3.2 - Costs
Definitions of firms, industries, markets, and revenue
A firm is any organisation engaged in business activities, such as producing goods or providing services. An industry consists of all firms that offer similar products or services, while a market includes both the suppliers of a specific good or service and the buyers involved in transactions.
Firms earn revenue through the sale of their output, which refers to the goods or services they produce. To create this output, firms use factors of production, including land, labour, capital, and enterprise. These factors come with associated costs. Profit is calculated as total revenue minus total costs, and over the long term, firms must generate profit to remain operational.
Economic costs, money costs, and opportunity costs
Costs in economics extend beyond simple financial outlays, incorporating broader considerations of resource use.
Economic costs vs money costs
Economic costs encompass both the money costs of factors of production that require payment and the opportunity costs of unpaid factors. Money costs are the direct financial expenses incurred when purchasing or hiring resources, such as wages or raw materials.
Opportunity costs
Opportunity cost represents the value of the next best alternative use of a factor of production. For instance, if an entrepreneur runs their own cafe, the income they could have earned from a salaried position elsewhere is the opportunity cost of their time and effort. This concept highlights that economic costs account for all resources and efforts invested in production, not just monetary spending.
Short run and long run in production
The distinction between short run and long run depends on the flexibility of factors of production, which can vary across different firms.
Short run
The short run is the timeframe during which at least one factor of production remains fixed and cannot be altered. This period differs by firm; for example, a taxi company might adjust its fleet quickly by hiring more drivers, resulting in a short run of weeks, whereas a wind turbine manufacturer could face a short run of years due to the time needed to expand factory capacity. In this phase, costs are divided into fixed and variable categories.
Long run
The long run is the period when all factors of production can be adjusted, allowing complete flexibility in operations. Consequently, all costs become variable in the long run, as there are no fixed constraints on resources.
Types of costs: fixed, variable, total, average, and marginal
Costs are categorised based on how they respond to changes in output levels, providing insight into a firm's financial structure.
Fixed and variable costs
Fixed costs remain constant regardless of output in the short run and must be paid even if no production occurs, such as rent for premises. Variable costs, however, rise with increasing output, for example, the cost of ingredients in a bakery, which escalates as more items are baked.
Total cost
Total cost (TC) represents the complete expense of producing a given output level, combining fixed and variable elements.
Where:
- TC = Total cost
- TFC = Total fixed costs
- TVC = Total variable costs
Average costs
Average cost (AC), also known as average total cost (ATC), measures the cost per unit of output.
Where:
- AC = Average cost
- TC = Total cost
- Q = Quantity produced
Average fixed cost (AFC) and average variable cost (AVC) are calculated similarly.
Where:
- AFC = Average fixed cost
- AVC = Average variable cost
- TFC = Total fixed costs
- TVC = Total variable costs
- Q = Quantity produced
Marginal cost
Marginal cost (MC) is the additional expense of producing one more unit of output, influenced solely by variable costs since fixed costs are unaffected by output changes.
Where:
- MC = Marginal cost
- ΔTC = Change in total cost
- ΔQ = Change in quantity
It can also be found as the difference in total cost between two consecutive output levels: MC = TCn - TCn-1.
Worked example - Calculating average and marginal costs
A firm has total fixed costs of £750. At an output of 120 units, total variable costs are £960, and at 121 units, total variable costs rise to £970. Calculate the average cost at 120 units and the marginal cost of the 121st unit.
Step 1: Identify the values
- Total fixed costs (TFC) = £750
- Total variable costs at 120 units (TVC120) = £960
- Total variable costs at 121 units (TVC121) = £970
Step 2: Calculate total cost at 120 units
TC120 = TFC + TVC120 = £750 + £960 = £1,710
Step 3: Calculate average cost at 120 units
AC120 = TC120 ÷ 120 = £1,710 ÷ 120 = £14.25 per unit
Step 4: Calculate marginal cost of the 121st unit
First, TC121 = £750 + £970 = £1,720
MC = TC121 - TC120 = £1,720 - £1,710 = £10
Cost curves and their relationships
Cost curves illustrate how costs behave as output changes, shaped by economic principles like the law of diminishing returns.
Shapes of cost curves in the short run
- Marginal cost (MC) curve - Forms a U-shape: it falls initially with rising output due to efficiencies, then rises as diminishing returns set in.
- Average variable cost (AVC) and average cost (AC) curves - Also U-shaped, decreasing to a minimum before increasing.
- Average fixed cost (AFC) curve - Continuously declines as output grows, since fixed costs are distributed over more units.
Key relationships between cost curves
- When MC is below AC, the AC curve falls.
- When MC exceeds AC, the AC curve rises.
- The MC curve intersects the AC curve at its lowest point, indicating productive efficiency.
- Similarly, MC intersects AVC at the minimum AVC.