10.2 - Costs
The basics of firms, revenue, costs, and profit
A firm is any organisation that produces goods or services with the aim of generating profit.
Key definitions related to firms and markets
- Firm - A business entity that supplies goods or services.
- Industry - A group of firms offering comparable products or services.
- Market - The environment where firms supply a specific good or service and interact with buyers.
How firms generate revenue and manage costs
Firms earn revenue by selling their products or services. To produce these, they use factors of production, each of which incurs a cost. Profit is calculated as total revenue less total costs. Over the long term, firms must achieve profit to remain viable.
Opportunity cost in production
In economics, the cost of production extends beyond just monetary expenses to include opportunity cost, which reflects the value of alternatives forgone.
Economic cost
Economic cost combines the explicit financial outlays for factors of production with the implicit opportunity costs of unpaid resources.
Calculating opportunity cost
Opportunity cost represents the potential earnings from the next best alternative use of a resource. This approach ensures that costs account for all resources and efforts involved in production, not merely cash spent.
Fixed and variable costs in the short and long run
Costs behave differently depending on the time frame, with some remaining constant regardless of output levels while others fluctuate.
Short run and long run
The short run is the timeframe during which at least one factor of production cannot be changed. This duration differs across firms. In contrast, the long run allows all factors to be adjusted.
Fixed and variable costs
- Fixed costs - These remain unchanged regardless of output in the short run and must be paid even if production halts.
- Variable costs - These rise directly with output increases.
In the long run, all costs become variable since firms can alter every aspect of production.
Total, average, and marginal costs
Various cost measures help firms analyse their expenses at different output levels, incorporating both fixed and variable elements.
Total cost
Total cost (TC) represents the complete expense of producing a given output quantity.
Formula for total cost:
Where:
- Total fixed costs (TFC) = Costs unchanged by output (£)
- Total variable costs (TVC) = Costs that vary with output (£)
Average costs
Average cost (AC), or average total cost (ATC), is the expense per unit of output.
Formula for average costs:
Average fixed cost (AFC) and average variable cost (AVC) break this down further:
Marginal cost
Marginal cost (MC) is the additional expense of producing one more unit of output, influenced solely by variable costs.
Formula for marginal cost:
Where:
- TCn = Total cost at current output level (£)
- TCn-1 = Total cost at one unit lower output (£)
Alternatively, for changes over multiple units:
Example cost calculations for a firm
| Total output | Total fixed costs (£) | Total variable costs (£) | Total cost (£) | Average fixed cost (£) | Average variable cost (£) | Average total cost (£) | Marginal cost (£) |
|---|---|---|---|---|---|---|---|
| 0 | 80 | 0 | 80 | - | - | - | - |
| 1 | 80 | 90 | 170 | 80 | 90 | 170 | 90 |
| 2 | 80 | 150 | 230 | 40 | 75 | 115 | 60 |
| 3 | 80 | 220 | 300 | 26.67 | 73.33 | 100 | 70 |
| 4 | 80 | 310 | 390 | 20 | 77.5 | 97.5 | 90 |
| 5 | 80 | 430 | 510 | 16 | 86 | 102 | 120 |
The relationship between marginal and average costs
The interaction between marginal cost and average cost reveals important insights into efficiency, shaped by the law of diminishing returns.
How marginal cost influences average costs
Marginal cost starts low and rises after an initial decline due to diminishing returns, resulting in a U-shaped curve.
This affects average costs as follows:
- When marginal cost is below average cost, average cost decreases.
- When marginal cost exceeds average cost, average cost increases.
The point where marginal cost equals average cost marks the minimum average cost, representing productive efficiency.
Marginal cost intersects average variable cost at its lowest point, leading to U-shaped curves for both average variable cost and average cost in the short run. Average fixed cost continually declines as output rises, spreading fixed expenses over more units.
Graphical representation of cost curves
Cost curves typically appear on a graph with costs on the vertical axis and output on the horizontal axis:
- Average fixed cost (AFC) - Steeply downward-sloping curve.
- Average variable cost (AVC) - U-shaped curve.
- Average cost (AC) - U-shaped curve above AVC, with the gap representing AFC.
- Marginal cost (MC) - U-shaped curve that crosses AVC and AC at their minimums.