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Economists work out costs slightly differently from how an accountant would. Economists use the concept of opportunity cost to work out the costs of a firm. First we work out the cost of the factors of production used (these are the costs an accountant would use) and then we add the opportunity cost of using them.


The following are all examples of opportunity costs that could be added to the accounting cost to arrive at the economic cost:

        The owner could work for somebody else's company and earn 20,000. This 20,000 is the opportunity cost of the owner's labour.

        The shop that the hairdresser owns could be rented out for 500 per week. This 500 per week is the opportunity cost of using the shop.

        The owner draws 10,000 from the bank to refurbish the shop. The opportunity cost of this 10,000 is the interest that it would have received if it were left in the bank.


We can identify two types of cost, fixed and variable. Fixed costs don't vary with the level of production. As production rises or even falls to zero the fixed costs remain the same and have to be paid, e.g., rent on buildings and machinery, utility charges, staff with contracts and advertising campaigns that are underway.


Variable costs on the other hand vary directly with the level of output. As production increases so does the variable cost, e.g., raw materials and casual labour.


Total Fixed Costs (TFC) are drawn as a straight line, this indicates that they don't change whatever the level of output. Total Costs (TC) and Total Variable Costs (TVC) both rise parallel to each other. The distance between the TC and TVC is equal to the TFC, this must be so as TC=TFC+TVC.



Average cost curves (AC, AFC and AVC) are simply the relevant cost divided by the quantity of output (we will look at the shape of these curves in the next section).


The Marginal Cost (MC) is the extra cost of increasing output by one unit, e.g., if it costs 50 to produce 10 units and 55 to produce 11, the marginal cost of the 11th unit is 5 and it is plotted halfway between 10 and 11 units.


It is possible to represent these costs on a diagram by drawing total, average and marginal cost curves. It is important to note that the MC always intersects the AC at its minimum.




Remember from unit 1, we are able to distinguish between short run and long run average costs. 



Notes on the internet
Costs PowerPoint Model
Shortrun Costs PowerPoint Presentation
Longrun Costs PowerPoint Presentation
Fixed and Variable Costs
Fixed and variable costs
Average costs
Produced by Drexel University
Marginal cost
Produced by Drexel University
The marginal cost and the supply curve
Produced by Drexel University
Long run average costs
Costs Worksheet



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