Firms' Costs of Production

Firms' Costs of Production

Understanding costs is essential for any business decision involving production, pricing, and profitability. This lecture examines how economists categorise and measure the costs that firms incur in producing goods and services. The economic approach to costs is broader than the accounting approach — it includes not just out-of-pocket expenditures but also the opportunity costs of resources the firm owns or controls.

Short Run vs Long Run

Economists distinguish between two time horizons in production:

• The short run — a period in which at least one factor of production is fixed. Typically, capital (plant and equipment) is fixed in the short run, while labour can be varied. The short run is not defined by a specific calendar period — it varies by industry (a bakery might have a short run of a few weeks; a steel plant might have a short run of years).
• The long run — a period long enough for all factors of production to be varied. In the long run, a firm can change its scale of operations entirely — build larger or smaller facilities, enter or exit the industry.

Explicit and Implicit Costs

Economists distinguish between two types of costs:

• Explicit costs — direct out-of-pocket expenditures: wages paid to employees, rent paid for premises, payments for raw materials, utility bills. These show up in accounting records.
• Implicit costs — opportunity costs of resources the firm owns or the owner provides; they do not involve cash payments but represent real costs. Key examples include: the foregone salary the owner could earn working elsewhere (the opportunity cost of the owner's time); the foregone return on capital the owner has invested in the business instead of earning interest or dividends; the opportunity cost of using owner-provided premises instead of renting them out.

This distinction gives rise to two different profit concepts:

• Accounting profit = Total revenue - Explicit costs
• Economic profit = Total revenue - (Explicit costs + Implicit costs)

A business can be making accounting profit but zero or negative economic profit — meaning it is not earning a return adequate to compensate for all the resources employed, including the owner's time and capital.

Fixed, Variable, and Total Costs

In the short run, a firm's costs divide into:

• Fixed costs (FC) — costs that do not change with the level of output; they must be paid even if the firm produces nothing. Examples: rent on premises, insurance, loan repayments, salaries of permanent management staff. Fixed costs are sometimes called overhead or sunk costs in the short run (once committed, they cannot be avoided by reducing output).
• Variable costs (VC) — costs that change with the level of output; they rise as output rises and fall as output falls. Examples: raw materials, electricity used in production, piece-rate wages for production workers.
• Total cost (TC) = Fixed cost (FC) + Variable cost (VC)

Average Costs

Average cost measures cost per unit of output:

• Average Fixed Cost (AFC) = FC / Q — as output increases, AFC continuously decreases (fixed cost is spread over more units — this is the source of economies of scale in the short run)
• Average Variable Cost (AVC) = VC / Q — initially falls as output rises (due to specialisation and efficiency gains), then eventually rises (as diminishing returns set in)
• Average Total Cost (ATC) = TC / Q = AFC + AVC — U-shaped; falls initially as AFC falls and efficiency gains dominate, then rises as diminishing returns cause AVC to rise faster than AFC falls

Marginal Cost

Marginal cost (MC) is the additional cost incurred from producing one more unit of output. It is the most important cost concept for production decisions. MC is calculated as: MC = Change in TC / Change in Q. The MC curve is U-shaped: initially falling as efficiency increases, then rising as diminishing returns set in. The MC curve intersects both the AVC and ATC curves at their lowest points — when MC is below ATC, ATC is falling; when MC is above ATC, ATC is rising.

The Law of Diminishing Returns

The law of diminishing (marginal) returns states that as more units of a variable input are added to a fixed input, at some point the marginal product of the variable input will begin to decline. In other words: adding more workers to a fixed factory eventually produces smaller and smaller additions to output — because the fixed capital is shared among more workers, each contributing less additional output than the previous one. This is why variable costs — and therefore marginal cost — eventually rise as output increases.

Long Run Costs and Economies of Scale

In the long run, all inputs can be varied. The long-run average cost curve (LRAC) shows the minimum average cost of producing each level of output when all inputs are optimally chosen:

• Economies of scale — long-run average cost falls as output increases. Causes include: specialisation of labour, bulk purchasing of inputs, spreading fixed costs of R&D and management, and technical efficiencies of larger scale equipment. Industries with significant economies of scale tend toward natural monopoly.
• Diseconomies of scale — long-run average cost rises as output increases, typically because coordination problems, bureaucracy, and management inefficiencies grow at very large scales.
• Constant returns to scale — long-run average cost remains constant as output increases.