Costs of production

Production involves the purchase or hiring of scarce factor inputs which creates production costs.

Types of cost in the short run

There are several ways to classify costs, but the starting point is to distinguish fixed and variable costs.

Fixed costs

Costs which are fixed do not change with output.

Fixed costs typically include some labour and administration costs, marketing costs, rents, insurance, and depreciation of fixed assets.

Variable costs

Costs which are variable do change with output - these commonly include raw materials and most labour costs.

By short-run costs we mean costs incurred in a firm's short run, which is defined as a situation when some costs remained fixed, and others are variable. The long-run for a firm is when all costs can be changed - in other words, all costs are variable.

Go to cost schedules for a numerical example.

Measuring costs

Costs can be measured in terms of ‘total’, and average values. Costs can also be measured in terms of marginal values, which measure the cost or revenue associated with producing (or selling) an additional unit.

While total and average values provide important information to a business, marginal values are particularly import in economics. Indeed, the ‘marginal revolution’ in economics involved the attempt to understand economic decision making by looking at very small changes in costs, revenue and utility.

Example

Consider a firm making packs of porcelain floor tiles, with the following costs:

Cost schedule

Fixed costs are £5,000, and variable costs per pack will increase with output.

Graph for average and marginal cost

We can observe that the marginal cost (MC) curve cuts the average cost (AC, or ATC) curve at its lowest point.

The pattern is for average costs to be relatively high at low levels of output – because the impact of fixed costs, such as rents and interest payments, is high and drags up the average. However, as more variable factors are added to increase output, the significance of the fixed costs begins to diminish, and average costs fall.

However, economic theory predicts that the returns to adding extra variable units of production will begin to diminish – the so-called law of diminishing returns. This drags up average costs and pushes the firm above its productively most efficient level.

Diminishing returns

Diminishing returns sets in when marginal cost begins to rise - in this case, at an output of 3000. The upward increase in marginal costs then drags up the average cost. In this example, the firm is productively efficient at 4000 units as this is the lowest average cost (at £15 per unit).

This can be seen more effectively in the graph for average costs. It is also true that average costs will be at their lowest when average cost equals marginal cost (per unit).