Costs

A firms uses a two step procedure to determine how to produce a certain amount of output efficiently. If first determines whether or not it is technologically efficient, i.e. producing the desired level with the least amount of inputs. Once this has been established it must then become economically efficient. This involves minimizing the cost of producing this level of output.

Economists include all relevant costs, both explicit and implicit. The economic or opportunity cost os the value of the best alternative use of a resource.

Determining the opportunity cost of capital requires special consideration. Capital is a durable good. Capital may be rented or purchased. Economists amortize the cost of capital on the basis of its opportunity cost at each moment of time, which is the amount that the firm could charge others to rent the capital. This usually falls over time. It may also change due to shifts of supply and demand. Economists ignore the historical price of capital, i.e. what was paid for it.

To make profit maximising decisions, a firm needs to know how its cost varies with output. Some outputs, such as capital, cannot be varied in the short run. As a result it is usally more costly for a firm to increase output in the short run than in the long run when all inputs can be varied.

To produce a given level of output, a firm incurs costs for both its fixed and variable inputs. Variable cost changes with the level of output. A firms marginal cost is the amount by which a firms cost changes if the firm produces one more unit of output.

Firms use three average cost measures. The average fixed cost is the fixed cost divided by the units of output produced. This falls as output rises because the fixed cost is spread over more units. The average variable cost is the variable cost divided by the units of output produced. This may increase or decrease with output. A firm uses average variable cost to decide whether to shut down operations when demand is low. The average cost is the total cost divided by the units of output produced. A firm uses the average cost to determine whether or not it is making a profit.

Taxes applied to a firm shift some or all of the marginal and average cost curves.  In the short run, the cost associated with inputs that cannot be adjusted is fixed while the cost that can be adjusted from inputs is variable. Given constant input prices, the shapes of the cost, variable cost marginal cost and average cost curves are determined by the production function. Where there are diminishing marginal returns to variable input the variable cost and cost curves become relatively steep as output increases, so the average, average variable cost and marginal cost curves rise with output. Both the average cost curve and the variable cost curve fall when marginal cost is below them and rise when it is above, so the marginal cost curve cuts both of these at their minimum points.

In the long run, a firm adjusts all its inputs so that its cost of production is as low as possible. Although firms may incur fixed costs in the long run these fixed costs are avoidable. This means that all inputs can be varied.  As a result the long run there are no long run fixed costs. To produce a given quantity of output at minimum cost a firm uses information about the production function and the price of labour and capital.

While a given level of output can be produced in many different technologically efficient ways, a firm will look to be economically efficient. To minimize cost, the firm adjusts inputs until the last euro spent on any input increases output by as much as the last euro spent on any other input. If the firm calculated the cost of producing every possible output level given current input prices, it knows its cost function. Cost is a function of the input prices and the output level. If the firms average cost falls as output expands, it has economies of scale. If the opposite happens, it has diseconomies of scale.

A firm can always do in the long run what it does in the short-run, so its long run cost can never be greater than its short run cost. Because some factors are fixed in the short run, the firm, to expand output, must greatly increase its use of other factors, a relatively costly choice. In the long run, the firm can adjust all factors, a process that keeps its cost down. Long-run cost may also be lower than short run cost if technological progress occurs.

If it is less expensive for a firm to produce two goods jointly rather than separately then there are economies of slope. If the opposite is true, then there are diseconomies of slope.