Costs of Production

A College Economics Guide

Supplementary resources for college students

Introduction

Making something–which is what economists mean when they talk about production–always costs something. Whether you are planting a seed in the hope of a future tree, making your house cleaner by vacuuming or hiring cleaning services, hiring workers to serve food at a restaurant or deliver pizza, building a new factory, or buying new machinery or a great new app that will help you out, there are always production costs of some kind. The costs of production may be tangible money you have to lay out, but also may be the time you yourself put in.

Traditionally, economists use the costs of production at a factory as a familiar, though abstract, example. The costs of producing something at a factory can be broken down into the costs of hiring inputs–also called factors of production. The two main inputs are usually broken down into labor–such as paying wages, salaries, contractor fees, delivery fees–and capital–meaning buying or renting machinery, equipment, buildings, land, etc.

Thinking about the costs of labor and capital leads economists to think about which kinds of inputs can be hired or bought quickly–such as labor–versus which kinds of inputs may take a longer time to produce–such as building a factory, buying or customizing new machinery or a new app, or reclaiming swampland. Some costs are fixed–meaning they are developed or contracted over the long term. Other costs are flexible–meaning they can be adjusted on the fly. Traditionally, the costs of building or buying capital are considered examples fixed costs, while the costs of hiring or firing labor or contractors are considered examples of flexible costs.

You may be surprised by how many activities and items involve production costs. If you have to pay for government-required licenses–from buying medallions for taxi cabs to paying for certificates for hairdresses–that is all part of your costs of production. Transactions costs–such as what it may cost you to deliver raw materials to your business or even to deliver your final product to the market once it is produced, or even the negotiations it may take with a neighboring business to come to an agreement about using each other’s driveways or airspace–are very much a part of production costs. Advertising to let people know you exist, and subtle matters such as acquiring and maintaining a reputation for doing a great job are also important parts of production costs.

Another matter bearing on the costs of production is that some work is just plain fun. We all know, be it from experience or intuition, that a worker or entrepreneur sometimes really enjoys aspects of the work. The elation from simply being paid for a first job, or from finding a job that matches exactly with what you love doing, or from knowing that what you are doing every day helps others in need, may be enough to convince you to take lower wage or even work for free as a volunteer. Many people strive for a long-run job or business situation that they find splits the difference–partially paying for your time working hard, and partially enjoyable and motivating–even if it might mean taking a lower salary. Measuring these non-cost or cost-reducing effects is difficult for economists. Economists call them “consumption effects.” Economists do know they are an important yet understudied wrinkle in our understanding the costs of production.

Definitions and Basics

Costs of Production. An Economics Topics Detail.

Costs of production affect the decision an individual firm makes about how much to produce. They also affect how many firms will be in an industry….

Spatial Economics, by Wolfgang Kasper. Concise Encyclopedia of Economics.

Producers and buyers are dispersed in space, and overcoming the distances between them can be costly. Much commercial activity is concerned with “space bridging,” and much entrepreneurship is aimed at making good use of locational opportunities and cutting the costs of transport and communication….

Michael Munger on Sharing, Transaction Costs, and Tomorrow 3.0. Podcast episode on EconTalk.

… I think the three categories of transactions costs are: First, triangulation–the people who want to cooperate or buy and sell have to be able to find each other. And they have to be able to identify each other as possessing something that the other wants. Usually in economics we start with this idea that A has a widget; B has some money and wants a widget; and then they negotiate on price. Well, how did they meet? How did they know that they have a widget? Do they speak the same language? Do they have a currency that they can use to consummate the exchange?…

Advertising, by George Bittlingmayer. Concise Encyclopedia of Economics.

Economic analysis of advertising dates to the 1930s and 1940s, when critics attacked it as a monopolistic and wasteful practice. Defenders soon emerged who argued that advertising promotes competition and lowers the costs of providing information to consumers and distributing goods. Today, most economists side with the defenders most of the time….

Liability, by W. Kip Viscusi. Concise Encyclopedia of Economics.

Until the 1980s, property and liability insurance was a small cost of doing business. But the substantial expansion in what legally constitutes liability has greatly increased the cost of liability insurance for personal injuries….

In the News and Examples

Elizabeth Pape on Manufacturing and Selling Women’s Clothing and Elizabeth Suzann. Podcast episode on EconTalk.

… Most fabrics shrink 10-20% in length. So, we’re using probably about 15% more fabric than the H&M tunic, because we’ve accounted for shrinkage. If you throw that tunic in the wash, I can almost guarantee you that it’s going to shrink to an unwearable size. So, shrinkage ends up being a pretty big factor in our bottom line. So, we’ve got fabric. And then we’ve got trim, which is pretty minimal–thread. We’ve got the garment tag, the care tag, the hang tag. So, all those go into the material cost. And we end up at about $30–I think $31 dollars…. for the material cost going into that shirt.

… Then we’ve got the labor cost. So, all of our garments are, as we said, cut and sewn in the building. So, we’ve got a gal over there who, she creates a marker, which is essentially a template that’s laid out over various plies of fabric. Those have been cut through with a kind of electric knife–she cuts through the big stacks and then she pairs together the garment pieces that go together….

Mitch Weiss on the Business of Broadway. Podcast episode on EconTalk.

… Every theater is slightly different and has its own characteristic. So the designers–in addition, let me throw in a very important feature. New York City has the most stringent fire code in the world. When, if you light a cigarette on stage, there are two stage hands who have been specially trained and licensed, standing with fire extinguishers on each side of the stage, for that particular moment. Then they go back and do whatever else they are doing. So, when you see, fire or any sort of thing on stage, there is a lot going on backstage. And New York has never had a fire that the audience had to worry about. So, whether it’s right or wrong–of course, you can go to Chicago, and you can do what you want….

Wally Thurman on Bees, Beekeeping, and Coase. Podcast episode on EconTalk.

… If you take bees into an almond orchard, you might rent them for a 10-day service while the trees are blooming, for $150, $175, maybe $200 per colony. You might put two colonies per acre. So $300, $350 an acre is how much the almond grower would pay the beekeeper. A little perspective on that is that’s going to work out to be not huge in the spreadsheet of an almond-grower, maybe a 5-7% cost share. So among all the seed and land–well, per anything. Of all his costs–labor, chemicals, fertilizer, land, etc.–renting pollination services is going to be 5, 10, 7% of his costs….

Michael Munger on Milk. Podcast episode on EconTalk.

… if you want to know the markup on something–and a lot of times people say, oh, the liquor is so expensive, that’s where they make all their money; they lose money on everything else but they get it back on the liquor. Or, they make it up on the desserts. Or whatever it is. And one of the things that ignores–it ignores a couple of things. It ignores the fixed and sometimes not so fixed cost of a liquor license, which makes the actual profit of the item different from what the markup is. I think people think, I know what a bottle of wine costs, and this is so much more than that in the restaurant. But of course the steak is a lot more, too. You say, well, okay, but there are labor costs; there’s not much labor cost in a bottle of wine. How could that be the legitimate, competitive markup?…

Keith Smith on Free Market Health Care. Podcast episode on EconTalk.

… Yeah. Yeah, so much for the spiraling cost of healthcare. And, I’d like to point out that some of the prices on our website may actually look higher than when we first started. And the reason for that is that the actual bundle of services that we are providing that initially maybe were not inside of the bundle of care, are….

Corruption, by François Melese. Concise Encyclopedia of Economics.

… Corruption hurts investment in at least three ways. First, it increases the cost of doing business, which then raises the threshold revenues required for businesses to break even….

Advanced Resources

Michael Munger on the Nature of the Firm. Podcast episode on EconTalk.

… It’s not free to use the price system. Firms exist when it’s too expensive to use the price system. Home repair or home improvement: invite someone into your house, their bid never turns out to be what you pay, always surprises. Some you pay by the hour; but that gives them an incentive to go slowly. Maybe best way is flat rate; but you rejected the high bidder who may have anticipated that and now you are stuck with uncomfortable situation and maybe having to pay more. …

L.S.E. Essays on Cost, by James M. Buchanan and George F. Thirlby.

… In his paper, ‘Economics and Knowledge’, included in this volume, Hayek scarcely mentioned ‘cost’. Nonetheless he provides indirectly the strongest argument for attempting, through the publication of this collection of essays, to focus the attention of modern economists on the elementary meaning of cost. Hayek emphasized the differences, in principle, between the equilibrium position attained by a single rational decision-maker in his own behavioural adjustments, given his preference function and the constraints that he confronts, and the equilibrium potentially attainable through the interaction of many persons….

The Theory of Interest, by Irving Fisher.

… But even if we change the orchard to machines, houses, tools, ships (that is, “produced means to further production”) the principle that the value of anything is the discounted value of its expected income stands unrefuted. This is not to say cost of production does not have an influence. But past costs have no influence on the present value of a capital good, except as those costs affect the value of the future services it renders and the future costs….