COMPONENTS OF ECONOMIC OR PRODUCTION COST | FIXED, VARIABLE AND TOTAL COSTS

Economic costs include all costs associated with the alternative chosen as well as the forgone opportunity.

It represents the sum of all accounting and opportunity costs associated with an economic decision. 

An example of economic costs would be the cost of attending university. 

The accounting cost would include all charges such as tuition, books, housing fees, and other expense. 

The opportunity cost will include the salaries or wages the student could have received if he was employed during his university years instead.

Therefore, the economic cost will be the accounting and opportunity costs of attending the university

 Accounting profit vs economic profit

There are many components of economic costs that a firm considers before making economic decisions. 

These components include total cost, variable cost, fixed cost, average total cost, average variable cost, average fixed cost, and marginal cost.

Let's take a closer look at each one of them.

Total Fixed cost(TFC)

Fixed cost is the cost of employing a fixed factor. It is independent of the level of production. 

It does not vary with production. Fixed costs last for some time, therefore, it is said to be time-related. An example of a fixed cost is the rent of a factory. 

Fixed costs do not affect marginal cost and the profit-maximizing quantity because they are fixed.

At zero output, all the costs are always fixed. Fixed costs exist only in the short run. 

Graphically, the fixed cost curve is depicted as a horizontal straight line on the cost curves.

A fixed cost may be a sunk cost. A sunk cost is a cost that has been incurred so that it cannot be recovered. 

Sunk costs are irrecoverable and irretrievable. They are forever lost after they are paid.

An example of sunk cost is advertising costs. After paying for it, firms cannot recover the advertising fee even if it is ineffective. 

Generally, firms do not consider sunk cost in future economic analysis because it is irrecoverable.

Total Variable Cost(TVC)

Variable cost is the cost of employing a variable factor. It is directly related to the quantity produced. 

They do increase with quantity, and therefore, are said to be volume-related

Variable costs affect marginal cost and the profit-maximizing quantity because they vary with output.

Labour and raw materials are examples of variable costs.

Variable costs vary with output, hence, there will be no variable costs at zero output (because the firm is not producing)

Total cost(TC)

This is the total economic cost of production. It is the summation of the cost of each factor of production expressed as part of a variable cost or fixed cost. 

At zero output, the total cost is equal to the amount of fixed cost because there is no variable cost at this output.

Because total cost is the sum of fixed cost and variable cost, the total variable cost curve will always lie below the total cost curve. 

Also, because the total cost is the sum of fixed and variable costs, the distance between the total cost curve and the variable cost curve will be the amount of the fixed cost. 

The relationship between the quantity of output produced and the costs of producing them can be represented on a table, or what economists called a cost schedule. 

Looking at the accompanying cost schedule, you will observe that: at zero output, the firm is still incurring a cost of €20.

This cost represents a fixed cost that is always present even if the firm is not producing.

Also, you will observe that the total cost is the sum of the fixed cost and variable cost.

Quantity

Fixed Costs Variable costsTotal costs
020020
1201030
2201434
3201939
4202545
5203252

We can represent this information on a graph or cost curves.


Variable, fixed and total cost curves

Looking at the graph above, you would observe the fixed cost is a horizontal straight line.

This signifies the constant nature of fixed costs. 

As you will observe, the distance between the total cost and variable cost is the same for every output. 

Why?

The fixed cost does not vary with output. 

Marginal cost

This is the additional cost associated with a unit increase in production.

It is the change in the total cost when the quantity produced changes by one unit.

Marginal cost is the slope of total cost and variable cost because it shows the change in total cost, which is exactly what the slope signifies.

Mathematically, marginal cost is expressed as:

$$\text{Marginal cost}=\frac{\text{change in total cost}}{\text{change in output}}$$

For example, if a firm could produce 49 books for $\$376$ or produce 50 books for $\$390.$

Then, Marginal cost=$\frac{\$390-\$376}{50-49}$
                        =$\frac{\$14}{1}=\$14$

Cost functions can also be used to calculate marginal costs. 

This is something you will learn about here.

The marginal cost curve is typically U-shaped. The marginal cost starts relatively high, then declines, and then reaches a minimum point.

Thereafter, rises as production increases. This reflects the law of diminishing returns.

To economists, marginal cost is a very important concept because profit-maximizing firms will only produce at the point where marginal cost equals marginal revenue. 

Marginal cost is also important for solving third-degree price discrimination.

Needless to say, the supply curve of a perfectly competitive firm is the portion of the Marginal cost curve above the shutdown point

Average fixed cost(AFC)

This is the fixed cost per unit of all units produced. It is fixed costs divided by the quantity of output.

$$\text{Average fixed cost}=\frac{\text{fixed cost}}{\text{Quantity}}$$

The average fixed cost decrease throughout the production period and is, therefore. downward sloping.  

A falling average fixed cost curve indicates that a constant fixed cost is being spread over an increasing number of outputs. 

As a higher quantity is produced, the average fixed cost becomes relatively insignificant to the average total cost calculation so that the average variable cost curve sneaks closer to the average total cost curve

Average variable cost(AVC)

This is variable cost divided by the quantity of output produced. It is the variable cost per unit produced.

Mathematically, it is expressed as
$$\text{Average variable cost}=\frac{\text{variable cost}}{\text{Quantity}}$$
       
Let's test our knowledge on this:

Find the AVC of producing 80 books if the variable cost of producing those books is  $\$480$.

AVC=$\frac{\$480}{80}=\$6$

The average total cost is the summation of average fixed cost and average variable costhence, the average variable cost curve will always lie below the average total cost curve at any given output.  

Average Total Cost (ATC) or Average cost

This is the cost per unit of all units produced. It is the total cost divided by the quantity produced. 

Mathematically, average total cost is represented as follows:

$$\text{Average Total Cost}=\frac{\text{Total cost}}{\text{Quantity}}$$.

For example, if the total cost of producing 100 cars is $\$400000$. Then, 

ATC=$\frac{\$400000}{100}$
       $=\$4000$

The average total cost can also be obtained by adding the average fixed cost and average variable cost.

Wondering if this is true? Ok, look at this!!!

ATC=$\frac{\text{total cost}}{\text{Quantity}}$

Recalled that,
Total cost(Tc)=fixed cost(FC) + variable cost(VC)

So, ATC=$\frac{FC+VC}{Q}$

This translate to
ATC=$\frac{FC}{Q}+\frac{VC}{Q}$

AFC=$\frac{FC}{Q}$, AVC=$\frac{VC}{Q}$

Hence,

ATC=AFC+AVC

The average total cost curve is generally u-shaped. The u-shaped average total cost can be attributed to the relationship between the average fixed cost and the average variable cost. 

As the firm’s output rises, the average fixed cost will decline because the total fixed cost( which does not increase with output) is being spread over the rising quantity of units. 

At the same time, the average variable cost will be increasing because of diminishing returns to the variable factor. 

The rising variable cost will eventually surpass the effect of declining average fixed cost, prompting the average total cost to rise.

It is important to note that the minimum point on the average cost curve describes the quantity that has the least cost. Most firms will love to produce at the quantity with the least cost. 

However, they can not do so because the cost-minimizing level is not always the profit-maximizing point. 

What is the difference between the cost-minimizing output and the profit-maximizing output?

The cost-minimizing point indicates the profit-per-unit maximizing point, whereas, the profit-maximizing shows the total profit-maximizing point.

So far, we have discussed average fixed, average variable and total cost, it will be nice if we can visualize this on the graph.

Marginal, average variable, average fixed cost and average total cost curves

From the graph above, we can pinpoint two things:

1. The marginal curve intersects the average cost at the latter's lowest point.

2. The marginal and average variable cost curves intersect at the latter's lowest point.

Economists call this the shutdown point.

The shutdown point is the point where the marginal cost curve and the average variable cost curve intersect.  

No firm (or, should I say profit-maximizing firm) will produce below the shutdown because the price charged is not even covering the variable costs.

It should be noted that shutdown only exist in the short run.

Related post.

Relationship Between Average Total Cost And Marginal Cost

The relationship between average total cost is such that:

1. When the average total cost decreases, the marginal cost is lesser than the average total cost. 

2. When the average total cost increases, the marginal cost is greater than the average total cost. 

3. When the average total cost stays the same, the marginal cost equals the average total cost. 

For example, the average total cost of producing 7 pens is €10. it was decided to produce the 8th pen which has a marginal cost of €11. 

You can see that the MC>ATC, therefore, the ATC will increase. 

Now, suppose the Marginal cost of the 8th pen is €7. in this case, the MC<ATC, so, you can categorically say that the ATC will decrease. 

Again, Let's assume that the marginal cost of the 8th pen is €10. you will be right to say the ATC will remain the same.

That is all there is to it. You can check out the next post for some practical examples that will help you deepen your understanding of the components of economic cost.

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