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Business Costs

Students should be able to:
Illustrate and perform simple calculations using total cost; total fixed cost; total variable cost; average total cost; average fixed cost; average variable cost and marginal cost.
Draw and interpret cost curves; distinguish between short run and long run costs; and explain the shape of the average cost curve in terms of diminishing marginal returns and economies of scale.

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Business Costs

  1. 1. How can we calculate the costs of a firm? Topic 3.3.4
  2. 2. How can we calculate the costs of a firm? Topic 3.3.4 Students should be able to: • Illustrate and perform simple calculations using total cost; total fixed cost; total variable cost; average total cost; average fixed cost; average variable cost and marginal cost. • Draw and interpret cost curves; distinguish between short run and long run costs; and explain the shape of the average cost curve in terms of diminishing marginal returns and economies of scale.
  3. 3. Key Concepts – Short Run Costs Average Cost Total cost per unit of output = Total cost / output = TC/Q Average Fixed Cost Total fixed cost per unit of output = TFC/Q Average Variable Cost Total variable cost per unit of output = TVC/Q Diminishing Returns Addition of a variable factor to a fixed factor results in a fall in marginal product Fixed Cost Business expense that does not vary directly with the level of output Marginal cost The change in total costs from increasing output by one extra unit
  4. 4. Google and Apple’s RevenueReminder of the Factors of Production Factors of production are the inputs available to supply goods and services in markets and industries. Land Labour Enterprise Capital Natural resources available for production The human input into the production process Goods used in the supply of other products e.g. tech Entrepreneurs organise factors of production and take risks
  5. 5. Short Run • At least one of the factor inputs is fixed (usually this is capital but can also be land) Long Run • All factors of production are variable and the scale of production can also change The Short Run and the Long Run The length of the short run will vary by industry
  6. 6. Consulting fees Rental Costs Marketing Budgets Research Projects Google and Apple’s RevenueFixed Costs
  7. 7. Fixed costs do not change as output varies in the short run Fixed cost has to be paid, whatever the level of sales achieved The higher the level of fixed costs in a business, the higher must be the achieved output in order to break-even Google and Apple’s RevenueFixed Costs
  8. 8. Commission Bonuses Wage Costs Component parts Basic raw materials Google and Apple’s RevenueVariable Costs
  9. 9. Costs that relate directly to the production or sale of a product Increase in short run output (Q) will cause total variable cost to rise (TVC) Average variable cost = total variable cost / output (TVC?Q) Variable cost is determined by marginal cost of extra units Google and Apple’s RevenueVariable Costs
  10. 10. Output Total Fixed Cost (£) Total Variable Cost (£) Total Cost (£) 0 2000 0 2000 50 2000 500 2500 100 2000 700 2700 150 2000 850 2850 200 2000 1000 3000 250 2000 1250 3250 300 2000 1900 3900 350 2000 2550 4550 400 2000 3600 5600 Google and Apple’s RevenueCalculating Total Cost Total cost = total fixed cost + total variable cost
  11. 11. Output Total Fixed Cost (£) Total Variable Cost (£) Total Cost (£) Average Total Cost (£) 0 2000 0 2000 50 2000 500 2500 50 100 2000 700 2700 27 150 2000 850 2850 19 200 2000 1000 3000 15 250 2000 1250 3250 13 300 2000 1900 3900 13 350 2000 2550 4550 13 400 2000 3600 5600 14 Look at what is happening to average cost Google and Apple’s RevenueCalculating Average Total Cost Average cost = total cost / output
  12. 12. Output Total Cost (£) Average Total Cost (£) Marginal Cost (£) 0 2000 50 2500 50 10 100 2700 27 7 150 2850 19 3 200 3000 15 3 250 3250 13 5 300 3900 13 13 350 4550 13 13 400 5600 14 21 Google and Apple’s RevenueCalculating Marginal Cost Marginal cost is the change in total cost from producing one extra unit of output
  13. 13. Output Total Cost (£) Average Total Cost (£) Marginal Cost (£) 0 2000 50 2500 50 10 100 2700 27 7 150 2850 19 3 200 3000 15 3 250 3250 13 5 300 3900 13 13 350 4550 13 13 400 5600 14 21 MC < AC; AC falling MC < AC; AC falling MC < AC; AC falling MC < AC; AC falling MC < AC; AC falling MC = AC; AC constant MC = AC; AC constant MC > AC; AC rising Google and Apple’s RevenueChanging Marginal Cost as Output Rises
  14. 14. Output Total Fixed Cost (£) Average Fixed Cost (£) 0 2000 50 2000 40 100 2000 20 150 2000 200 2000 10 250 2000 300 2000 350 2000 400 2000 5 Google and Apple’s RevenueTotal and Average Fixed Cost
  15. 15. Output Total Fixed Cost (£) Average Fixed Cost (£) 0 2000 50 2000 40 100 2000 20 150 2000 200 2000 10 250 2000 300 2000 350 2000 400 2000 5 Total fixed costs remain constant at each level of output in the short run Output (Q) Cost TFC £2000 AFC As output expands in the short run, the overhead costs per unit will fall Output = 1 unit Google and Apple’s RevenueAverage Fixed Cost Falls as Output Rises
  16. 16. Total, Average and Marginal Product • Total product (total output). In manufacturing industries such as motor vehicles, it is straightforward to measure how much output is being produced. In service or knowledge industries, where output is less “tangible” it is harder to measure productivity. • Average product measures output per-worker- employed or output-per-unit of capital. • Marginal product is the change in output from increasing the number of workers used by one person, or by adding one more machines to the production process in the short run
  17. 17. Short Run Production Function • The short run is a time period where at least one factor of production is in fixed supply • A business has chosen its scale of production and sticks with this in the short run time period • We assume that the quantity of plant and machinery is fixed and that production can be altered by changing variable inputs such as labour, raw materials and energy • Hence in the short run we make a distinction between fixed and variable costs of production
  18. 18. (Short Run) Law of Diminishing Returns • In the short run at least one factor of production is fixed (normally capital, but can also be land) • The law of diminishing returns states that as more units of a variable input are added to fixed amounts of land and capital, the change in total output will first rise and then fall • Diminishing returns to labour occurs when marginal product of labour starts to fall. • This means that total output will be increasing at a decreasing rate
  19. 19. MCCost Output Rising MC due to diminishing returns in the short run Google and Apple’s RevenueThe Shape of Short Run Marginal Cost
  20. 20. MCCost Output AC AC will fall when MC < AC Average cost is at a minimum when it is intersected by the MC curve Google and Apple’s RevenueMarginal Cost and Average Total Cost
  21. 21. MCCost Output AC AC will fall when MC < AC Average cost is at a minimum when it is intersected by the MC curve AC will rise when MC > AC Google and Apple’s RevenueMarginal Cost and Average Total Cost
  22. 22. MCCost Output AC AVC MC also cuts AVC curve at min of AVC Google and Apple’s RevenueMC, AC and Average Variable Cost (AVC)
  23. 23. MCCost Output AC AVC AFC AFC will fall as the level of output expands MC also cuts AVC curve at min of AVC Google and Apple’s RevenueMC, AC and Average Fixed Cost (AFC) Average fixed costs must fall continuously as output increases because total fixed costs are being spread over a higher level of production.
  24. 24. MCCost Output AC AVC Google and Apple’s RevenueThe Family of Short Run Cost Curves
  25. 25. MCCost Output AC1 AVC AC2 Google and Apple’s RevenueShowing a Rise in Fixed Costs A change in fixed costs has no effect on marginal costs. Marginal costs relate only to variable costs!
  26. 26. MC1Cost Output AC1 MC2 AC2 Google and Apple’s RevenueShowing a Rise in Variable Costs A rise in variable costs of production leads to an upward shift both in marginal and average total cost
  27. 27. 1. Changes in the unit costs of production – Lower unit costs mean that a business can supply more at each price – for example higher productivity – Higher unit costs cause an inward shift of supply e.g. a rise in wage rates or an increase in energy prices / other raw materials 2. A fall (depreciation) in the exchange rate causes an increase in prices of imported components and raw materials – 3. Advances in production technologies – outward shift of supply 4. The entry of new producers into the market – outward shift 5. Favourable weather conditions e.g. for agricultural products 6. Taxes, subsidies and government regulations – Indirect taxes cause an inward shift of supply – Subsidies cause an outward shift of supply – Regulations increase costs – causing an inward shift of supply Google and Apple’s RevenueKey Factors causing Supply Shifts
  28. 28. Source: DEFRA * data for May 2015 65.02 79.32 80.3 67.43 78.88 120.97 137.87 107.05 123.76 169.17 179.26 175.95 143.06 127.15 0 20 40 60 80 100 120 140 160 180 200 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015* Pricepertonnein£s Falling wheat prices will cause a reduction in the resource costs for food manufacturers such as cereal producers. If other factors remain constant, producers who use wheat will see an outward shift of supply Google and Apple’s RevenueWheat prices – a variable cost for firms
  29. 29. Google and Apple’s RevenueCarbon Prices and Variable Costs • The UK has a Carbon Price Floor which applies to fossil fuels used for electricity generation • The minimum price for carbon emissions is designed to provide a stable carbon price signal as a way of internalising externalities • The minimum Carbon Price Floor started at £16/tCO2 in 2013 • In 2014 the UK government announced a cap of £18/tCO2 from 2016 until 2020 • Carbon prices within the EU emissions trading system have been highly volatile in recent years and currently are very low Arguments for a carbon price floor • Reduces the risks, and thus costs, of investing in low carbon projects • Helps to reduce carbon price volatility – sends signal to polluters • Makes low carbon electricity more competitive – boost to renewables Arguments against a carbon price floor • Restrict supply of carbon permits to increase the free market price • A carbon tax is a better alternative and raises useful tax revenues • Price floor set high might damage international competitiveness
  30. 30. Google and Apple’s RevenueThe Living Wage and Business Costs • Living Wage Foundation (LWF) • The LWF living wage is an hourly rate of pay set annually by reference to the basic cost of living in the UK and London. • The current living wage is £7.85 per hour outside London and £9.15 per hour in London – employers can voluntarily pay it – many do! • Government National Living Wage • The NLW applies to workers aged 25 and over and will be introduced at an initial rate of £7.20 per hour from April 2016. It effectively takes the place of the National Minimum Wage for workers aged 25 and over. 0 1 2 3 4 5 6 7 8 9 2011 2012 2013 2014 2015 Wageperhourin£s Living wage Minimum wage
  31. 31. How can we calculate the costs of a firm? Topic 3.3.4

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