Cost, Cost, Cost
Businesses or firms strive to earn the most profits possible. They do this by trying to increase revenue and decrease cost. In a competitive environment, there is not much firms can do to increase revenue. They lack pricing power. Firms do have the ability to control cost, so in order to maximize their profits they try to produce at the lowest cost possible.
Economists break down costs into different categories, the first of which are fixed costs or overhead. A firm's fixed costs are those costs that don't change regardless of the level of production. Rent, property tax, management salaries, and depreciation are examples. Whether a factory is running at full capacity or is idle, the overhead remains the same. Firms also face variable costs. Variable costs change with the level of a firm's output. Utilities, hourly wages, and per unit taxes are representative of variable costs. As a firm's production increases, so do its variable costs. Total cost is the sum of a firm's fixed and variable costs.
The marginal cost of production is of special interest to economists. Marginal cost is the change in total cost for each unit produced. Think of marginal cost as the additional cost of producing one more item. For each additional unit of output a firm produces, it incurs more variable cost and hence more total cost. This means that its marginal cost increases as well. For example, each Big Mac costs more to produce than the previous Big Mac because McDonald's had to pay for more ingredients and pay its workers more for the extra time it took to produce the additional Big Mac. Firms like McDonald's maximize their profits when they produce at the point where marginal cost equals marginal revenue. In other words, if a firm wants to make the largest profits it can, it will produce up to the point where the additional cost of producing one more item is the same as the additional revenue earned by producing one more item.
In the long run, all costs are variable. Over time, firms are able to add or subtract capital, renegotiate rent, and alter management salaries. The distinction between fixed and variable costs disappears with the passage of time.