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ECO101
Selected Economic Glossary
SSC351--Improving Office Productivity Through TQM
SSC351--Work Measurement and Work Standards
SSC351--Promotion
SSC351--Managing Human Resources
SSC351--Communicating in the Office
SSC351--Administrative Office System
SSC351--Appraising The Office Worker's Performance
SSC351 Study Guide

 

Before firms can produce goods and services, they must first buy the necessary factors of production. And in the process of transforming these factors of production into goods and services, firms will further spend money. In the simplest of definition, we can say that all the amount of money spent in purchasing factors of production and then transforming them into goods or services is called production cost. Costs are usually viewed as short-run production costs and long-run production costs. Before proceeding to discuss short- and long-run costs, let us look at the various types of costs first. Please refer to the following table:

(1)

Quantity

q

(2)

Fixed cost

FC

($)

(3)

Variable cost

VC

($)

(4)

Total cost

TC

($)

0

55

0

55

1

55

30

85

2

55

55

110

3

55

75

130

4

55

105

160

5

55

155

210

6

55

225

280

Fixed, Variable, and Total Costs. The major elements of a firms costs are fixed costs (which do not vary at all when output changes) and variable costs (which increase as output increases). Total costs are equal to fixed plus variable costs:

TC=FC + VC

TOTAL COST: FIXED AND VARIABLE. In the above example, consider a firm that produces a quantity of output (denoted by q) using inputs of capital, labour, and materials. The firm buys these inputs in the factor markets. The above table shows the total cost (TC) for each different level of output q. Looking at columns (1) and (4), we see that TC goes up as q goes up. This makes sense because it takes more labour and other inputs to product more of a good: extra factors involve an extra money cost. It costs $110 in all to produce 2 units, $130 to produce 3 units, and so forth.

Fixed Cost. Column (2) and (3) break total cost into two components: total fixed cost (FC) and total variable cost (VC). What are a firms fixed costs? Sometimes called "overhead" or "sunk costs," they consist of items such as rent for factory or office space, contractual payments for equipment, interest payments on debts, salaries of tenured faculty, and so forth. These must be paid even if the firm produces no input, and they will not change if output changes. Because FC is the amount that must be paid regardless of level of output, it remains constant at $55 in column (2).

Variable Cost. Column (3) shows variable cost (VC). Variable costs are those which vary as output changes. Examples include materials required to produce output (such as steel to produce cars), production workers to staff the assembly lines, power to operate factories, and so on. In a supermarket, checkout clerks are a variable cost, since managers can easily adjust their hours worked to match the number of shoppers coming through the store. By definition, VC begins at zero when q is zero. It is the part of TC that grows with output; indeed, the jump in TC between any two outputs is the same as the jump in VC. Why? Because FC stays constant at $55 throughout and cancels out in the comparison of costs between different output levels.

Let us summarize these cost concepts:

  • Total cost represents the lowest total dollar expense needed to produce each level of output q. TC rises as q rises.
  • Fixed cost represents the total dollar expense that is paid out even when no output is produced; fixed cost is unaffected by any variation in the quantity of output.
  • Variable cost represents expenses that vary with the level of output including raw materials, wages, and fuel and includes all costs that are not fixed.

Always, by definition, TC = FC + VC

Short-run Short-run is the period of time long enough to adjust variable inputs, such as materials and production labour, but too short to allow all inputs to be changed. In the short run, fixed or overhead factors such as plant and equipment cannot be fully modified or adjusted. Therefore in the short run, typically labour and materials costs are variable costs, while capital costs are fixed. Short-run production costs are the costs incurred by firms in the short-run.

Long-run The period of time where all inputs can be adjusted including labour, materials, and capital; hence, in the long run all costs are variable and none are fixed. Long-run production costs are the costs incurred by firms in the long run.