Costs of production (HL only)
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.
Classifying different costs of production in the short run.
Lesson time: 45 minutes
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.
Short run costs of production (HL only)
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.
Average cost - the total cost of production divided by the number of units produced (Q). It can also be expressed as AVC + AFC.
Average fixed costs - calculated by total fixed costs / output or FC / Q. As output rises the AFC will fall as the fixed costs are divided by a larger and larger number of units.
Average variable costs - calculated by the total variable cost divided by output or VC / Q.
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: Short run costs
Watch the following short video before answering the questions that follow:
(a) Why are costs important for any business?
(b) What are the two types of costs?
(c) Total cost is calculated by adding which two variables together
(d) How do you calculate a firms marginal cost
(e) Why does the AFC fall as output rises?
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?
(b) Which are variable costs?
3. There is an increase in sales. Which costs will rise and which will not?
4. What time period represents the long run in this business?
Activity 3: Paper three type
Complete the following table by adding in the missing values:
Units produced (000s)
Total cost (TC) (000s)
Average cost (AC) (000s)
Marginal cost (MC) (000s)
Average fixed cost (AFC) (000s)
Average variable cost (AVC) (000s)
What is the level of fixed costs for this business
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:
Total cost (TC) $
Average cost (AC) $
Marginal cost (MC) $
Average fixed cost (AFC) $
Average variable cost (AVC) $
(b) Use the graph paper included to plot the MC and AC curves.