Chapter+13+THE+COSTS+OF+PRODUCTION+Linds

**Significance** The burden sustained in order to perform a certain activity, to carry out a certain production, to achieve certain goals.In a balance sheet, costs raise commercial liabilities to be settled. They should not be confused with money outflows. By contrast, in economics, most formal models ignore this distinction between costs and payments. **Actual costs** refer to real transactions, whereas **opportunity costs** refer to the alternative taken into consideration by decision makers who might want to choose the line of activity which minimize the costs. From an external point of view, it is difficult to ascertain which are the alternative considered.

**Fixed costs** are simply not responsive to production levels. If there are only fixed costs, the total costs follow this rule:  For instance, the cost of renting an office is a fixed cost, since usually the contract fixes it for a certain period of time (say one year), without any reference to the income produced by the operations that take place in the same office. The firm deciding to rent this office, however, will have usually expected to be able to afford it as well as to be reasonably sure that it will not be too small for the kind of operation it intends to carry out. This brings us to an important conclusion: a very common situation is that of **quasi-fixed costs**. They are flat in a certain range of (expected) production but they are forced to jump to higher levels if certain thresholds are overcome. Near these thresholds, in fact, quality deterioration of output and other negative phenomena take place. Symmetrically, below other minimum thresholds in level of activities, the same costs become unaffordable and will probably be reduced. Here you have the graph of total costs when there are only quasi-fixed costs:  **Variable costs** grow with higher levels of production (proportionally or not). If there are only variable costs, at zero production the total costs will be zero. Total costs will follow for instance this rule:  In particular, **economies of scale** describe situation when the total costs rise less than proportionally to production increases, as you see in the following diagram:   **Constant return to scale** are the intermediate situation in which the growth in production is exactly matched by the same percentage increase in total costs, i.e.elasticity of costs to production levels is 1. <span style="font-family: Verdana,Arial,Helvetica,sans-serif;">In this case, productivity is constant.
 * Dis-economies of scale** represent the opposite situation:

<span style="font-family: Verdana,Arial,Helvetica,sans-serif;"> media type="youtube" key="8I6BIuCGuaE" height="344" width="425"

<span style="font-family: Verdana,Arial,Helvetica,sans-serif;">To understand the sources of economies of scale is helpful to consider that **total costs** for production inputs depends on two components: the **quantity** and the **price of the inputs**. <span style="font-family: Verdana,Arial,Helvetica,sans-serif;">Accordingly, it is often useful to distinguish two broad reasons for cost to rise: an increase of the input quantity or a soaring price for input. This allow for distinguishing different reasons for costs behaviours in reaction to changes in production levels.

<span style="font-family: Verdana,Arial,Helvetica,sans-serif;">**Total and average costs** <span style="font-family: Verdana,Arial,Helvetica,sans-serif;">**Total costs** are the sum of all costs. By dividing the total costs by the quantity produces, one gets the **average costs**: how much a unit of production costs ("unit cost"). <span style="font-family: Verdana,Arial,Helvetica,sans-serif;">Average costs can be directly compared with price to compute profitability: if the price is higher than average cost, the production is profitable. <span style="font-family: Verdana,Arial,Helvetica,sans-serif;">**Total profits** will be given by multiplying the average profit with the quantity produced and sold. <span style="font-family: Verdana,Arial,Helvetica,sans-serif;">Identically, total profits can be obtain as total revenues less total costs. <span style="font-family: Verdana,Arial,Helvetica,sans-serif;">The relationship between total revenue and total costs depending on the production level is analysed by the so-called "break-even analysis". <span style="font-family: Verdana,Arial,Helvetica,sans-serif;">Let's see mathematically what component crucially influences average costs at two widely different levels of production. <span style="font-family: Verdana,Arial,Helvetica,sans-serif;"> <span style="font-family: Verdana,Arial,Helvetica,sans-serif;">In the simplified situation of a production process characterised by a **fixed cost (F)** plus **a proportionally-growing variable cost (VC)**, **total costs (TC)** are described by the easy formulas below: <span style="font-family: Verdana,Arial,Helvetica,sans-serif;"> TC = F + VC×q <span style="font-family: Verdana,Arial,Helvetica,sans-serif;">where q is the quantity of good. <span style="font-family: Verdana,Arial,Helvetica,sans-serif;">**Average costs (AC)** are thus the following: <span style="font-family: Verdana,Arial,Helvetica,sans-serif;"> AC= TC/q = F/q + VC <span style="font-family: Verdana,Arial,Helvetica,sans-serif;">The first term of the right side (F/q) decreases systematically the higher the production level (q). At low production levels, this reduction is quantitatively relevant wherease for a high q it is not. <span style="font-family: Verdana,Arial,Helvetica,sans-serif;">In fact, for high q, the average cost is practically equal to variable cost VC. <span style="font-family: Verdana,Arial,Helvetica,sans-serif;">**Marginal costs** <span style="font-family: Verdana,Arial,Helvetica,sans-serif;">**Marginal costs** indicate by how much the **total costs** changes because of modification in the production level **by one unit**. <span style="font-family: Verdana,Arial,Helvetica,sans-serif;">When there are only fixed costs, marginal cost will be zero: any increase of production does not change costs. <span style="font-family: Verdana,Arial,Helvetica,sans-serif;">If there are only proportionally-growing variable costs, marginal costs will be equal to variable costs.

<span style="font-family: Verdana,Arial,Helvetica,sans-serif;">**Sunk costs** are investment costs incurred before a certain activity takes place which **cannot be recovered by the possible sale of the asset they produced**. <span style="font-family: Verdana,Arial,Helvetica,sans-serif;">Highly specific investment (e.g. R&D) are usually sunk costs. <span style="font-family: Verdana,Arial,Helvetica,sans-serif;">Sunk costs represent barriers to exit. A firm which has incurred in high sunk costs will have difficulties in deciding to exit the market even if it sees good opportunities outside. <span style="font-family: Verdana,Arial,Helvetica,sans-serif;">Conversely, a firm that is deciding whether to enter into a certain business will have to consider with a particular attention the sunk costs and the risk that during the operations period they might not be recovered. Sunk costs, in this perspective, represent barriers to entry.

<span style="font-family: Verdana,Arial,Helvetica,sans-serif;">Question for Review:

<span style="font-family: Verdana,Arial,Helvetica,sans-serif;">1. Why does a market shut down in the short run? and why does it exit in the long run? Explain with graph.

2. Can sunk costs be recovered?