Overview – Theory of supply: Cost of production

We are still on our journey to see how a market system solves the economic problem of scarcity, which arises because resources are limited and our wants and needs are unlimited. One of the fundamental questions that we have identified is the question of how to produce goods and services. Firms that are responsible for the production of goods and services shoulder this responsibility. The challenge that economic systems face is how to ensure that firms not only produce goods and services efficiently, but also produce the right combination of goods and services – in other words, how to ensure both technical and allocative efficiency.

Looking at our circular flow model, we can see that firms have a central position in that they employ the factors of production, and through this employment, income is generated. Firms also then supply goods and services through the goods market to households.

The goods market consists of the demand and supply of goods and services, and in studying the behaviour of a market, we have seen how the forces of demand and supply determine the equilibrium price and how changes in the price of a good or service ensure that market equilibrium is reached.

We have also identified that behind the supply is firms' willingness and ability to supply goods and services, and that the cost of production is a major determinant of the supply of a good or service. In this section, we take a closer look at the cost of production for a firm in a market system.

A firm’s total costs relate to the production of goods and services. A firm (or business) combines the inputs of labour, capital, land and raw or finished component materials to produce outputs. If the firm is successful, the outputs are more valuable than the inputs. This activity of production goes beyond manufacturing (i.e. making things). It includes any process or service that creates value, including transportation, distribution, wholesale and retail sales. Production involves a number of important decisions that define the behaviour of firms. These decisions include, but are not limited to, the following:

  • What product or products should the firm produce?
  • How should the products be produced (i.e. what production process should be used)?
  • How much output should the firm produce?
  • What price should the firm charge for its products?
  • How much labour should the firm employ?

The answers to these questions depend on the production and cost conditions facing each firm, and this will influence the firm’s cost of production. In the sections that follow we will take a closer look at the cost of production.