Production Costs: Types and Structure

The production function shows technical possibilities. But the firm makes decisions based on costs—the monetary expression of the resources used. Understanding the structure of costs is critical for analyzing firm behavior.

Economic vs Accounting Costs

Accounting costs:

Explicit payments for resources
Wages, rent, materials, interest
Reflected in financial statements

Economic costs:

Accounting costs plus implicit (opportunity) costs
Opportunity cost of all resources used
Include: foregone income from own capital, the owner's time

Example: An entrepreneur invests $100,000 of his own funds and works in his own business. Accounting profit is $40,000. But:

At a salaried job he could earn $60,000
$100,000 in a bank would bring $5,000 in interest

Economic profit = $40,000 − $60,000 − $5,000 = −$25,000

The business is profitable in accounting terms, but unprofitable economically.

Fixed and Variable Costs

Fixed costs (FC — Fixed Costs):

Do not depend on the volume of production in the short run
Rent, insurance, depreciation, managers' salaries
Exist even with zero output

Variable costs (VC — Variable Costs):

Depend on the volume of production
Raw materials, electricity, piece-rate labor
With zero output equal zero

Total costs (TC — Total Costs):

$ TC = FC + VC $

Note: the division into FC and VC is a feature of the short run. In the long run, all costs are variable.

Average Costs

Average fixed costs (AFC):

$ AFC = FC / Q $

Decrease as Q increases—fixed costs are "spread" over a higher output.

Average variable costs (AVC):

$ AVC = VC / Q $

Usually fall at first (specialization), then rise (diminishing returns).

Average total costs (ATC or AC):

$ ATC = TC / Q = AFC + AVC $

U-shaped curve: first falls (AFC and AVC decrease), then rises (AVC rises faster than AFC falls).

Marginal Costs

Marginal costs (MC — Marginal Cost):

$ MC = \Delta TC / \Delta Q = dTC / dQ $

The cost of producing one more unit. Since FC do not change:

$ MC = \Delta VC / \Delta Q $

Connection between MC and MP:

$ MC = w / MPL $

(where $w$ is wage)

When MPL falls (diminishing returns) → MC rises.

Shape of the MC curve:

At first may fall (specialization, increasing returns)
Then rises (diminishing returns)
MC intersects AVC and ATC at their minimums

Relationship of MC and AVC/ATC curves:

If $MC < AVC$ → AVC falls
If $MC > AVC$ → AVC rises
$MC = AVC$ at the minimum of AVC

Similarly for ATC.

Intuition: if the cost of an additional unit is less than the average, the average falls. If more—the average rises.

Long-Run Costs

In the long run, all factors are variable. The firm chooses the optimal size—the optimal combination of $K$ and $L$ for each level of $Q$.

Long-run average costs (LRAC):

Envelope of the short-run ATC curves
For each $Q$, the minimally possible AC with the optimal plant size

Shape of LRAC is determined by returns to scale:

Economies of scale (LRAC falls)
Constant returns to scale (LRAC is horizontal)
Diseconomies of scale (LRAC rises)

Economies and Diseconomies of Scale

Economies of Scale:

Specialization and division of labor
More efficient equipment with larger volumes
Distribution of fixed costs (R&D, marketing)
Bulk discounts from suppliers

Diseconomies of Scale:

Coordination problems—management complexity
Bureaucratization
Decreased employee motivation
Communication failures

Minimum Efficient Scale (MES): the minimum output at which all economies of scale are achieved. Important for industry structure—determines how many firms can exist.

For the Investor

Cost structure:

High FC → operational leverage → earnings volatility
High VC → flexibility, but limited margin potential as output increases

Economies of scale:

Strong → advantage for large players, industry consolidation
Weak → possibility for niche players

MES:

High relative to the market → natural oligopoly or monopoly
Low → competitive market with many players