Now let’s shift our focus to producers and the supply side of the market. How does the market process determine the amount of each good that will be produced? To figure this out, we first have to understand what influences the choices of producers. Producers convert resources into goods and services by doing the following:
1. organizing productive inputs and resources, like land, labor, capital, natural resources, and intermediate goods;
2. transforming and combining these inputs into goods and services; and
3. selling the final products to consumers.
Producers have to purchase the resources at prices determined by market forces. Predictably, the owners of these resources will supply the resources only at prices at least equal to what they could earn elsewhere. Put another way, each resource the producers buy to make their product has to be bid away from all other potential uses. Its owner has to be paid its opportunity cost. The sum of the producer’s cost of each resource used to produce a good will equal the opportunity cost of production.
There is an important difference between the opportunity cost of production and standard accounting measures of cost. Accountants generally do not count the cost of the firm’s assets, such as its buildings, equipment, and financial resources, when they calculate a product’s cost. But economists do. Economists consider the fact that these assets could be used some other way-in other words, that they have an opportunity cost. Unless these opportunity costs are covered, the resources will eventually be used in other ways. The opportunity cost of these assets to the firm is the amount of money the firm could earn from the assets if they were used another way. Consider a manufacturer that invests $10 million in buildings and equipment to produce shirts. Instead of buying buildings and equipment, the manufacturer could simply put the $10 million in the bank and let it draw interest. If the $10 million were earning, say, 10 percent interest, the firm would make $1 million on that money in a year’s time. This $1 million in forgone interest is part of the firm’s opportunity cost of producing shirts. Unlike an accountant, an economist will take that $1 million opportunity cost into account. If the firm plans to invest the money in shirt-making equipment, it had better earn more from making the shirts than the $1 million it could earn by simply putting the money in the bank. If the firm can’t generate enough to cover all of its costs, including the opportunity cost of assets owned by the firm, it will not continue in business.
Tags: capital, goods, real estate