Costs of production (HL only)

Introduction

This page begins the section of the course on revenues and costs of a business.  I find that I am very often surprised by the confusion that the word cost means to many IB economics students, with so many confusing the term with revenue.  This is probably because as consumers many think of the cost of something as being the cost that consumers pay and businesses receive.  When from a business perspective costs include monies paid out while revenue includes the money coming into business.

The difference between the short and long run can also cause some difficulty among IB students, with many presuming that the difference lies in a set period of time − typically 12 months. 

Enquiry question

Classifying different costs of production in the short run.

Teacher notes

Lesson time: 45 minutes

Lesson objectives:

Explain the distinction between the short run and the long run, with reference to fixed factors and variable factors.

Distinguish between total costs, marginal costs and average costs.

Draw diagrams illustrating the relationship between marginal costs and average costs and explain the connection with production in the short run.

Calculate total fixed costs, total variable costs, total costs, average fixed costs, average variable costs, average total costs and marginal costs from a set of data and/or diagrams.

Teacher notes:

1. Beginning activity - begin with the opening question and allow 5 minutes for discussion

2. Processes - technical Vocabulary - the students can learn the key concepts through the short class handout and the activities provided. (30 minutes)

3. Final reflective activity - Having plotted the graph, reflect on the final two questions. (10 minutes)

Beginning question

In economics what is the difference between the short run and the long run?

Surprisingly the answer is not a set period of time, 6 months, 12 months e.t.c.  In economics the short run can be defined as a period when one or more of the factors of production are fixed, where as the long run can be defined as a period of time when all the factors of production are variable.

Short run costs of production (HL only)

Key definitions:

Total cost (TC) - represents the total costs of production incurred by a firm. This is equal to fixed plus variable costs.  In economics this includes all implicit costs as well as the explicit ones.

Fixed costs (FC) - costs within a business which do not change when output changes. Often these are one off start up costs such as a factory lease or machinery plus administrative costs.

Variable costs (VC) - the opposite of FCs and change directly with output.  Examples include direct labour costs as well as supplies and raw materials.  Variable costs include the power / electricity that directly powers the production machinery. It does not include the electricity costs associated with heating and lighting the office or factory areas as these are semi variable costs.

Semi-variable costs - the most difficult cost to classify as they are costs which do not fit easily into either fixed or variable cost categories.  Examples of this include electricity and lighting as already discussed plus costs such as marketing, cleaning and maintenance services.  As a firm increases their output they are likely to incur greater maintenance and cleaning costs but the relationship is less direct, than for example raw material supplies.

Marginal cost - the additional cost incurred when the firm produces one more unit or output.

Short run - a period of time when at least one cost is fixed.

Long run - a period of time when all costs are variable.

Available as a PDF file at:  Costs of production

Activity 1

Watch the following short video before answering the questions that follow:

(a) Why are costs important for any business?

It is important to control or at least understand costs so that a business can calculate profit and calculate how many units to produce e.t.c.

(b) What are the two types of costs?

Fixed and variable

(c) Total cost is calculated by adding which two variables together

FC + VC

(d) How do you calculate a firms marginal cost

The change in costs when you add one more unit of a variable cost i.e. change in cost / change in output

(e) Why does the AFC fall as output rises?

Because TFC does not change so as output rises TFC gets divided by a larger and larger number of units

Activity 2

A small firm sets up a plant making soft pandas. They have one production unit, with a two year lease on the premises; two soft panda making machines and two machine operators.  There is a manager / owner who completes all non operative work and the machines have a life span of 12 months, after which they will have to be replaced.  They also have to purchase the raw material to make the bears and spend a little also on marketing and other administrative costs.

(a) Which of the above costs are fixed?

The fixed costs (FC) are the two teddy bear making machines, rent on the production unit, marketing and other administrative expenses and the managers / owners salary.  These costs will not be directly effected by changes in output.

(b) Which are variable costs?

Variable costs include the raw materials and the wages of the two operators.  As the firm produces more and more pandas they would need to purchase more supplies and may also need to hire another operative.

3. There is an increase in sales. Which costs will rise and which will not?

Following a rise in sales the VC will rise but the FC will not.

4. What time period represents the long run in this business?

2 years, the length of the lease.

Activity 3: Paper three type

Complete the following table by adding in the missing values:

Units produced (000s)

Total cost (TC) (000s)

Marginal cost (MC) (000s)

Average fixed cost (AFC) (000s)

Average variable cost (AVC) (000s)

0

100

--

10

1

110

100

10

8

2

118

50

9

6

3

124

33.33

8

4

4

128

25

7

6

5

134

20

6.8

8

6

142

16.67

7

10

7

152

14.28

7.42

12

8

164

12.5

8

What is the level of fixed costs for this business

$ 100,000

Note that in Paper 3 HL, students may be asked to calculate the above figures from the information provided.

Activity 4: Paper three type

(a) Complete the following table by adding in the missing values:

Units produced

Total cost (TC) $

Marginal cost (MC) $

Average fixed cost (AFC) $

Average variable cost (AVC) $

0

10

--

4

5

30

2

4

2

10

40

1

3

4

15

60

0.66

3.33

6

20

90

0.5

4

8

25

130

0.4

4.8

10

30

180

0.33

5.67

12

35

240

0.29

6.57

14

40

310

0.25

7.5

Activity 5: classifying costs

An IB school has the following costs, decide whether each is a fixed cost for the school, a variable cost or semi-variable?

Fixed costsVariableSemi-variable
Salaried teaching staff

Security and maintenance staff

Heating / lighting for classrooms

Desks for classroom

Desks for offices

√ (though perhaps semi variable)

Marketing budget

Textbooks / science equipment

School gardener

Support staff (e.g. special needs)

Food for the canteen

Electricity / heating for corridors and communal spaces

Exam fees (to the IB)

IB accreditation certificate

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