Cost of production refers to the total sum of money needed for the production of a particular quantity of output.
Production refers to the output of goods and services produced by businesses within a market. Production creates the supply that allows our needs and wants to be satisfied.
Short run production
The short run is a period of time when there is at least one fixed factor input. This is usually the capital input such as plant and machinery and the stock of buildings and technology. In the short run, the output of a business expands when more variable factors of production (e.g. labour, raw materials and components) are employed.
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Long run production
In the long run, all of the factors of production can change giving a business the opportunity to increase the scale of its operations. For example, a business may grow by adding extra labour and capital to the production process and introducing new technology into their operations.
Marginal product (MP) = Change in total output from adding one extra unit of labour
Average product (AP) = Total Output divided by the total units of labour employed
The law of diminishing returns
The law of diminishing returns occurs because factors of production such as labour and capital inputs are not perfect substitutes for each other. This means that resources used in producing one type of product are not necessarily as efficient (or productive) when switched to the production of another good or service.
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Cost of production
Costs are defined as those expenses faced by a business when producing a good or service for a market. Every business faces costs and these must be recouped from selling goods and services at different prices if a business is to make a profit from its activities. In the short run a firm will have fixed and variable cost of production. Total cost is made up of fixed costs and variable costs
These costs relate do not vary directly with the level of output. Examples of fixed costs include:
- Rent paid on buildings and business rates charged by local authorities.
- The depreciation in the value of capital equipment due to age.
- Insurance charges.
- The costs of staff salaries e.g. for people employed on permanent contracts.
- Interest charges on borrowed money.
- The costs of purchasing new capital equipment.
- Marketing and advertising costs.
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Variable costs vary directly with output. i.e. as production rises, a firm will face higher total variable costs because it needs to purchase extra resources to achieve an expansion of supply. Examples of variable costs for a business include the cost of production ie; raw materials, labour costs and other consumables and components used directly in the production process.
Average Total Cost (ATC) is the cost per unit of output produced. ATC = TC divided by output
Marginal cost (MC) is defined as the change in total costs resulting from the production of one extra unit of output. In other words, it is the cost of expanding production by a very small amount.
Long run cost of production
The long run is a period of time in which all factor inputs can be changed. The firm can therefore alter the scale of production. If as a result of such an expansion, the firm experiences a fall in long run average total cost, it is experiencing economies of scale. Conversely, if average total cost rises as the firm expands, diseconomies of scale are happening.