1.3.3 Costs of production What are the fixed and variable costs of running today’s economics lesson? How could average costs be lowered? AS: P RODUCTION, COSTS AND REVENUE Y1: Production, costs and revenue

1.3.3 C OSTS OF PRODUCTION  The difference between the short run and the long run  The difference between fixed and variable costs  The difference between average and total costs  You should be able to calculate average and total costs from given data  You should appreciate that the short-run average cost curve is likely to be U-shaped but a formal link with the law of diminishing returns is not expected  You should understand that the shape of the long-run average cost curve is determined by economies and diseconomies of scale

S HORT RUN V L ONG RUN  The short run is the time period in which a minimum of one factor of production is fixed. This production occurs in real time i.e. now. In the short run we look at marginal product (or returns) of a variable factor of production and the productivity of the firm  In the short run firms will stay in production if they are covering their average variable costs as this will help them to pay off their average fixed costs  The long run is the time period in which no factors of production are fixed. Therefore, the scale of output can be changed. In the long run we look at returns to scale  In the long run firms will leave the industry if they do not cover their average total costs In the short run a firm has sunk costs. These are costs that the firm has already paid and are not recoverable if the firm wishes to leave the industry. They are unavoidable. In the long run a firm faces prospective costs. These are costs that the firm will take into account when making an investment decision and are avoidable as they are based on the future. When looking at new investment the firm should ignore sunk costs and base decisions on merit. However, this is rarely the case.

S HORT R UN AND L ONG R UN P RODUCTION In the long run the firm is able to increase the scale of production leading to economies of scale. It is able to change all factor inputs, including capital. Economists normally make the assumption that capital is most likely to be fixed in the short run. For example, it is difficult to build a new factory in a short period of time. In the short run we can only increase output by adding more of the variable factors of production to fixed capital. At some point the law of diminishing returns sets in and marginal costs begin to rise. In the long run the firm is able to increase the scale of production leading to economies of scale i.e. it is able to change all factor inputs, including capital. Economies of scale will lead to increased productive efficiency. Economies of scale are decreases in the average cost of production as the scale of production is increased. In the short run we can add more of the variable factor e.g. labour to the fixed factor of production e.g. capital. In the long run we can add more of the fixed factor, increasing the scale of the firm. This is the important distinction between short and long run.

D EFINITION OF C OSTS  Fixed cost (FC) or Total fixed cost (TFC) does not vary with output. This might include rent, capital goods such as factories and machinery, or marketing costs. Therefore, the fixed cost curve is shown as a horizontal straight line. Average fixed cost (AFC) is: Total Fixed Cost/Output  Variable cost (VC) varies with output. As output increases so does variable cost and vice versa. This might include the costs of raw materials. The variable cost curve slopes upwards and to the right  Total cost (TC) is calculated as: Total Fixed Cost (TFC) + Total Variable Cost (TVC). The total cost curve slopes upwards and to the right. It begins at the same point as the FC curve. It will incorporate the VC curve because FC + VC = TC Draw a diagram to show FC, VC and TC.

D EFINITION OF C OSTS  Average cost (AC) or Average Total Cost (ATC) is the average cost of producing a unit of output: Total Cost/Output. The average cost (AC) curve is U-shaped. The MC curve always cuts the AC curve at its lowest point. When MC is less than AC then AC is falling. When MC is greater than AC then AC is rising. At lower levels of output AC is falling steeply. At higher levels of output AC is rising steeply. Average variable cost (AVC) is: Total Variable Cost/Output  Short run (SR) costs occur where at least some costs are fixed. The time frame for this will differ between firms and industries  Long run (LR) costs occur when all costs can be variable. The time frame for this will differ between firms and industries Economists often use the terms total fixed costs and fixed costs interchangeably. In the same way total variable cost and variable cost are often used as synonyms. It is important that you distinguish between variable costs in aggregate i.e. TVC and VC per unit.

C ALCULATING A F IRM ’ S C OSTS OutputTFCTVCTCAC TFC is £100. VC per unit is £10. Fill in the table.

C ALCULATING A F IRM ’ S C OSTS OutputTFCTVCTCAC TFC is £100. VC per unit is £10. Fill in the table.

S HORT R UN AND L ONG R UN A VERAGE C OST C URVES SRAC SRAC 1 SRAC 2 SRAC 3 SRAC 4 SRAC 5 SRAC 6 Costs Output Minimum efficient scale Q We can distinguish between short run and long run average cost curves. SRAC shows a firm that is operating with 5 machines. In twelve months time it decides to buy a 6 th machine, moving its SRAC to SRAC 1. Twelve months later it buys a 7 th machine moving to SRAC 2 and so on. The LRAC curve shows what happens as the firm increases the scale of production i.e. it buys more machines or capital. Each SRAC curve is below the previous one due to economies of scale. LRAC In the short run average cost curves are always U-shaped showing that average cost per unit will fall and then rise. In the long run the average cost curve is also U-shaped. However, this is due to economies of scale lowering average cost per unit at first; then, when diseconomies of scale outweigh economies of scale, average cost per unit will rise. Economies of scale outweigh diseconomies of scale Diseconomies of scale outweigh economies of scale Economies and diseconomies of scale occur at the same time. When economies of scale are greater AC per unit is falling. When diseconomies of scale are greater AC per unit is rising.

H OW C OSTS AFFECT D ECISION - MAKING BY F IRMS  Relevant costs are those costs that are used to make decisions on an investment. These will include the opportunity cost of the investment being made  Sunk costs should always be seen as irrelevant when making these decisions but, as can be seen in behavioural economics this is not always seen to be the case  Individuals face loss aversion often basing decisions on past costs rather than the latest information as they fear making losses more than the benefits achieved through acquiring gains  Firms will take into account a variety of costs  These will be used to see if a project is worthwhile or not

P RODUCTIVITY AND FACTOR PRICES AFFECT FIRMS ’ COSTS OF PRODUCTION AND THE CHOICE OF FACTOR INPUTS  Short run cost curves look at the impact of productivity on a firm. At first average costs per unit increase as we add more units of labour. Increasing the input of labour increases productivity leading to lower average costs per unit  Long run cost curves look at the impact of factor prices on a firm. As the firm increases the scale of production economies of scale lead to lower average costs per unit  At some point diseconomies of scale start to outweigh economies of scale and average costs per unit begin to rise LRAC Output Costs

T EST YOURSELF OutputTFCTVCTCAC TFC is £1200. VC per unit is £80. Fill in the table and plot the lines on a graph. Annotate your diagram to show your understanding of the shape of each curve.