Costs and the Supply of Goods

The business firm is used to organize productive resources and transform them into goods and services. There are three major business structures- proprietorships, partnerships, and corporations. Proprietorships are the most numerous, but most of the nation's business activity is conducted through corporations.

The demand for a product indicates the intensity of consumers desires for the item. The (opportunity) cost of producing the item indicates the desire of consumers for other goods that must now be given up because the necessary resources have been used in the production of the item. In a market economy, these two forces-demand and costs of production-balance the desire of consumers for more of a good against the reality of scarce resources, which requires that other goods be forgone as more of any one specific item is supplied.

Economists employ the opportunity cost concept when figuring a firm's costs. Therefore, total cost includes not only explicit (money) costs but also implicit costs associated with the use of productive resources owned by the firm.

Since accounting procedures often omit costs, such as the opportunity cost of capital and owner-provided services, accounting costs generally understate the opportunity cost of producing a good. As a result of these omissions, the accounting profits of a firm are generally larger than the firm's economic profits.

Economic profit (loss) results when a firm's sales revenues exceed (are less than) its total costs, both explicit and implicit. Firms that are making the market rate of return on their assets will therefore make zero economic profit. Firms that transform resources into products of greater value than the opportunity cost of the resources used will make an economic profit. On the other hand, if the opportunity cost of the  resources used exceeds the value of the product, losses will result.

The firm's short-run average total cost curve will tend to be U-shaped. When output is small (relative to plant size), average fixed cost (and therefore ATC) will be high. As output expands, however, AFC (and ATC) will fall. As the firm attempts to produce a larger and larger rate of output using its fixed plant size, diminishing returns will eventually set in, and marginal cost will rise quite rapidly as the plant's maximum capacity is approached. Thus, the short-run ATC will also be high for large output levels because marginal costs are high.

The law of diminishing returns explains why a firm's short-run marginal and average costs will eventually rise as the rate of output expands. When diminishing marginal returns are present, successively larger amounts of the variable input will be required to increase output by one more unit. Thus, marginal costs will eventually rise as output expands. Eventually, marginal costs will exceed average total costs, causing the latter to rise, also.

The ability to plan a larger volume of output often leads to cost reductions. These cost reductions associated with the scale of one's operation result from (a) a greater opportunity to employ mass production methods, (b) specialized use of resources, and (c) learning by doing.

The LRATC reflects the costs of production for plants of various sizes. When economies of scale are present (that is, when larger plants have lower per unit costs of production), LRATC will decline. When constant returns to scale are experienced, LRATC will be constant. A rising LRATC is also possible. Bureaucratic decision-making and other diseconomies of scale may in some cases cause LRATC to rise.

In analyzing the general shapes of a firm's cost curves, we assumed that the following factors remained constant: (a) resource prices, (b) technology, and (c) taxes. Changes in any of these factors would cause the cost curves of a firm to shift.

In any analysis of business decision-making, it is important to keep the opportunity cost principle in mind. Economists are interested in costs primarily because costs affect the decisions of suppliers. Short-run marginal costs represent the supplier's opportunity cost of producing additional units with the existing plant facilities of the firm. The long-run average total cost represents the opportunity cost of supplying alternative rates of output, given sufficient time to vary all factors, including plant size.

Sunk costs are costs that have already been incurred. They should not exert a direct influence on current business choices. However, they may provide a source of information that will be useful in making current decisions.