Costs of production

What are costs of production?

What are costs of production?

• In preparing goods and services for sale, firms incur a range of costs. These costs of production can be be broken into different categories:

Fixed costs (FC)

• These are costs that do not change as the level of output changes

• They have to be paid whether output is zero or 5000 

  • For example, building rent, management salaries, insurance and bank loan repayments

Variable costs (VC)

• These are costs that vary directly with output

• These increase as output increases and vice versa

  • For example, raw material costs and wages of workers directly involved in production

Total costs (TC)

• These are the sum of the fixed and the total variable costs 

Cost calculations

Cost calculations

• Based on the above definitions, we can calculate several different types of costs

1. Total costs (TC)

$\mathrm{Total} \mathrm{costs} \left(\mathrm{TC}\right) = \mathrm{Total} \mathrm{fixed} \mathrm{costs} \left(\mathrm{TFC}\right) + \mathrm{Total} \mathrm{variable} \mathrm{costs} \left(\mathrm{TVC}\right)$

2. Total variable costs (TVC)

$\mathrm{Total} \mathrm{variable} \mathrm{cost} \left(\mathrm{TVC}\right) = \mathrm{Variable} \mathrm{cost} \left(\mathrm{VC}\right) \times \mathrm{Quantity} \left(\mathrm{Q}\right)$

3. Average total costs (ATC)

$\mathrm{Average} \mathrm{total} \mathrm{cost} \left(\mathrm{ATC}\right) = \frac{\mathrm{Total} \mathrm{cost} \left(\mathrm{TC}\right)}{\mathrm{Quantity} \left(\mathrm{Q}\right)}$

4. Average fixed costs (AFC)

$\mathrm{Average} \mathrm{fixed} \mathrm{cost} \left(\mathrm{AFC}\right) = \frac{\mathrm{Total} \mathrm{fixed} \mathrm{costs} \left(\mathrm{TFC}\right)}{\mathrm{Quantity} \left(\mathrm{Q}\right)}$

5. Average variable costs (AVC)

$\mathrm{Average} \mathrm{variable} \mathrm{cost} \left(\mathrm{AVC}\right) = \frac{\mathrm{Total} \mathrm{variable} \mathrm{costs} \left(\mathrm{TVC}\right)}{\mathrm{Quantity} \left(\mathrm{Q}\right)}$

Drawing and interpreting cost diagrams

Drawing and interpreting cost diagrams

Fixed costs (FC)

• The firm has to pay its fixed costs which do not change, irrespective if the output is 0 or 100,000 units

• The fixed costs for this firm are $4,000

Variable costs (VC)

• The variable costs initially rise proportionally with output, as shown in the diagram

• At some point the firm will benefit from a purchasing economy of scale and the rise will no longer be proportional

Total cost (TC)

• The total cost is the sum of the variable and fixed costs

• The total costs cannot be 0, as all firms have some level of fixed costs

Average fixed cost (AFC)

• If the fixed costs of a firm are $1,000 and it produces 1 unit of output, then its AFC is $1,000 ($1,000/1)

• If the firm increases its output to 1000 units, then the AFC is $1 per unit ($1000/1,000)

• The more units a firm produces, the lower its AFC will be

• This is one reasons why large levels of output help to increase the profit per unit

Average total cost (ATC)

• As a firm grows, it is able to increases its scale of output generating efficiencies that lower its average total costs (AC) of production

• These efficiencies are called economies of scale 

• As a firm continues increasing its scale of output, it will reach a point where its average total costs (AC) start to increase

• The reasons for the increase in the average costs are called diseconomies of scale