A firm that provides a good or service incurs costs, or gives something up in doing so. The economic cost is the sum of explicit and implicit (opportunity) costs. An explicit cost, such as the money for raw materials for production, is a cost that involves a monetary payment. An explicit cost can clearly be accounted for. On the other hand, implicit costs, such as using machinery that the firm already owns, can be less tangible. An implicit cost, also known as an opportunity cost, is a cost that does not require the buyer to pay cash, or that cannot easily be assigned a monetary value. Opportunity cost is the value or benefit of the next best alternative given up when making a choice. A firm's total costs are both its economic and opportunity costs.
The short run is the period in which at least one productive input is fixed. For simplicity, consider the size of a firm's capital stock as its fixed input and labor as its variable input, holding all other factors constant. This means that the capital stock of the firm, the fixed input, is constant over the time period defined as the short run, and only the amount of labor, the variable input, changes. However, in reality, firms will likely have multiple fixed and variable inputs. The long run is the length of time it would take for all the firm's inputs to become variable.
Consider Belva's Beauty Shop. The firm has to rent the space for the shop and then hire stylists. Once Belva signs her lease, she can no longer adjust the size of her shop. So, her shop would be her fixed input. Once the lease expires, Belva can consider larger or smaller spaces to rent—that would be in the long run. However, once she signs another lease, she is back in the short run with a fixed input.
A firm's fixed cost (FC) is the cost of fixed inputs, which does not change as output changes. It represents costs such as rent, property taxes, and managers' salaries. Because the quantity of fixed inputs does not change in the short run, these fixed costs do not vary with output. For example, once Belva signs a lease to rent a shop, she must pay the rent, even if she never styles a single customer's hair. Thus, fixed costs occur even when output is zero.
A firm's variable cost (VC) is the cost of variable inputs and changes as output changes. Variable costs include things such as labor (stylists) and materials (shampoo, hair dye, towels, etc.). To increase the number of hairstyling sessions produced, Belva must increase the use of these variable inputs. Belva must pay each stylists she hires $100 per day. She must also pay for supplies such as dyes and shampoo. Consequently, variable cost will rise.
Short-Run Costs for Belva's Beauty Shop
| Number of Stylists (L) | Number of Styling Sessions (Q) | Fixed Cost (FC) | Variable Cost (VC) | Total Cost (TC) |
|---|---|---|---|---|
| 0 | 0 | $100.00 | $0.00 | $100.00 |
| 1 | 8 | $100.00 | $100.00 | $200.00 |
| 2 | 14 | $100.00 | $200.00 | $300.00 |
| 3 | 18 | $100.00 | $300.00 | $400.00 |
| 4 | 20 | $100.00 | $400.00 | $500.00 |
| 5 | 21 | $100.00 | $500.00 | $600.00 |
A firm's minimum total cost equals its fixed cost. Increases in the total cost depend on its variable cost.
The law of diminishing marginal returns is the observation in the short run that each additional unit of a production input, holding all other inputs fixed, will yield progressively smaller increases in output. Increasing the number of stylists, for example, yields fewer and fewer additional units of output because the size of the shop is limited—only so many stylists can fit before they begin running into each other. Consequently, the variable cost curve for Belva's Beauty Shop increases steeply, then flattens out, and then becomes steeper again.
At zero units of output, the variable cost is zero. If the shop produces no hairstyles, it doesn't need to hire any stylists. As output rises, variable cost for a fixed number of hairstyles rises at an increasing rate. This reflects the fact that the additional variable cost of producing another unit of output becomes greater as the firm produces more. This increase in cost occurs because using more resources makes those resources more scarce. For example, if styling supplies need to be shipped from farther away or stylists are paid overtime for working more than eight hours, the cost of a styling session will also increase accordingly.
Total cost (TC) is the sum of a firm's fixed and variable costs. The total cost curve for Belva's Beauty Shop has the same shape as the variable cost curve, but is shifted up by the amount of the fixed cost. At an output of zero, total cost is equal to fixed cost. Belva must pay the rent in the short run.