Suppose honda's total cost of producing

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CHAPTER

13 The Costs of Production

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T

he economy is made up of thousands of firms that produce the goods and services you enjoy every day: General Motors produces automobiles, General Electric produces lightbulbs, and

General Mills produces breakfast cereals. Some firms, such as these three, are large; they employ thousands of workers and have thousands of stockholders who share in the firms' profits. Other firms, such as the local barbershop or café, are small; they employ only a few workers and are owned by a single person or family.

In previous chapters, we used the supply curve to summarize firms' production decisions. According to the law of supply, firms are willing to produce and sell a greater quantity of a good when the price of the good is higher, and this response leads to a supply curve that slopes upward. For analyzing many questions, the law of supply is all you need to know about firm behavior. In this chapter and the

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ones that follow, we examine firm behavior in more detail. This topic will give you a better understanding of the decisions

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behind the supply curve. In addition, it will introduce you to a part of economics called industrial organization—the study of how firms' decisions about prices and quantities depend on the market conditions they face. The town in which you live, for instance, may have several pizzerias but only one cable television company. This raises a key question: How does the number of firms affect the prices in a market and the efficiency of the market outcome? The field of industrial organization addresses exactly this question.

Before turning to these issues, we need to discuss the costs of production. All firms, from Delta Air Lines to your local deli, incur costs as they make the goods and services that they sell. As we will see in the coming chapters, a firm's costs are a key determinant of its production and pricing decisions. In this chapter, we define some of the variables that economists use to measure a firm's costs, and we consider the relationships among these variables.

A word of warning: This topic is dry and technical. To be honest, one might even call it boring. But this material provides a crucial foundation for the fascinating topics that follow.

13-1 What Are Costs? We begin our discussion of costs at Caroline's Cookie Factory. Caroline, the owner of the firm, buys flour, sugar, chocolate chips, and other cookie ingredients. She also buys the mixers and ovens and hires workers to run this equipment. She then sells the cookies to consumers. By examining some of the issues that Caroline faces in her business, we can learn some lessons about costs that apply to all firms in an economy.

13-1a Total Revenue, Total Cost, and Profit We begin with the firm's objective. To understand the decisions a firm makes, we must understand what it is trying to do. It is conceivable that Caroline started her firm because of an altruistic desire to provide the world with cookies or, perhaps, out of love for the cookie business. More likely, Caroline started her business to make money. Economists normally assume that the goal of a firm is to maximize profit, and they find that this assumption works well in most cases.

What is a firm's profit? The amount that the firm receives for the sale of its output (cookies) is called its total revenue. The amount that the firm pays to buy inputs (flour, sugar, workers, ovens, and so forth) is called its total cost. Caroline gets to keep any revenue that is not needed to cover costs. Profit is a firm's total revenue minus its total cost:

Profit = Total revenue − Total cost. Caroline's objective is to make her firm's profit as large as possible.

total revenue the amount a firm receives for the sale of its output total cost the market value of the inputs a firm uses in production profit total revenue minus total cost

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To see how a firm goes about maximizing profit, we must consider fully how to measure its total revenue and its total cost. Total revenue is the easy part: It equals the quantity of output the firm produces times the price at which it sells its output. If Caroline produces 10,000 cookies and sells them at $2 a cookie, her total revenue is $20,000. The measurement of a firm's total cost, however, is more subtle.

13-1b Costs as Opportunity Costs When measuring costs at Caroline's Cookie Factory or any other firm, it is important to keep in mind one of the Ten Principles of