Costs of Production In Economics

The costs of production are all expenses that a firm incurs in the process of transforming inputs into outputs, or in the process of creating and delivering products and services to the market. The major types of production costs include labor, raw materials, equipment, rent, and marketing costs. The sum of all expenses necessary to produce and sell goods and services is referred to as costs of production.

Short-run v long run production

In economics, short run production is when at least one factors of production such as labor, capital, or land is fixed and cannot be changed. The company can produce more output in the short run by adding more variable factors to the fixed factors of production. On the other hand, long run production occurs when all factors of production can be varied. In the long run, the company can benefit from economies of scale as the scale and capacity of production can increase.

For example, a company that is producing clothes has one factory, machines, labor, and cotton for the production of clothes. Cotton as raw materials can be added to increase production in the short run. The firm can also hire more workers to increase labor for more production. However, the firm cannot easily replace machines or build a new factory to increase production in the short run. In the short run, labor and raw materials are variable, while machines and infrastructure are fixed. It comes to a time when adding more labor or raw materials is inefficient because the firm does not have enough productive capacity. For instance, more and more labor can be added until a time when there is more labor than machines, and some workers stay idle because they lack machines to operate. In the long run, new machines and new factories can be added to accommodate more raw materials and labor.

Types of Production Costs

Costs of production can be classified into different types depending on the time range when the costs are incurred. This depends on short run or long run production. The major types of production costs are:

  • Fixed costs
  • Variable costs
  • Total costs
  • Average cost
  • Marginal cost

Fixed Costs: these are costs which do not change with changes in the output. For example: Land, equipment and infrastructure. A company incurs fixed costs regardless of whether production activity is carried out or not. For instance, the firm incurs land rates and rents regardless of whether he does business on the land or not.

Variable Costs: variable costs are costs that can change in respect to changes in production output. Variable costs relate directly to the production or sale of a product. For example, wages, raw materials, and energy costs are variable costs because they change when the production levels change. When there is limited demand for clothes, the firm buys less raw materials and hires fewer workers, hence incurring less labor costs and less raw materials.

Total Costs: Total costs are the aggregate costs derived from the summation of all variable and fixed costs involved in the producing a certain level of output.

Total Costs (TC) = Fixed Costs (FC) + Variable Costs (VC)

Average Costs: Average costs are unit costs of production, or costs incurred for the production of a single unit of product or service. It is calculated by dividing total costs by total output as shown below:

Average cost formula

Average variable cost (AVC) = Variable Cost (VC)/output (Q)

Average fixed cost (AFC) = Fixed cost (FC)/output (Q)

Average Cost (AC) = AVC + AFC

Marginal Costs: Marginal Costs (MC) refer to the changes in total costs as a result of changes in output.

Example:

AVC reaches the lowest point at a lower level of output Q1 compared with ATC. This is because ATC includes both AFC and AVC.

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