevant to this unit.

What’s Next?

In the next unit we look competition. Although firms want to maximize profits, they face four type so limits on what they can do. We’ve already seen that the choices of consumers limit what firms can do – consumers and the demand curve can always say “no we won’t buy it at that price”. In this unit we saw that firms are also limited by their costs and technology. In the next unit we see how the decisions of other firms, or competition, work to limit what firms can do and how much profit they can make. Later in the course we will see how governments can also limit what firms do.