Types of Costs

 A list and definition of different types of economic costs.

Fixed Costs (FC) The costs which don’t vary with changing output. Fixed costs might include the cost of building a factory, insurance and legal bills. Even if your output changes or you don’t produce anything, your fixed costs stay the same. In the above example, fixed costs are always £1,000.

Variable Costs (VC) Costs which depend on the output produced. For example, if you produce more cars, you have to use more raw materials such as metal. This is a variable cost.

Semi-Variable Cost. Labour might be a semi-variable cost. If you produce more cars, you need to employ more workers; this is a variable cost. However, even if you didn’t produce any cars, you may still need some workers to look after an empty factory.

Total Costs (TC)  = Fixed + Variable Costs

Marginal Costs – Marginal cost is the cost of producing an extra unit. If the total cost of 3 units is 1550, and the total cost of 4 units is 1900. The marginal cost of the 4th unit is 350.

Definition of Marginal Cost

Marginal Cost is the cost of producing an extra unit.

It is the addition to Total Cost from selling one extra unit.

Q	Total Cost (TC)	Marginal Cost (MC)	Average Cost (AC)
1	10	10	10
2	16	6	8
3	23	7	7.6
4	32	9	8
5	45	13	9
6	66	21	11

• For example, the marginal cost of producing the fifth unit of output is 13.
• The total cost of producing five units is 45.
• But, for the marginal cost, we find, the change in total cost of producing the fifth unit.
  • Total cost of 4 units 32
  • Total cost of 5 units 45
  • Marginal cost of 5th unit = 13

Diagram Showing Marginal Cost

Note:  Marginal cost is often shaped like this in the short term because of the law of diminishing marginal returns.

Opportunity Cost – Opportunity cost is the next best alternative foregone. If you invest £1million in developing a cure for pancreatic cancer, the opportunity cost is that you can’t use that money to invest in developing a cure for skin cancer.

Economic Cost. Economic cost includes both the actual direct costs (accounting costs) plus the opportunity cost. For example, if you take time off work to a training scheme. You may lose a weeks pay of £350, plus also have to pay the direct cost of £200. Thus the total economic cost = £550.

Accounting Costs – this is the monetary outlay for producing a certain good. Accounting costs will include your variable and fixed costs you have to pay.

Sunk Costs. These are costs that have been incurred and cannot be recouped. If you left the industry, you could not reclaim sunk costs. For example, if you spend money on advertising to enter an industry, you can never claim these costs back. If you buy a machine, you might be able to sell if you leave the industry. See: Sunk cost fallacy

Avoidable Costs. Costs that can be avoided. If you stop producing cars, you don’t have to pay for extra raw materials and electricity. Sometimes known as an escapable cost.

Explicit costs – these are costs that a firm directly pays for and can be seen on the accounting sheet. Explicit costs can be variable or fixed, just a clear amount.

Implicit costs – these are opportunity costs, which do not necessarily appear on its balance sheet but affect the firm. For example, if a firm used its assets, like a printing press to print leaflets for a charity, it means that it loses out on revenue from producing commercial leaflets.

Absorbed costs

Absorbed costs involve including all the variable and fixed costs in producing a unit of output.

For example, in producing a motor car, the absorbed costs include the variable raw material costs and the associated fixed manufacturing costs, such as the factory, safety inspections and maintenance of machines.

Absorbed costs would not include general administration of a firm or expenditure on advertising.

Absorbed vs variable costs

Absorbed costs can be contrasted with the variable costs or the direct costs of producing a good. The direct costs are those specific to the good – labour, raw materials. However, this excludes those fixed costs which are part of the overall cost.

Which is better to use absorbed costs or variable costs?

For certain decisions, firms may prefer to use variable costs. Variable costs give a guide to operating profit – given that fixed costs have already been spent. For short-term decision making, a firm will look at marginal cost (which will be the extra variable costs associated with increasing output) and marginal revenue.

For external accounting and evaluation in the long-term, absorption costs are needed. They give a fuller picture of the long-term profitability of the firm and real costs associated with producing a good.

Evaluation of absorbed costs

• One issue with absorbed costs is deciding what will count as a fixed manufacturing overhead cost.
• The cost per unit will typically fall with increased output. Economies of scale will reduce the manufacturing average fixed costs.

Isoquant and isocosts

• An isoquant shows all combination of factors that produce a certain output
• An isocost show all combinations of factors that cost the same amount.
• Isocosts and isoquants can show the optimal combination of factors of production to produce the maximum output at minimum cost.

Definition isoquant

An isoquant shows all the combination of two factors that produce a given output

In this diagram, the isoquant shows all the combinations of labour and capital that can produce a total output (Total Physical Product TPP) of 4,000. In the above isoquant, this could be

• 20 capital and 18 labour or (more capital intensive)
• 9 capital and 35 labour. (more labour intensive

An isoquant is usually shaped convex to the origin because of the law of Marginal Rate of Technical Substitution (MRTS) which means there are diminishing returns from using more of one factor of production.

Marginal rate of factor substitution

The marginal rate of substitution is the amount of one factor (e.g. K) that can be replaced by one factor (e.g. L). If 2 units of capital could be replaced with one-factor labour, the MRS would be 2

Diminishing marginal rate of substitution

If the firm employs 2 L and 40 K. Then employing one extra worker can enable it to save 10K. This is quite an efficient saving. The firm only has to pay one extra worker but can save the cost of 40.

However, at a combination of 9 Labour, employing an extra worker enables a saving of only 2 capital. Therefore, the more that workers are employed, there is diminishing rate at which you can substitute the other factor. There comes a point, where employing more workers barely saves any capital at all. This is when diminishing returns of labour is very high – workers effectively get in each other’s way.

As one moves down the isoquant, output remains the same. Therefore the output gained from employing more labour must equal the output lost from employing more capital.

MPP (L) x ΔL = MPP (K) x ΔK

This equation gives us

Isoquant map

An isoquant map shows different levels of output. For example

• I1 may show the combinations of capital and labour that can produce 4,000 TPP.
• I2 may show the combinations of capital and labour that can produce 5,000 TPP.
• I5 is a higher output than I4

In the short-term, a firm faces a trade-off along one particular isoquant. But, in the long-term, a firm can invest in increasing capital stock and produce at a higher output for the same quantity of labour.

Isocost

An isocost shows all the combinations of factors that cost the same to employ.

In this example, a unit of labour and capital cost £6,666 each.

• If we employ 30K and 30L, the total cost will be £200,000 + £200,000
• If we employ 10 K and 50L, the total cost will be £66,666 +£333,333 = £400,000

Change in labour costs

• In this example, initially, the cost of labour and capital is both £5,000. (e.g. 60L = 60 x £5,000 = £300,000)
• However, if Labour cost rises to £10,000, then the isocost shifts to the left. Now, to keep cost at £300,000, a firm could only employ 30 workers (30 x £10,000)
• The slope of an isocost is, therefore, Pι / Pκ

Profit maximisation

To maximise profits, a firm will wish to produce at the point of the highest possible isoquant and minimum possible isocost

In this example, we have one isocost and three isoquants. With the isocost of £400,000 the maximum output a firm can manage would be a TPP of 4,000. If it produced at say 13 K and 48 Labour, it would only be able to produce a TPP of 3,500.

A total TPP of 4,500 is currently not possible without increasing costs beyond £400,000

Profit maximisation – the least cost method of production

Another way of seeking to maximise profits is to target an output of say 4,00 and then find the isocost with the lowest possible cost. In this case, the isocost which touches the tangential point of the TPP is a TC of £400,000.

Market Failure

• Social Costs. This is the total cost to society. It will include the private costs plus also the external cost (cost incurred by a third party). May also be referred to as ‘True costs’

Social Cost

Definition of social cost – Social cost is the total cost to society. It includes private costs plus any external costs.

Example of driving to work

• Costs of paying for petrol (personal cost)
• Costs of increased congestion (external cost)
• Pollution and worse air quality (external cost)
• The social cost includes all the above. (Petrol + congestion + pollution)

Example of social cost – smoking

If you smoke, the private cost is £6 for a packet of 20 cigarettes. But, there are also external costs to society

• Air pollution and risks of passive smoking
• Litter from discarded cigarette butts
• Health costs to society

The social costs of smoking include the total of all private and external costs.

Example of social cost of building airport

Private costs of airport

• Cost of constructing an airport.
• Cost of paying workers to run airport

External costs of airport

• Noise and air pollution to those living nearby.
• Risk of an accident to those living nearby.
• Loss of landscape.

Importance of social cost

Rational choice theory suggests individuals will only consider their private costs. For example, if deciding how to travel, we will consider the cost of petrol and time taken to drive. However, we won’t take into consideration the impact on the environment or congestion levels for other members in society.

Therefore, if social costs significantly vary from private costs then we may get a socially inefficient outcome in a free market.

Marginal social cost (MSC)

The marginal social cost is the cost to society of producing/consuming one extra unit of output.

Example of Marginal social cost

• PMC = Private marginal cost
• XMC = External marginal cost
• SMC = Social marginal cost

Diagram showing marginal social costs

For goods with negative externalities the social cost is greater than the private cost.

In a free market, if people ignore the external costs, the equilibrium will be at output 20. But, social efficiency (where social marginal cost = social marginal benefit) would be at output 16.

• External Costs. This is the cost imposed on a third party. For example, if you smoke, some people may suffer from passive smoking. That is the external cost.
• Private Costs. The costs you pay. e.g. the private cost of a packet of cigarettes is £6.10
• Social Marginal Cost. The total cost to society of producing one extra unit. Social Marginal Cost (SMC) = Private marginal cost (PMC) + External marginal Cost (XMC)

Diagram of Costs Curves

• Total Fixed Cost (TFC) – costs independent of output, e.g. paying for factory
• Marginal cost (MC) – the cost of producing an extra unit of output.
• Total variable cost (TVC) = cost involved in producing more units, which in this case is the cost of employing workers.
• Average Variable Cost AVC = Total variable cost / quantity produced
• Total cost TC = Total variable cost (VC) + total fixed cost (FC)
• Average Total Cost ATC = Total cost / quantity

Costs in the short run

Short run cost curves tend to be U shaped because of diminishing returns.

In the short run, capital is fixed. After a certain point, increasing extra workers leads to declining productivity. Therefore, as you employ more workers the marginal cost increases.

Diagram of Marginal Cost 

Because the short run marginal cost curve is sloped like this, mathematically the average cost curve will be U shaped. Initially, average costs fall. But, when marginal cost is above the average cost, then average cost starts to rise.

Marginal cost always passes through the lowest point of the average cost curve.

Average Cost Curves

• ATC (Average Total Cost) = Total Cost / quantity
• AVC (Average Variable Cost) = Variable cost / Quantity
• AFC (Average Fixed Cost) = Fixed cost / Quantity

Costs

• Fixed costs (FC)  remain constant. Therefore the more you produce, the lower the average fixed costs will be.
• To work out the marginal cost, you just see how much TC has increased by.
• For example, the third unit sees TC increase from 450 to 500, therefore, the increase in MC is 50.
• The 12th unit sees total cost rise from 1,700 to 2,400, so the marginal cost is 700

Average fixed costs

Fixed, variable and total cost curves

Total cost (TC) = Variable cost (VC) + fixed costs (FC)

Long Run Cost Curves

The long-run cost curves are u shaped for different reasons. It is due to economies of scale and diseconomies of scale. If a firm has high fixed costs, increasing output will lead to lower average costs.

However, after a certain output, a firm may experience diseconomies of scale. This occurs where increased output leads to higher average costs. For example, in a big firm, it is more difficult to communicate and coordinate workers.

Diagram for Economies and Diseconomies of Scale 

Note, however, not all firms will experience diseconomies of scale. It is possible the LRAC could just be downward sloping.

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