Production outputs are the goods and services created in a given time period, by a firm, industry or country. These goods can either be consumed or used for further production. Production outputs can be anything from crops to technological devices to accounting services. Producing these outputs incur costs which must be considered when determining how much of a good should be produced.
Determining what to produce and how much to produce can be difficult. Microeconomics assumes that firms and businesses are profit-seeking. This means that above all else they will produce goods and services to the degree that maximizes their profits. In economic theory, the profit-maximizing amount of output in occurs when the marginal cost of producing another unit equals the marginal revenue received from selling that unit . When the product's marginal costs exceeds marginal revenue, the firm should stop production.
Production Conditions
A firm will seek to produce such that its marginal cost (MC) is equal to marginal revenue (MR, which is equal to the price and demand). It is not produced based on average total cost (ATC).
Once a firm has established what its profit-maximizing output is, the next step it must consider is whether to produce the good given the current market price. There are several key terms to be familiar with prior to addressing this question.
- Fixed costs are those expenses that remain constant regardless of the amount of good that is produced. For example, no matter how much of a good you produce, you will still have to pay the same amount of rent for your factory or storage units.
- Variable costs are only those expenses that are directly tied to the production of more units; fixed costs are not included.
- Opportunity costs are the cost of an opportunity forgone (and the loss of the benefits that could be received from that opportunity); the cost equals the most valuable forgone alternative.
- Average total cost is the all expenses incurred to produce the product, including fixed costs and opportunity costs, divided by the number of the units of the good produced.
There are four different types of conditions that generally describe a firm's profit as described in :
- Economic Profit: The firm's average total cost is less than the price of each additional product at the profit-maximizing output. The economic profit is equal to the quantity output multiplied by the difference between the average total cost and the price.
- Normal Profit: The average total cost equals the price at the profit-maximizing output. In this case, the economic profit equals zero. In this scenario, the firm should produce of the product.
- Loss-minimizing condition: The firm's product price is between the average total cost and the average variable cost. The firm should still continue to produce because additional sales would offset a portion of fixed costs. If the manufacturer stopped production, it would sustain all the fixed costs as a loss.
- Shutdown: The price is below average variable cost at the profit-maximizing output. Production should be shutdown because every unit produced increases loss. The revenue gained from sales of these products do not offset variable and fixed costs. If it does not produce goods, the firm suffers a loss due to fixed costs, but it does not incur any variable costs.