Costs of Production (Cambridge (CIE) IGCSE Economics): Revision Note

What are costs of production?

• In preparing goods and services for sale, firms incur a range of costs. These costs of production can be be broken into different categories:

Fixed costs (FC)

• These are costs that do not change as the level of output changes

• They have to be paid whether output is zero or 5000 

  • For example, building rent, management salaries, insurance and bank loan repayments

Variable costs (VC)

• These are costs that vary directly with output

• These increase as output increases and vice versa

  • For example, raw material costs and wages of workers directly involved in production

Total costs (TC)

• These are the sum of the fixed and the total variable costs 

Cost calculations

• Based on the above definitions, we can calculate several different types of costs

1. Total costs (TC)

2. Total variable costs (TVC)

3. Average total costs (ATC)

4. Average fixed costs (AFC)

5. Average variable costs (AVC)

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Drawing and interpreting cost diagrams

Fixed costs (FC)

• The firm has to pay its fixed costs which do not change, irrespective if the output is 0 or 100,000 units

• The fixed costs for this firm are $4,000

Variable costs (VC)

• The variable costs initially rise proportionally with output, as shown in the diagram

• At some point the firm will benefit from a purchasing economy of scale and the rise will no longer be proportional

Total cost (TC)

• The total cost is the sum of the variable and fixed costs

• The total costs cannot be 0, as all firms have some level of fixed costs

Average fixed cost (AFC)

• If the fixed costs of a firm are $1,000 and it produces 1 unit of output, then its AFC is $1,000 ($1,000/1)

• If the firm increases its output to 1000 units, then the AFC is $1 per unit ($1000/1,000)

• The more units a firm produces, the lower its AFC will be

• This is one reasons why large levels of output help to increase the profit per unit

Average total cost (ATC)

• As a firm grows, it is able to increases its scale of output generating efficiencies that lower its average total costs (AC) of production

• These efficiencies are called economies of scale 

• As a firm continues increasing its scale of output, it will reach a point where its average total costs (AC) start to increase

• The reasons for the increase in the average costs are called diseconomies of scale