COST OF PRODUCTION

The cost-of-production theory of value is the theory that the price of an object or condition is

determined by the sum of the cost of the resources that went into making it. The cost can comprise any

of the factors of production (including labor, capital, or land) and taxation.

TYPES OF COST

Fixed costs are expenses that do not change in proportion to the activity of a business, within the

relevant period or scale of production. For example, a retailer must pay rent and utility bills irrespective

of sales.

Variable costs by contrast change in relation to the activity of a business such as sales or production

volume.

Average cost is equal to total cost divided by the number of goods produced.

Marginal cost is the change in total cost that arises when the quantity produced changes by one unit. In

general terms, marginal cost at each level of production includes any additional costs required to

produce the next unit. So, the marginal costs involved in making one more wooden table are the

additional materials and labor cost incurred.

Sunk costs are those that cannot be recovered if a firm goes out of business.

AVERAGE COST (EXPLAIN)

Average cost or unit cost is equal to total cost divided by the number of goods produced (the output

quantity, Q). It is also equal to the sum of average variable costs (total variable costs divided by Q) plus

average fixed costs (total fixed costs divided by Q). Average costs may be dependent on the time period

considered (increasing production may be expensive or impossible in the short term, for example).

Average costs affect the supply curve and are a fundamental component of supply and demand.

Short-run average cost will vary in relation to the quantity produced unless fixed costs are zero and

variable costs constant. A cost curve can be plotted, with cost on the y-axis and quantity on the x-axis.

Long-run average cost

The long run is a time frame in which the firm can vary the quantities used of all inputs, even physical

capital. A long-run average cost curve can be upward sloping, downward sloping, or downward sloping

at relatively low levels of output and upward sloping at relatively high levels of output, with an in -

between level of output at which the slope of long-run average cost is zero. The typical long-run average

cost curve is U-shaped, by definition reflecting increasing returns to scale where negatively sloped and

decreasing returns to scale where positively sloped.

SHORT RUN

All production in real time occurs in the short run. The short run is the conceptual time period in which

at least one factor of production is fixed in amount and others are variable in amount. Costs that are

fixed, say from existing plant size, have no impact on a firm's short-run decisions, since only variable

costs and revenues affect short-run profits.

LONG RUN

The long run is the conceptual time period in which there are no fixed factors of production as to

changing the output level by changing the capital stock or by entering or leaving an industry. The long

run contrasts with the short run, in which some factors are variable and others are fixed, constraining

entry or exit from an industry. The long run is the period when the general price level, contractual wage

rates, and expectations adjust fully to the state of the economy, in contrast to the short run when these

variables may not fully adjust