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The theory of production presented above showed how a firm may select inputs to produce a given output at minimum cost. In this section we will now refine this understanding of cost by clarifying what economic costs are, and their constituent components. This can help understand the short and long term dimensions of production decisions, the effects of learning and more clearly see how different industries’ cost structures can profoundly influence production decisions with different returns to scale. This is particularly relevant for understanding the nature of technological change within the neoclassical model – as technology is conceived as operating by lowering costs. Underpinning the neoclassical analysis of the firm is that operational managers should take a forward looking view of costs and calculate how they can rearrange resources in the future to lower costs and improve profitability.
In contrast to a retrospective view of simply the explicit costs of operations, such as wages, rent Figure 2.4 The production function and the cost of materials, an ‘economic’ perspective endeavours to focus attention on opportunity costs; or the costs foregone by not putting a firm’s resources to the highest value use (Pindyck and Rubinfeld, 1992:198). Explicit costs are still important as well, because they involve opportunity costs – for example, wages are the opportunity cost of labour inputs purchased in a competitive market. However, opportunity costs can also differ from such explicit costs. For example, consider a manager who runs her own business, but does not pay herself a salary. Although no monetary cost transaction has transpired, the firm nevertheless incurs an opportunity cost because the owner could have earned a competitive salary by working elsewhere.
This notion is also essential for investment banks – the so-called brains of the capitalist system – in how they allocate resources between different projects such as renewable energy versus fossil fuel projects. It is not so important that a project is able to earn a positive return for a given level of risk over and above what the bank can earn by borrowing at low rates from the central bank. Bankers, if they do their job properly, will scour the economy looking for projects which maximise this rate of return, seeking out the best projects, thereby allocating resources in the most effective way across the economy. A tension of course has arisen recently in the context of the financial crisis in how well bankers do this job – or whether in fact they are more focused on choosing the projects that maximise their own remuneration which many argue has become disconnected from them achieving their social function in allocating capital (Kay, 2012). Just as opportunity costs might not embody financial transfers but should be taken into account in economic decision making, sunk costs embody financial costs, but should not be taken into account.
A sunk cost is an expenditure which has already been made but cannot be recovered. For example, if a piece of specialised plant or equipment has no alternative use, then its opportunity cost is zero and it should not be included in the firms’ current or future costs. While in general, capital costs include not just the upfront purchase and running the machinery but also the wear and tear to that asset which occurs over time – in theory, the sunk cost component of the investment should not affect current investment decisions. In practice, however, they often exert a strong influence over decisions and can contribute to path dependency – the tendency of some decisions once taken to make other similar decisions more likely. This has given rise to the concept of stranded assets and has especially been the focus of research related to decisions to extend the operating life of a nuclear power plants (De Bont and Makhija, 1987).
This is another area where the common assumptions underpinning decision-making under the standard approach have been called into question. For instance, while it may be useful pedagogical tool to separate ‘explicit’ and ‘opportunity’ costs in textbooks, in practice, some economic practitioners may be just as backwards looking, especially as most economic forecasts are constructed on past performance. This has given rise to the counter movement of behavioural finance, in order to reinject a sense of realism back into financial and economic management. With this more detailed understanding of what is meant by ‘cost’ – we can now move onto describe its constituent components. The costs of the firm are typically separated out into short and long term elements.
While the analysis in Figure 2.3 assumed perfect flexibility between factors of production, in practice, it is often impossible to vary some inputs and these costs must be paid irrespective of the level of production. These costs are called fixed costs (FC) and include items such as plant and expensive specialised equipment which can only be varied in the long run. Short-run costs can also be described as variable costs (VC) in that they vary with the level of output produced; for example, wages and materials such as water, electricity or components used in production. There are two types of variable cost. Firstly, marginal cost (MC) is the increase in cost that results from producing one extra unit of output.
As it does not include fixed costs, it only represents the increase in variable costs that results from an extra unit of output. Because marginal cost tells us how much it costs to expand the firm’s output by one unit – it is also often considered analogous to the firm’s supply curve. The second category of variable cost is average total cost (AC or ATC) and average variable cost (AVC). Average total costs are the costs per unit of output including fixed costs, while average variable cost excludes these fixed costs. Figure 2.5 sets out these relationships graphically.
Increasing returns means that for the early units of production (up to Qe), there is a high marginal product for variable cost inputs (such as labour). Up until this point, for every extra unit of production, average costs are falling. The slope of the variable cost curve at any point gives the marginal cost. Average variable costs are minimised when the ray from the origin in panel (a) touches the variable cost curve. This occurs at point a in panel (b) and the short-run variable costs exhibit constant returns (similarly for total costs at point e).
When the marginal cost is below the average cost curves, average costs are falling, and when it is above the AVC and ATC curves, diminishing returns have set in with average costs are rising. Because fixed costs are constant, average fixed costs fall with increasing output. By comparing average total cost to the price of the product, or marginal revenue, it is possible to determine the economic profitability of the firm. In a perfectly competitive market it is assumed that firms are price takers – this means that any one firm does not have the ability to influence the market price for their output so the market price is also the firm’s marginal revenue curve (MR). Furthermore, at the point of equilibrium in perfect competition, all firms are required to be producing at zero economic profit.
This requires equilibrium to occur at point e in Figure 2.5, where marginal revenue is Pe and equal to marginal cost at the minimum point of the ATC curve. Note that at this point an accounting profit is still possible, a return is being made on capital invested and salaries are being paid – it is just that resources cannot be allocated in a better way by this firm. If Pe is above this point then the firm would be operating at positive economic profit and if it was below it would be making a loss and eventually have to stop production. If a technological innovation occurs which enables the firm to lower the cost of production for any given level of output then the MC curve shifts downwards and to the right taking the average cost curves with it. If market prices remain constant at Pe this enables the firm to earn greater profit.
It is this process that provides the engine for continual improvements in technology and management processes for if a firm can stay ahead of ‘the market’ norm of technology excess profits will be able to be earned – above normal market rates. Figure 2.5 The components of cost: short run In the long-run, fixed costs are flexible (as in the model presented in Figure 2.3) and firms can alter the scale of production, for example, by adding new production facilities. Figure 2.6 The components of cost: long-run In this case, the short-run average total cost curves for the firm can be described by SRAC1, SRAC2 and SRAC3 in Figure 2.6. In Phase 1 the firm is initially producing at Q1 but understands that by increasing its fixed costs and expanding its plant size, it could produce at a lower average cost. Provided the price (marginal revenue) supports such a move, the firm will move to Phase 2 capital expansion.
At this stage the firm still uses Plant 1 but at the reduced level of Q2 units with plant one and produces Q3 units with the medium sized Plant 2. Over the range z to y, the technologies which govern the expansion of output exhibit constant returns to scale. Any plant size (capital) along this output range will produce the product at the same average cost. However, after point y, decreasing returns to scale set in, and while a move to Phase 3 of capital expansion with a large plant size may still be profitable if average costs for the largest plant are below the market price at P0. With this industrial structure, the long run average cost curve is given by the emboldened sections of the short-run average cost curves, because this shows the minimum cost of production for any output level.
Note that a small plant running at minimum cost is not as efficient as a large plant which can take advantage of increasing returns to scale to produce at a higher output level. The LRAC curve which envelopes this is the curve which traces the minimum SRAC curves if plants of any size could be built. A more formalised way to describe these economies of scale is through the elasticity of cost with respect to output. Recall that elasticity measures the change in one variable in response to a change in another variable. Hence we can define the elasticity of supply: (2.8) When εs is equal to one, costs increase proportionately with output (constant returns to scale); when εs is greater than one, costs increase more rapidly than output (decreasing returns to scale); and when it is less than one costs increase at a slower rate than output (increasing returns to scale).
While increasing returns to scale mean that costs will fall up to a point: as described by the movement along the long-run AC curve (from point b to point e), perhaps the most profound driver of lowering average costs over time is learning and technological change. This is shown graphically in Figure 2.5 by the shift from AC1 to AC2 and from MC1 to MC2. There are several forces that can be behind this process, for example: Learning by doing and learning by watching: as workers perform the same job over and over, they gain experience, which means that they take less time to complete specific tasks. In addition, managers become more adept at scheduling the production process from the flow of materials to the organisation of the firm itself. Engineers also learn from experience and, over time, will improve the design and efficiency of machinery, create better and more specialised tools, faster computer chips and so on; Improvements in material inputs.
Learning by doing and watching also affects businesses which supply the firm – so improvements are continually being made by the firm’s suppliers who may pass some of the benefits of this onto the firm in the form of more effective and cheaper material inputs; and New technological products. Advances in technology may create whole new products which can revolutionise the costs of production for certain industries. For example, the internet has resulted in a large productivity boost for many firms which have been able to change the way they interact with their customers. One such case is the airline business, where passengers now book their tickets directly on-line, rather than go through a travel agent. As a result average costs have come down substantially.
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