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Our A-level AQA Economics teacher explains cost functions.


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Cost Curves for A Level Economics

First of all, we need to understand the difference between a firm and an industry. A firm is a single business, an industry is a collection of all businesses in one area. For example, a farmer is one firm, the industry consists of all farmers in the country (area). A school is one firm, but all schools in the country is an industry – more broadly the education industry, which will also include universities and other education institutes.

A firm is a single business unit. It produces output and sells it in the market, to people or other businesses. Firms earn a revenue by selling output in the market. Our A levels economics tutor will prepare you for all market models and you will learn about the different models in the following chapters.

Factors of Production

In order to create output, firms must deploy some inputs to produce that output. These inputs are called factors of production. Namely, these are land, labor, capital, and entrepreneurship. When a firm hires these factors of inputs – it incurs a cost to the firm. This brings us to our topic today – cost of production. Clearly, when firms hire land or labor or capital – they have to pay these factors of production. A firm pays rent on land, wage to labor, and interest rate to capital. The idea is that firms borrow capital and so have to pay a rent (interest) on that borrowed capital.

Opportunity Cost

When economists talk about the cost of production they are referring to the economic cost of producing the output. The economic cost includes the money cost of factors of production that have to be paid for, but it also includes the opportunity cost of the factors that aren’t paid for. For instance, the cost of the next alternative use is also included. This is the main difference between accounting costs and economic costs.

If a person chooses to run his own business and gives up a job paying $50,000 – then the opportunity cost of him working in his own business is $50,000 that he could have earned otherwise. The opportunity cost of a factor of production is the money that you could have got by putting it to its next best use. So, in economics, cost isn’t just a calculation of money spent — it takes into account all of the effort and resources that have gone into production.

Types of Cost

The short run is the period of time when at least one of a firm’s factors of production is fixed. The short run isn’t a specific length of time — it varies from firm to firm. For example, the short run of a cycle courier service could be a week because it can hire new staff with their own bikes quickly, but a steel manufacturer might have a short run of several years because it takes lots of time and money to build a new steel-manufacturing plant. Long-run is when all factors of production can be varied. If I run a small coffee shop and I have a coffee-maker, in short-run I can hire more baristas (or fire them, unfortunately) but I cannot immediate add more coffee machines or ovens or equipment (as easily). Although, eventually I will be able to – so in the long-run no factor of production is fixed.

Fixed Costs : costs that have to be incurred regardless of whether output is produced or not. In a way, this is good and bad for a business. First, bad because even if we sell nothing or produce nothing we still have to pay these costs. For example, we have to pay our coffee shop’s rent even if we sell no coffee. This was one of the issues during the Corona pandemic. Firms had to shut down and they earned no revenue. However, their fixed costs such as rents, wages, and bills continued. This is why the government introduced a bill to make it easier for firms.

Variable Costs : these costs are variable with output. In other words, it is the cost of producing output, like ingredients and raw materials. For a coffee shop this will be the cost of coffee, milk, cup, sleeve, lid, straws, napkins, etc. The more we sell coffee, the more we need these products.  The table below shows the calculation of different types of costs. Our a levels economics tutor in London will prepare you to calculate, graph and explain these costs in detail.


A Levels Economics Tutor London Costs Table

Long-Run Average Total Cost A levels Economics

In the short run a firm has at least one fixed factor of production. This means that it operates on a particular short run average cost curve (SRAC curve), e.g. SRAC1 on the diagram below. As a firm increases output in the short run by increasing variable factors of production, it moves along its short run average cost curve. In the long run a firm can change all factors of production. When it does this it moves onto a new SRAC curve, e.g. SRAC2. The MINIMUM POSSIBLE AVERAGE COST at each level of output is shown by a LONG RUN AVERAGE COST CURVE (LRAC curve).

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SRAC curves can touch the LRAC curve, but they can’t go below it. For a firm to operate on its LRAC curve at a particular level of output, it has to be using the most appropriate mix of all factors of production. This means that it may not be able to reduce costs to this minimum level in the short run (since in the short run, some factors are fixed). This means that it may not be able to reduce costs to this minimum level in the short run (since in the short run, some factors are fixed).


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