Costs of Production

Costs of Production

Costs of production are the expenses a firm incurs in order to produce goods and services. Inputs or resources have to be acquired for use in production; the money paid for the use of these inputs is part of production costs, e.g. rent for land, interest for capital, wages and salaries for labour, and profit for enterprise. In the short run, there are basically two types of costs, namely fixed costs and variable costs. All costs are variable in the long run since all factors of production can be varied. 

Figure 1: The average cost curves

Graph showing the average cost curves

Short run costs
Total Fixed Cost (TFC) or Fixed Cost (FC)
Total fixed cost is the cost that the firm must incur regardless of the production or output level. If the output level is zero, fixed cost will still be incurred. Fixed costs are usually associated with the use of fixed factors of production. Examples of fixed costs include rent, cost of machine, insurance and salaries. The fixed cost curve is a horizontal line because it remains unchanged within a period of time (see Figure 2 below).

Figure 2: Fixed cost, total variable cost and total cost curves

Graph showing total cost, total variable cost and fixed cost

Total Variable Cost (TVC) or Variable Cost (VC)
These costs are directly related to production level because if the firm wants to produce more units of output, it has to spend more on the variable factors of production. For example, a firm needs to buy more raw materials if it wants to increase its output. However, the firm does not incur any variable cost if it does not produce any unit of output. That is why the total variable cost starts from the origin (Figure 2).  The total variable cost curve rises at a decreasing rate initially; then it rises at an increasing rate. This is caused by diminishing returns. Initially, the productivity of an extra unit of the variable factor employed increases, leading to a slower rise in cost. The output produced by the additional variable factor later starts to fall leading to a rapid rise in cost. 

Total  Cost (TC)
Total cost is the addition of total fixed cost and total variable cost (Table 1 below). It is the sum of the costs of all the factors of production employed by the firm.  The total cost curve has exactly the same shape as the total variable cost curve. The only difference is that it does not start from the origin because of the fixed cost which shifts it upward (Figure 2). 

Average Total Cost (ATC) or Average Cost (AC)
This is the cost of one unit of the product. It is obtained by dividing the total cost by the amount of output produced (Table 1 below). It can also be obtained by adding the average fixed cost and average variable cost.  The average total cost curve is U-shaped (Figure 1 above); it falls initially and then starts to rise.  This means that output increases initially and then falls. The initial increase in output comes with a reduced average cost as the total cost is spread over large output. The average cost starts to rise because of diminishing returns total cost rises more than the output leading to a rise in average cost.

Average Fixed Cost (AFC)
This is the amount of fixed cost incurred on a unit of output. It is the total fixed cost divided by the quantity of output (Table 1 below). The average fixed cost falls continuously because a constant amount is being divided by increasing units of output (Figure 1 above). Therefore, as output increases average fixed cost decreases.

Average Variable Cost (AVC)
Average variable cost is the variable cost of a unit of output. It is obtained by dividing the total variable cost by the amount of output made (Table 1 below). The average variable cost falls and then rises afterwards because of diminishing returns which sets in (see Figure 1 above).

Marginal Cost (MC)
Marginal cost is the cost of producing one more unit of output. It can be obtained by dividing the change in total cost by the change in the quantity produced. In Table 1 below, the marginal cost for the 2nd quantity is 50 (1,100-1,050/2-1). The marginal cost curve initially falls and rises later on (see Figure 1 above). The output will first rise when an additional worker is employed; but it will later start to fall. The rise in the output of an extra worker coincides with a fall in marginal cost and the fall in marginal output leads to a rise in marginal cost. The marginal cost curve cuts the average variable cost curve and the average total cost curves at their lowest points.

Table 1: Numerical example of costs


Long run costs
Long Run Average Cost (LRAC)
The long run average cost curve is an envelope curve that joins the minimum or lowest points on the firm’s short run average cost curves (Figure 3 below). The lowest point on each short run average cost curve is the cheapest way of producing each amount of output. In other words, the points on the long run average cost curve are the least expensive way of producing each output level. A  firm cannot produce at a point below its long-run average cost curve. But It can produce at a point above it even though it is an inefficient way of producing. The U-shape of the long run average cost curve means that long run average cost will fall first and go up later on. Economies of scale are responsible for its fall while diseconomies of scale make it go up. As the firm increases its output, it moves rightwards on its long run average cost curve.  External economies of scale will lead to a downward shift of the curve while external diseconomies of scale will shift it upwards.  Increased costs can move the curve upwards while a decrease in costs moves it downwards.

Figure 3: Long run average cost curve
Long run average cost curve


The very long run
The very long run is a production run in which technology changes. Technological innovation will drive down the costs of a firm, thereby shifting the long run average cost curve downwards (Figure 4 below).

Figure 4: Shift of the long run average cost curve
Very long run curve