Production Costs and Firm Profits

The firm's primary objective in producing output is to maximize profits. The production of output, however, involves certain costs that reduce the profits a firm can make. The relationship between costs and profits is therefore critical to the firm's determination of how much output to produce.

Explicit and implicit costs. A firm's explicit costs comprise all explicit payments to the factors of production the firm uses. Wages paid to workers, payments to suppliers of raw materials, and fees paid to bankers and lawyers are all included among the firm's explicit costs.

A firm's implicit costs consist of the opportunity costs of using the firm's own resources without receiving any explicit compensation for those resources. For example, a firm that uses its own building for production purposes forgoes the income that it might receive from renting the building out. As another example, consider the owner of a firm who works along with his employees but does not draw a salary; the owner forgoes the opportunity to earn a wage working for someone else. These implicit costs are not regarded as costs in an accounting sense, but they are a part of the firm's costs of doing business, nonetheless. When economists discuss costs, they have in mind both explicit and implicit costs.

Accounting profits, economic profits, and normal profits. The difference between explicit and implicit costs is crucialto understanding the difference between accounting profits and economic profits.

Accounting profits are firm's total revenues from sales of its output, minus the firm's explicit costs. Economic profits are total revenues minus

explicit and implicit costs. Alternatively stated, economic profits are accounting profits minus implicit costs. Thus, the difference between economic profits and accounting profits is that economic profits include the firm's implicit costs and accounting profits do not.

A firm is said to make normal profits when its economic profits when its economic profit are zero. The fact that economic profits are zero implies that the firm's reserves are enough to cover the firm's explicit costs and all of its implicit costs, such as the rent that could be earned on the firm's building or the salary the owner of the firm could earn elsewhere. These implicit costs add up to the profits the firm would normally receive if it were properly compensated for the use of its own resources — hence the name, normal profits.

Fixed and variable costs. In the short-run, some of the input factors the firm's fixed costs. The firm's fixed costs do not vary with increases in the firm's output.

The firm also employs a number of variable factors of production. The cost of these variable factors of production are the firm's variable costs. In order to increase output, the firm must increase the number of variable factors of production that it employs. Therefore, as firm output increases, the firm's variable costs must also increase.

Total and marginal costs. The firm's total cost of production is the sum of all its variable and fixed costs. The firm's marginal cost is the per unit change in total cost that results from a change in total product. The firm's variable, fixed, and total costs can all be calculated on an average or per unit basis.

Economies of scale. At low level of output, a firm can usually increase its output at a rate that exceeds the rate at which it increases its factor inputs. When this situation occurs, the firm's average total costs are falling, and the firm is said to be experiencing economies of scale.

At higher levels of output, the firm may find that its output increases at the same rate at which it increases its factor inputs. In this case, the firm's average total costs remain constant, and the firm is said to experience constant returns to scale. At even higher output levels, the firm's output will tend to increase at a rate that is.below the rate at which it increases its factor inputs. In this situation, average total costs are rising, and the firm is said to experience diseconomies of scale.

The firm's minimum efficient scale is the level of output at which economies of scale end and constant returns to scale begin.

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