Costs of Production (AQA A Level Economics)

Different Types of Costs

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

1. Fixed costs (FC) are costs that do not change as the level of output changes

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

     • E.g. Building rent, management salaries, insurance, bank loan repayments, etc.

2. Variable costs (VC) are costs that vary directly with output

   • These increase as output increases, & vice versa

     • E.g. Raw material costs, wages of workers directly involved in production

3. Total costs (TC) are the sum of the fixed + total variable costs

The distinction between short run and long run costs

• The distinction between short run and long run costs revolves around the degree of flexibility in adjusting inputs (the factor of production)
   

• In the short run, some inputs are fixed and cannot be varied easily, such as capital equipment or the size of the production facility

  • Variable inputs like labour and raw materials can to a certain extent be adjusted

  • Short run costs include both fixed and variable costs, but the state of capital is fixed 

• In the long run, all inputs are able to change

  • Firms have the flexibility to adjust their production processes, expand or contract their scale of operations, and invest in new capital equipment

  • Consequently, all costs become variable as firms can make adjustments to their input mix to optimise production efficiency

Cost Calculations & Cost Graphs

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

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   Cost Calculations Using the Above Formulas Where VC is $60

A Graphical Representation of Costs

Type of Cost	Diagram	Explanation
Fixed Cost (FC)		The firm has to pay its fixed costs which do not change, irrespective of whether the output is 0 or 100,000 units The fixed costs for this firm are $4,000
Variable Cost (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 & fixed costs The total costs cannot be zero, 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 (AC)		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) will start to increase The reasons for the increase in the average costs are called diseconomies of scale