Economics (9640) | Costs of production

💰 Costs of Production: Understanding How Firms Spend

Welcome to one of the most important chapters in microeconomics! Understanding costs is not just about counting money; it’s about making smart decisions.

For any firm—whether it's a small local bakery or a huge multinational tech company—knowing the costs of production is essential for:

• Setting the right price.
• Deciding how much to produce (output).
• Maximising profit.

Don't worry if this seems tricky at first. We will break down the complex concepts of time, fixed costs, and variable costs into simple, manageable pieces.

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1. The Economic Time Horizon: Short Run vs. Long Run

In Economics, the terms Short Run and Long Run don't refer to a fixed period like six months or five years. They are defined by how flexible a firm's inputs (Factors of Production) are.

The Short Run

The Short Run is defined as a time period where at least one factor of production is fixed.

• A fixed factor is typically Capital (like the size of a factory, or the machinery owned).
• To increase output in the short run, the firm can only increase its variable factors (like hiring more labour or buying more raw materials).

Analogy: Imagine you run a pizza shop. In the short run, you are stuck with the current size of your kitchen and oven (fixed capital). If demand increases, all you can do is hire more chefs and buy more ingredients (variable factors).

The Long Run

The Long Run is defined as a time period where all factors of production are variable.

• The firm has enough time to change its capital, technology, or scale of operations.
• If the pizza shop sees consistent high demand, they can decide in the long run to build a bigger kitchen, buy a second oven, or even open a second branch.

2. Classifying Costs: Fixed vs. Variable

Costs are the monetary payments firms make to secure factors of production. We classify them based on whether they change with the level of output.

Fixed Costs (FC)

Fixed Costs (FC) are costs that do not change with the level of output (Q). They must be paid even if the output is zero.

• Examples: Rent on the factory building, insurance payments, interest payments on loans, or salaries of essential permanent staff.

Key Takeaway: Fixed costs only exist in the Short Run. In the long run, all costs are variable because the firm can change its size or leave the industry.

Variable Costs (VC)

Variable Costs (VC) are costs that change directly with the level of output (Q).

• If output is zero, variable costs are zero.
• Examples: Wages paid to hourly workers, raw materials (flour, steel, chips), electricity to run the machinery, and fuel for transport.

3. Total, Average, and Marginal Costs (The Calculations!)

To analyse costs, economists use three main measures: Total, Average, and Marginal.

A. Total Costs (TC)

Total Cost (TC) is simply the sum of all fixed costs and all variable costs incurred in production.

The formula is:

\[TC = TFC + TVC\]

Where: TFC = Total Fixed Costs and TVC = Total Variable Costs.

Did you know? Since TFC doesn't change, the shape of the TC curve is determined entirely by the shape of the TVC curve.

B. Average Costs

Average costs tell us the cost per unit of output. These are crucial for a firm when setting prices and determining profitability.

1. Average Fixed Cost (AFC)

This is the fixed cost per unit of output. As output increases, the same fixed cost is spread over more units, so AFC continuously falls.

\[AFC = \frac{TFC}{Q}\]

2. Average Variable Cost (AVC)

This is the variable cost per unit of output.

\[AVC = \frac{TVC}{Q}\]

3. Average Total Cost (ATC) or Average Cost (AC)

This is the total cost per unit of output. It is the most important measure for deciding if a firm is profitable (if Price > ATC, the firm makes profit).

\[ATC = \frac{TC}{Q} \quad \text{or} \quad ATC = AFC + AVC\]

C. Marginal Cost (MC)

Marginal Cost (MC) is the additional cost incurred from producing one extra unit of output.

This concept is vital because firms use marginal cost to decide whether producing one more item is worthwhile (i.e., whether the revenue from that item covers the MC).

The formula is:

\[MC = \frac{\Delta TC}{\Delta Q}\]

Where \(\Delta TC\) is the change in Total Cost and \(\Delta Q\) is the change in Quantity.

Note: Since Fixed Costs (TFC) do not change when output increases, the marginal cost is only affected by the change in Variable Costs. Therefore, \(MC\) can also be calculated as \(\Delta TVC / \Delta Q\).

4. The Shapes of Short-Run Cost Curves

When we plot these costs against output (Q), the curves take on very specific shapes, which reflect what happens to productivity as a firm adds more variable inputs (like labour) to a fixed factor (like the factory).

Total Cost Curves

• Total Fixed Cost (TFC) Curve: This is a horizontal line because TFC remains constant regardless of output.
• Total Variable Cost (TVC) Curve: Starts at zero and increases as output increases.
• Total Cost (TC) Curve: Starts at the level of TFC (when Q=0) and runs parallel to the TVC curve.

Average and Marginal Cost Curves: The U-Shape

The Average Total Cost (ATC), Average Variable Cost (AVC), and Marginal Cost (MC) curves are typically U-shaped in the short run.

Why the U-Shape?

1. Initial Fall (Cost Savings): When output is low, adding more workers or inputs leads to increased efficiency (perhaps due to specialisation). Costs per unit (ATC, AVC, MC) fall.

2. The Bottom (Optimum Output): The curve reaches its minimum point. This is the most efficient level of output for that factory size.

3. The Rise (Inefficiency): As the firm continues to add more variable input (e.g., hiring the 20th, 21st, 22nd worker), the fixed factor becomes crowded or strained (too many chefs in one small kitchen!). Productivity falls, and costs per unit begin to rise.

Relationship between MC and AC/AVC:

The MC curve intersects the ATC and AVC curves at their minimum points.

• If \(MC < ATC\), the average cost is pulled down. (If the cost of your next item is cheaper than the average, the average drops.)
• If \(MC > ATC\), the average cost is pulled up. (If the cost of your next item is more expensive than the average, the average rises.)

Memory Aid: Think of your exam grades. If your Marginal (next) score is higher than your Average, your average goes up!

5. Costs in the Long Run (A Look Ahead)

In the long run, the firm can choose the best possible factory size (the best combination of all inputs). Therefore, the Long-Run Average Cost (LRAC) curve is typically formed by the minimum points of many possible short-run ATC curves.

The Shape of the LRAC Curve

The LRAC curve is also often U-shaped, but for different reasons than the short run. Its shape is determined by Economies of Scale (EoS) and Diseconomies of Scale (DoS).

• Falling LRAC: As output increases, the firm benefits from EoS (e.g., buying in bulk, specialisation). Costs fall.
• Rising LRAC: If the firm grows too large, it experiences DoS (e.g., complex bureaucracy, communication problems). Costs rise.

The bottom of the LRAC curve represents the Minimum Efficient Scale (MES), which is the output level where the lowest average cost of production is achieved. (This concept is explored further in section 3.1.3.4).