The nature of costs

The costs of production faced by producers in the economy have a very important influence over the supply decisions they make. Along with consumer demand, costs are crucial in determining price and output in all markets. The theory of costs underpins the theory of supply covered in Unit 2.2. There are two ways of looking at costs, implicit costs and explicit costs.

Implicit costs

An implicit cost is the opportunity cost that exists in every business decision-making situation. For example, if Coca Cola open a new factory in Vietnam, they might have to give up a plan to open a new factory in the USA which was their highest value alternative. This is sometimes called an implicit cost of production because it is not stated in money terms but arises whenever a business chooses between alternatives.

Explicit costs

Explicit costs are business costs that firms incur in their operations.  These are known as explicit costs because they are a stated money value arising from the use of resources by firms. In Economics we can categorise explicit costs in terms of the factors of production:

• Land cost is rent
• Labour cost is wages
• Capital cost is interest
• Enterprise/entrepreneur cost is normal profits

Firms also incur costs such as energy, administration, marketing, etc, in their normal course of trading.

Time period

The short-run (production stage)

The short-run is the time period where at least one factor of production is fixed (normally capital) while other factors such as labour can be varied. Firms operate in the short run which is why it is called the production stage. For example, a coffee shop will find it relatively easy to vary the number of workers and raw materials (coffee, milk, water, etc) in the short run. The buildings used by the coffee shop along with the coffee making machines are more difficult to change in the short run and are categorised as fixed factors.

The long-run (planning stage)

The long-run is the time period where all factors of production are variable. Normally we would express this as a business being able to vary both labour and capital. Firms cannot operate in the long run which is why it is called the planning stage. In the long-run, a coffee shop business could increase the number of outlets it opens and employ more workers.

Costs in the short run

The theory of product

The theory of product is the quantitative way the output of a firm can be expressed in the short run.

There are three ways of measuring a firm’s product:

• Total product (TP): is the total output a firm can produce from a given quantity of labour and capital inputs
• Marginal product (MP): is the change in TP when one extra unit of labour is added (ΔTP/Δ labour input).
• Average product (AP): is the output per unit of labour input (TP/ labour input)

The table below sets out the product data for a shoe manufacturing business like Timberland. The data shows the number of pairs of shoes that can be produced in one hour by different numbers of workers working on two machines. The total product (TP), marginal product (MP) and average product (AP) of the firm that manufactures the shoes are set out in the table.

The law of diminishing returns

The law of diminishing return states that when a variable factor such as labour, is added to a given set of fixed factors, such as capital there is a point where the marginal product of the extra unit of variable factor added falls (diminishes).

In this shoe manufacturing example, the point of diminishing returns sets in when the fourth worker is added, marginal product and average products are both lower than is the case with 3 workers. This means that as output is increased the most efficient combination of labour and capital is passed when the fourth worker is employed in production. Diagram 2.56 sets out marginal and average product when more unit of labour is employed and how marginal and average product are affected by the law of diminishing returns.

Classifying costs

In the theory of cost, it is possible to classify the different types of costs that affect businesses. The table sets out how a firm’s explicit costs are categorised.

The effect of the law of diminishing returns on short-run cost

The law of diminishing returns only affects variable costs because these are the only costs that change with output.  When a firm starts producing the marginal product and average product increase at first which means that marginal cost and average variable cost fall initially, but once the law of diminishing returns sets in both marginal product and average product fall which makes average variable cost and marginal costs rise. Diagram 2.57 shows the link between the law of diminishing returns and marginal cost and average total cost.

In the shoe firm example set out in the table below, the variable cost is labour which can be hired at $10 per hour and the fixed cost is the machine which can be hired for $20 per hour.  The table sets out the link between the shoe firm’s unit costs and diminishing returns.

Short-run cost curve diagram

The short-run average total cost, average fixed cost, average variable cost and marginal cost curves are set out in diagram 2.58. The ATC, AVC and MC curves are U-shaped because of the law of diminishing returns.

Marginal costs and supply

The supply curve in a market is determined by the marginal cost curves of all the firms in the market. This is called horizontal summing, which means the market supply curve is derived by adding together all the marginal cost curves of the firms in the market. This means the upward slowing nature of the market supply curve is determined by the law of diminishing returns.

Evaluation of short-run cost theory

• The law of diminishing returns exists, but its importance to many firms is arguable. In large manufacturing organisations where labour is such a small proportion of the total cost, diminishing returns does not have an important effect on unit costs.
• Product theory assumes that all labour is equally productive, but this is not the case in reality.  A firm might see marginal product fall when a less motivated, unproductive worker is added to production but rise when a more motivated worker is employed.
• Costs such as maintenance are semi-variable and vary with output unpredictably. If a firm increases output machines will break down more often and incur maintenance costs, but it is difficult to predict how often this will happen.
• Economic theory looks at labour as a variable cost, but in some situations, labour is a fixed cost.  Once workers are hired and under contract, they have to be paid whatever the level of output.

Long-run costs

The long-run is the period where all factors of production are variable. This means it is possible to vary capital as well as labour. Our shoe manufacturing firm can expand by increasing its factory space as well as its workforce.

The long-run average total cost curve (LRATC)

Firms do not actually produce in the long run, but they can plan to produce at different scales of output. In diagram 2.58 a shoe manufacturing firm produces on SRATC1 and minimises unit costs cost at £25 for producing 20 pairs of shoes per hour.  It can increase output to 30 pairs, but ATC rises to £40 per pair.  Alternatively, the firm could purchase new machinery, move to SRATC2 and increase output to 50 pairs of shoes and see ATC fall to £15.

Returns to scale

Increasing returns to scale

Increasing returns to scale is where increasing the level of production (employing more labour and capital) in the long run leads to a fall in LRATC.  This means an increase in labour and capital input leads to a greater proportionate increase in output and LRATC falls. Increasing returns to scale occurs because of economies of scale.

Constant returns to scale

Constant returns to scale occur when an increase in labour and capital input leads to the same proportionate increase in output and the LRATC curve stays constant as output increases.

Decreasing returns to scale

Decreasing returns to scale occurs on the upward sloping portion of the LRATC curve. This means that an increase in labour and capital input leads to a smaller proportionate increase in output and LRATC rises. Over this range of output, the firm is experiencing diseconomies of scale.

Economies of scale

Economies are the cost advantages firms benefit from as they increase the scale of production.

 Types of economy of scale

• Commercial economies (or marketing economies) arise from the ability of large firms to buy and sell in bulk.  Walmart, for example, has huge buying power and can negotiate very low purchase prices from their suppliers.  They are also able to sell in bulk which reduces their unit cost of selling.
• Technical economies occur because large firms can use large scale machinery that reduces unit costs.  Walmart moves their goods in large HGV lorries which are lower cost per unit shipped than moving goods in small vans.
• Financial economies benefit large firms when they raise funds.  Banks are willing to offer firms like Walmart low rates of interest because they represent a lower risk than smaller retailers, and Walmart borrows larger amounts of money which reduce the cost per $ borrowed.
• Labour or managerial economies (specialisation economies) arise because workers in large firms can specialise in particular tasks.  Workers at Walmart will be put into departments like fruit and vegetables or the bakery, and this allows them to be more efficient than workers in small firms who have to divide their time between functions.

Diseconomies of scale

Diseconomies of scale are the cost disadvantages that result from the increase in the size of a firm and its scale of production.

Types of diseconomy of scale

• Communication diseconomies occur when firms become too big and it becomes more difficult for managers to communicate with workers as the number of employees, departments and offices increases. Walmart has outlets and offices all over the world which makes communication challenging for managers.
• Motivation diseconomies arise as large firms find it more difficult to manage workers in organisations that they find more difficult to identify with. A person who works for a small independent retailer may feel more motivated than someone who works for Walmart.
• Administrative diseconomies are more likely in large organisations where the level of bureaucracy increases which hinders the decision-making process. Imagine the administrative difficulties that Walmart might experience when it tries to change the goods it stocks.