Costs

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Business Costs - Different Measures

There are a number of different costs that firms can measure or have to pay to suppliers.

Fixed costs

Fixed costs do not change regardless of the level of production (or output). Fixed costs cannot be changed in the short run.
- E.g machinery.

Variable cost

Variable costs are generated in the act of producing. The more you produce, the greater the variable cost.
These can be changed in the short run.
- E.g the amount of material bought by Zara to make clothes.

Marginal cost

Marginal cost is the change in total cost divided by the change in output for each possible level of output.
These are usually rising.
Only variable costs affect marginal costs.

Average cost

Average cost measures cost per produced unit. Average cost is total cost over total output.
- Average total cost is the total cost divided by total output at each level of output.
- Average variable cost is variable cost divided by total output at each level of output.

Total cost

Total cost is the sum of the fixed and variable costs.

Lowest average cost

When marginal cost changes, it affects average cost.
- When marginal cost < average cost = average cost is decreasing.
- When marginal cost > average cost = average cost is increasing.
The lowest average cost is where average cost is equal to marginal cost.

The Shape of a Business' Cost Curves

Here are reasons for the shapes of the marginal, average and total cost curves:

Marginal cost curve

The marginal cost curve is U-shaped.
- Initially as output increases, marginal cost falls.
- But diminishing returns start to take place at a certain level, and so marginal cost will start to rise.

Average cost curve

The average cost curve is U-shaped.
- When the marginal cost is below the average cost, the average cost is falling.
- When marginal cost is above average cost, the average cost will rise.

Average total cost curve

This curve declines at first, as marginal cost is falling.
- This is because fixed costs stay the same, over an increasing level of output.
As marginal cost starts to rise, the average total cost curve will follow.

Diminishing Marginal Product

Diminishing marginal returns is the concept that the more of something you add, the lower the impact of each additional unit, assuming all else is fixed.

Diminishing marginal product

When firms choose to create goods or services they will select the most productive factors of production to use.
As they produce more goods, the firm will have to use less and less productive factors of production (because they have already used the best).

Farmer example

If you were a farmer, you would choose the most fertile field and effective workers available to you when you start producing.
If you want to produce any more you have to start using less fertile fields and less effective workers.
As a result, each extra field used and worker employed will be able to produce less than the ones before.

SRAC and LRAC

The LRAC is the 'envelope curve'. We usually draw the LRAC as smooth, but it is created by joining all the minimum points on lots of SRAC curves.
Each SRAC curve shapes is U-shaped. Assuming capital is fixed, diminishing marginal returns set in. When they become zero, the SRAC is at its lowest point. After that the marginal return is negative.