Cost Analysis-I

Introduction to Cost

We can look at the business firm from at least two points of view: productivity, inputs, and outputs or outputs and costs. In advanced microeconomics, these two points of view are called "duals." They are equally valid, but they point up different things. They are also opposites from a certain point of view-- the higher the productivity, the lower the costs. By looking at the firm from the point of view of costs, we shift our perspective somewhat, and gain a much more direct understanding of supply.

We also look more directly at the difference between the long and short run. In the short run, we have two major categories of costs:

• Fixed Costs

• Variable Costs

In the long run, however, all costs are variable. Thus, we must study costs under two quite different headings. Costs will vary quite differently in the long run and in the short.

Fixed and Variable Cost 

Variable costs are costs that can be varied flexibly as conditions change. In the John Bates Clark model of the firm, labor costs are the variable costs. Fixed costs are the costs of the investment goods used by the firm, on the idea that these reflect a long-term commitment that can be recovered only by wearing them out in the production of goods and services for sale.

The idea here is that labor is a much more flexible resource than capital investment. People can change from one task to another flexibly (whether within the same firm or in a new job at another firm), while machinery tends to be designed for a very specific use. If it isn't used for that purpose, it can't produce anything at all. Thus, capital investment is much more of a commitment than hiring is. In the eighteen hundreds, when John Bates Clark was writing, this was pretty clearly true.

Over the past century, education and experience have become more important for labor, and have made labor more specialized. Increasing automatic control has made some machinery more flexible. So the differences between capital and labor are less than they once were, but all the same, it seems labor is still relatively more flexible than capital. It is this relative difference in flexibility that is expressed by the simplified distinction of long and short run.

Of course, productivity and costs are inversely related, so the variable costs will change as the productivity of labor changes. 

Here is a picture of the fixed costs (FC), variable costs (VC) and the total of both kinds of costs (TC) for the productivity example in the last unit: