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Cost and Benefit Optimization for Producers

Cost and Benefit Optimization for Producers

Author: Kate Eskra

This lesson will explain the economic idea of cost and benefit optimization for producers.

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Hi, welcome to Economics. This is Kate. The title of this tutorial is "Cost and Benefit Optimization for Producers." As always, my key terms are in red and my examples are in green.

So by the end of this tutorial you'll be able to explain the choices that all firms need to make and how firms face resource constraints. You'll be able to identify the marginal cost and marginal benefit, or what we call marginal revenue, of a firm. And you'll see how these play a really important role in the production decision. Finally, you'll be able to explain how firms end up maximizing profit by producing up to the point where marginal revenue equals marginal cost.

All right, so let's get started. Let's start thinking like a business. All businesses have to make three major decisions. How much should we produce? How big should we grow as a company? How should we produce our good or service? And then finally, how much land, labor, and capital do we need to buy?

We know that businesses need to purchase things in order to produce anything. And what they need to purchase are what we call resources, or factors of production. We know that businesses are also constrained, as consumers are. A constraint is an element that interrupts production of a firm or consumption by individuals. Here in this tutorial, we're concerned with the production of a firm.

So what does constrain us? Well we as consumers are constrained by our time and our income and so are firms. But firms are also really constrained by their resources. By their land, labor, and capital. So it's especially in the short run that their resources are going to be constrained. Something is fixed, or something they cannot change in the short run.

So for example, let's say a business is doing really, really well and they want to start producing more of something. Certainly they could hire more workers, but do they have enough land or enough capital to make it worthwhile? What I mean by that is you can hire all the workers you want, but if your space is limited, if your building's not big enough, or if you don't have enough machines, or grills, for example, for them to work on, they're just going to be bumping into one another. It won't make it worthwhile for you to hire more labor if you don't have the land and capital to justify it. So in the short run, because something is fixed, like your ability to expand your business size, these things are very much constraints for you.

So how is it that firms decide how much land, labor, and capital that they need? Two major factors. First of all, how much are they producing? Which is something we're going to be looking at a couple of slides. And how expensive is each resource? How much are they going to be costing you?

Businesses all want to minimize cost. Cost minimization is just the output strategy that incurs the least amount of cost. And the reason they want to do that is because it helps them in profit maximization, the procedure of determining quantity and cost that's going to yield them the greatest profit.

So whereas we as consumers, when we're purchasing things, maximize our utility, or satisfaction, we base those on our own individual preferences. Firms maximize profit. And they have to base those profit maximization decisions on the opportunity costs of their resources, land, labor, and capital.

So back to this slide, where businesses have to make these three major decisions. I want to focus now on the first one. This is really, how much should we produce? This is the first step in profit maximization. A business first has to find the ideal quantity to produce.

So let's talk about that for a couple minutes. I made up a business here. These are totally made up numbers. And we see the price of their product, that is information given to you, it's $15. So that's what they're selling the product for once it's produced. These are the various quantities that they're producing. These are their total costs. I didn't get into fixed versus variable or anything. I'm just giving you the total cost of producing nothing, of producing one, two, three, four, and so on.

So as you can see, as they decide to produce more their total costs logically go up. Then we have marginal cost, total revenue, marginal revenue, and profit. I'm going to leave profit blank for a couple minutes, but obviously all of this means nothing without this column. This is what a business owner cares about the most, right? So don't worry, we're going to get there. They want to maximize their profit. But we need to understand these other terms first.

So any time you see the word marginal, as you see here marginal cost, marginal revenue, I want you to think the word additional, because that's what it means. It's an incremental analysis, which is what economists do a lot of. So marginal cost will go off of total cost. And what we're looking at here is what is the additional, or incremental, cost when we go from one unit to the next? So that's why when we go from producing nothing to one our total costs went up by $10. When we go from one to two, our incremental, or marginal, cost went up by an additional $5. And then another $5, and then up $10, and then $20, and then $30.

Here total revenue. Total revenue means the total amount of money that a business takes in from selling their product. So if they produce nothing, obviously they take in no money. If they produce and sell one, they take in $15. If they produce and sell two, they take in $30. This doesn't take costs into account, it's just how many they are producing, the quantity, times the price that they're selling them for.

Marginal revenue is the additional revenue every time they sell one more. So again, you could go back and look at this as the change in total revenue. But if you think about it, every time they sell one more, if the price of the product is the same, which it is in this example, marginal revenue will just be the price of the product. And so that's why I filled that in.

So here are some of the definitions to some of the terms that I've been talking about. Marginal revenue is the additional revenue resulting from the increase of product sales by one unit. So this is what I was talking about is going to be price, because when the business sells one more unit, they take in the price of that unit.

So marginal cost is-- again think additional when you see marginal-- the additional cost incurred when producing one additional product. All right, so producers will optimize their situation when they achieve maximum profitability through revenue maximization and cost minimization. We have to combine both the revenue coming in with the cost going out in order to optimize our situation.

So this is the big, big rule if you can try to remember this. Producers will always optimize their choices when they produce up to the point where these two marginals are equal. That's why I spent so much time going over the marginal analysis there. And for a producer, marginal revenue really is their marginal benefit. So they're going to produce right up to the point, but never past, where marginal revenue equals marginal cost.

Let's take a look at this again then. So I've indicated in green where marginal cost is actually less than marginal revenue. So where marginal revenue is greater than marginal cost, they should continue producing, continue producing, continue producing, because remember this is the bottom line. Profit, right? That's what they want to maximize. If they're taking in more money by selling the next one than it costs them, profits should be rising. And that's exactly what's happening.

Oh, but wait. Once we get down to five units here, now I've indicated this in red. The additional cost to produce it is greater than the additional revenue they're taking in by selling it. It's greater than the price. So they're never going to want to spend more money to bring a product to market than they're going to receive for it. Once that's the case, once marginal revenue is less than the marginal cost, their profit will fall.

Most people are under the assumption, oh, a producer should just crank out as much as they possibly can. But their cost structure is set up so that at some point it's not going to benefit them. And you can see that on this chart here. Their profit begins to drop.

So where should they produce up to? Well I made it on purpose on here so that marginal cost never exactly equals marginal revenue because that's not always the situation in real life. But I wanted to show you that they would never go past producing four. They'll go up to the point where marginal cost would equal marginal revenue, but as soon as here, producing that fifth unit marginal cost is greater, they would back it up and stop at four. So at four units, you'll notice that's where profit is highest.

So what did you learn in this tutorial today? You learned that firms have to choose how much to produce and how to produce, but they're constrained by their resources. They're always seeking to minimize cost in order to maximize profit. They will maximize profit by producing up to that point where marginal revenue equals marginal cost. That's so important.

Terms to Know

An element that interrupts production of a firm or consumption by individuals.

Marginal Cost

Additional cost incurred when producing one additional product.

Marginal Revenue

The additional revenue resulting from the increase of product sales by one unit.

Producer Optimization

Achieving maximum profitability through revenue maximization and cost minimization.

Profit Maximization

Procedure of determining quantity and cost that yields the greatest profit.