3.3 - Costs of Production
Definitions of firms, industries, markets and profit
A firm is a business organisation that produces goods or services, such as a small family bakery or a large supermarket chain. An industry consists of all firms offering similar products or services, while a market includes both the suppliers of a specific good or service and the buyers purchasing it.
Firms earn revenue by selling their output, which requires using factors of production like land, labour, capital and enterprise. These factors come with costs, and a firm's profit is calculated as total revenue minus total costs. In the long run, businesses must generate profit to remain operational.
Economic costs and opportunity cost
Economic costs represent the full expense of producing goods or services, including both monetary payments for factors of production and non-monetary elements.
Components of economic costs
- Monetary costs - These are direct payments for resources, such as wages for workers or rent for premises.
- Opportunity cost - This is the value of the next best alternative use of a resource that is not paid for in cash. For instance, if someone runs their own cleaning service, the income they could have earned from a salaried job elsewhere represents the opportunity cost of their time and effort.
Economic costs capture all resources and efforts involved in production, beyond just financial outlays.
Short run and long run in production
The short run is the timeframe during which at least one factor of production remains fixed and cannot be changed. This period differs between businesses; for a taxi company, it might last weeks as new drivers can be hired quickly, but for a car manufacturer, it could extend to years due to the time required to install new machinery.
In contrast, the long run is the period when all factors of production can be adjusted, allowing complete flexibility in operations.
Fixed and variable costs
Costs in the short run are classified as fixed or variable, depending on how they respond to changes in output levels.
Fixed costs
Fixed costs remain constant regardless of the amount produced, even if output is zero. Examples include insurance premiums or loan repayments on equipment, which must be paid irrespective of production volume.
Variable costs
Variable costs change directly with output levels, rising as more is produced. For example, the cost of packaging materials for a toy manufacturer increases with the number of toys made.
In the long run, all costs become variable since firms can alter every aspect of their operations.
Total, average and marginal costs and their relationships
Various cost measures help firms analyse production expenses at different output levels.
Total cost
Total cost (TC) is the overall expense of producing a specific quantity of output.
Where:
- TFC = Total fixed costs
- TVC = Total variable costs
Average costs
Average cost (AC), also known as average total cost (ATC), is the cost per unit of output.
Where:
- Q = Quantity produced
Average fixed cost (AFC) is the fixed cost per unit.
Average variable cost (AVC) is the variable cost per unit.
AFC decreases as output increases because fixed costs are spread over more units. Both AVC and AC form U-shaped curves in the short run, initially falling to a minimum before rising due to factors like resource constraints.
Marginal cost
Marginal cost (MC) is the additional cost of producing one extra unit of output, influenced only by variable costs.
Alternatively:
MC starts low and decreases initially with rising output, then increases, forming a U-shaped curve due to the law of diminishing returns.
Relationships between cost curves
- When MC is below AC, it pulls AC downwards.
- When MC is above AC, it pushes AC upwards.
- The MC curve intersects the AC curve at its lowest point, indicating productive efficiency.
- Similarly, MC intersects AVC at its minimum.
Worked example - Calculating total, average and marginal costs
A coffee shop has total fixed costs of £1,000 and produces 400 cups of coffee with total variable costs of £600. If production increases to 401 cups and total costs rise to £1,608, calculate the total cost, average cost and marginal cost at 400 cups, and the marginal cost for the 401st cup.
Step 1: Identify the values
- Total fixed costs (TFC) = £1,000
- Total variable costs (TVC) at 400 cups = £600
- Quantity at initial output (Q) = 400 cups
- Total costs at 401 cups = £1,608
Step 2: Calculate total cost at 400 cups
Step 3: Calculate average cost at 400 cups