A core economic concept is that getting something requires giving up something else. For example, earning more money may require working more hours, which costs more leisure time. Economists use cost theory to provide a framework for understanding how individuals and firms allocate resources in such a way that keeps costs low and benefits high.
Understanding the basics of cost theory can help you scale up your business's production efficiently.
Economists view costs as what an individual or firm must give up to get something else. Opening a manufacturing plant to produce goods requires an outlay of money, and once a plant owner spends money to manufacture goods, that money is no longer available for something else. Production facilities, machinery used in the production process and plant workers are all examples of the cost of production.
Cost theory offers an approach to understanding the costs of production that allows firms to determine the level of output that reaps the greatest level of profit at the lowest cost.
Cost theory contains various measures of costs, both fixed and variable. Fixed costs do not vary with the quantity of goods produced. Rent on a facility is an example of a fixed cost.
Variable costs change with the quantity produced. If increased production requires more workers, for example, those workers’ wages are variable costs. Producing more goods costs more, but the costs vary depending on how much work each additional worker can do. The sum of fixed and variable costs is a firm’s total costs.
Cost theory derives other cost measures, which can be useful for firms that are planning to scale production up or down. Marginal cost is the increase in total cost that results from increasing production by one unit of output. Marginal costs and marginal revenue are key concepts in mainstream economic thought.
Marginal costs typically fall at first when there is an increase in production. This is generally due to finding optimal machinery production rates, or getting bulk purchase deals from suppliers. Due to the Law of Diminishing Marginal Returns, though, at some point costs will increase exponentially as production increases.
Average total cost is the total cost divided by the number of goods produced. An average total cost curve is a U-shaped curve on an economic diagram that illustrates how average total costs decline as output rises and then rise as marginal costs increase. Average total costs decline at first because as production rises, average costs are distributed over a larger number of units of output. Eventually, marginal costs of increasing output rise, which increases average total costs.
Economic theory holds that the goal of a firm is to maximize profit, which equals total revenue minus total cost. Determining a level of production that generates the greatest level of profit is an important consideration, one that means paying attention to marginal costs, as well as marginal revenue, which is the increase in revenue arising from an increase in output. Under cost theory, as long as marginal revenue exceeds marginal cost, increasing production will raise profit.