Certificate course Macroeconomics for social negotiators
COSTS
In the firm all the stake-holders should be aware that their destiny considerably depends on the costs
of the firm. The employers in particular have the task of informing their counterparts on those
constraints that are represented by costs. High or low fixed costs, increasing or decreasing marginal
costs may imply that a business can/must grow or not. Marginal costs often indicate if a plant can o
cannot keep on producing and employing staff. In this section we shall also explain the link
between productivity and cost, in this way we shall explain why discussions on the containment of
costs or on the increase of productivity are two faces of the same medal. Finally we concentrate our
attention on those costs that firms mostly face when they operate on a market: transaction costs. We
explain that such costs can be a hot topic in the relations between firms and public authorities.
Marginal and Average Costs
How much does an increase in output influence total costs? Knowing this would be a useful tool to
decide if we have to produce more or less. How much is the additional cost generated by producing
one unit more? What is the average cost of producing ten additional units of output? Many business
decisions depend on information like this.
Cost increase
=
Marginal cost =
Total Cost after producing
some additional quantities
-
Total Cost before producing
the additional quantities.
Cost Increase .
N. of additional units
.
Are marginal cost and variable cost the same? No they are not: the marginal cost is the change in
variable cost as the level of output changes .In many industries marginal cost for certain production
volumes may decrease, but then, for bigger quantities, at least in the short term, they tend to grow.
For this reason we think that, in many industries, beyond certain thresholds, firms are ready to offer
greater quantities only at greater prices. So we represent the relation between quantities that they are
ready to sell and prices, the supply curve, as a upward-sloped curve.
We often sell every unit of product at the same price. Therefore we need to know:


The average cost of each unit of output.
If my average cost increases or decreases for different quantities of production.
Average Cost = Total Cost / Q
Where Q represents quantity or Total Output in physical terms.
If total cost is the sum of fixed costs and variable costs then:
Certificate course Macroeconomics for social negotiators
Average Cost = Total Cost = Fixed Cost
Q
Q
+ Variable Cost
Q
Average Cost = Unitary Fixed Cost+ Unitary Variable Cost
The average cost of a firm is affected both by the per unit contribution of the fixed cost and by the
per unit contribution of the variable costs.
The two main production factors are capital and labour, therefore the total cost can be expressed by
the sum of the cost of capital and the cost of labour.
Total Cost = Cost of Capital
Therefore the average cost is:
+ Cost of Labour
Average Cost = Total Cost = Cost of Capital
Q
Q
+ Cost of Labour
Q
The cost of capital is given by the interest rate times the invested capital.
The cost of labour is given by the wage (in this case inclusive of social contribution)
number of workers.
Therefore the average cost can be rewritten:
times the
Average Cost = Capital X interest rate + Wage X N. of workers
Q
Q
However the statement above is equivalent to the following:
Average Cost =
interest rate +
Q
Capital
Wage
.
Q .
N. of Workers
This means that the average cost is given by the sum of the cost of capital per unit of product and
the cost of labour per unit of product. The average cost of output depends not only on the interest
rate and the wage that firms pay, but on the productivity of capital (Total Output/ Capital or Q/K)
and on the productivity of Labour ( Total Output/ [No. of Workers] or Q/L). Increasing
productivities means reducing costs and becoming more competitive. The average cost may
increase because you increase wages, sometimes depending by the bargaining power of trade
unions, or because you reduce productivity, largely depending on the adopted technology, market
demand and on the management of the firm. In all debates between employers and trade unions this
is a hot topic.
Certificate course Macroeconomics for social negotiators
Fixed Costs and Variables Costs.
Costs can be variable or fixed. Variable costs depend on the quantity that the firm produces. Fixed
costs do not. In a sufficiently long period, all costs are variable, because in the long run getting rid
of a cost is always possible, you shut down the firm and stop producing. Fixed costs, in the short
term, do not depend on the quantity you produce. Symmetrically the short term is the time when
some costs are fixed and the long term is the time when all costs become variable. This distinction
is not always so obvious and neat. Example: maintenance and advertising: are they fixed or
variable costs? You should always carry out some maintenance, but if you produce more the
quantity of needed maintenance may increase. Our time framework makes costs fixed or variable.
Fixed costs should not be confused with sunk costs. A cost is sunk if in the future we cannot
recover it. Many fixed costs in some future may be recovered.
These often are fixed costs:
 Overheads or administrative costs.
 Taxes on real estate.
 Properties (apartment, house, warehouse building, land, etc.) that you cannot easily sell or
you rent with long term contracts.
 Equipment you own or rent on a long term basis.
 A mortgage.
 The power required by minimum maintenance.
 Employees that you cannot easily fire.
 Long term supply contracts.
Figure 2 Fixed costs do not depend on the produced quantity
(no marginal costs)
Examples of Variable Costs, those which change when output changes, are:
Certificate course Macroeconomics for social negotiators







Petrol for your car.
Paper for your printer.
Materials and supplies that you only buy, when you have to produce additional quantities.
The power that machines consume because they produce.
Employees you can easily fire.
Real estate you can rent on a short term basis.
Commissions to salesmen.
Total Cost = Fixed Cost + Variable Cost
Linear Variable Costs
Linear variable costs normally indicate constant marginal returns, i.e. constant marginal
productivity. Every time I add a new piece of equipment or a new worker that produces as the
previous ones. They also indicate that each additional unit of output costs the same.
Figure 3 Linear variable costs (constant marginal costs).
This is the case of a guy who rents a shop (inclusive of utilities) and a photocopying machine. Then
he only pays per unit cost for paper, ink and the labour of a boy who is paid for the number of
copies that he does (piece work labour).
If we consider both fixed costs and linear variable costs, we obtain a picture like Figure 4
Certificate course Macroeconomics for social negotiators
Figure 4 A company with fixed cost and linear variable costs
Variable costs which grow more and more (increasing marginal costs)
The costs of a firm which pays higher and higher overtime salary to its staff are an example. A
business that becomes more and more difficult the greater is the produced quantity is another
example, e.g. digging a mine deeper and deeper or building a skyscraper taller and taller. They
often indicate decreasing marginal returns.
Figure 5 Total cost in a firm where variable costs grow more and more (increasing marginal costs)
Variable costs which grow less and less (diminishing marginal costs).
Certificate course Macroeconomics for social negotiators
These costs can be found for example in a business where experience matters a lot. There is a
learning process: if you learn how to do it, the cost of doing it becomes lower and lower (you
become faster and you save time and €). Imagine when you learn using Excel… Usually a curve
like this indicates increasing marginal returns.
Figure 6 Total costs in a firm with variable costs increasing less and less (diminishing marginal costs); a business
where growth is very rewarding.
The supply: Is the firm ready to sell a certain quantity? At which price?
The availability of firms to sell a product at a certain price usually changes whether they are in a
short term or long term perspective. In the short term they have certain costs that they should face
anyway, notwithstanding the quantity that they produce (fixed costs); therefore when they define
the amount of goods that they want to sell at a certain price, in the short run they may ignore fixed
costs. They cannot ignore those costs directly deriving from the act of producing, those costs that
they could avoid, just not producing anything: the variable costs. In the short term firms should
have revenue at least as big as variable costs; otherwise they rather do not produce. This means that
the price (the per unit revenue) that they demand should be at least as big as the average variable
cost or per unit variable cost. But this is usually not yet enough. Let’s assume that, to produce more,
firms should pay overtime to their employees, should carry out additional maintenance of the plants
and in general should carry costs which are growing more and more (increasing marginal costs). In
these cases the last produced unit is the most expensive to produce. Usually firms will be willing to
produce the last unit of production only if the price will cover the additional costs caused by its
production, i.e. its marginal cost. So in the short term firms are ready to sell a quantity of product
not only at a price at least equal to the average variable cost, but also at least equal to the marginal
cost. On this basis they ask greater prices for greater quantities and we can represent this with an
up-sloped curve.
Certificate course Macroeconomics for social negotiators
Figure 7 The supply curve
In the long term the firm not only must cover the variable costs, it musts also cover its fixed costs, if
it does not, it is not sustainable and it has the option of stopping production and exiting the industry.
Therefore in the long term the firm can only sell at a price, which is not only greater than marginal
cost and unitary variable cost, but also greater than the average cost (average cost = total cost /
quantity). At industry level, for very low prices, only very competitive producers can produce, and
for higher prices other producers become able to produce and for very high prices, even high cost
producers can join the market with their product. For these reasons at high prices the aggregate
supply is much bigger than at low prices.
The Firm Supply Curve: a more technical presentation
The firm’s supply curve tells us how many units of a product a firm is willing to sell at any given
price. A firm will be willing to sell a unit of output as long as the price received for that unit covers
the cost of producing that additional unit of output – the marginal cost of output. Hence, the firm
will supply a unit of output as long as the price equals the marginal cost. At any given price then we
can determine from the marginal cost curve the quantity of output that the firm will be willing to
supply. For the case of increasing marginal cost as depicted in Figure 5 the supply curve is as
depicted in Figure 7.
Keeping in mind that the price must cover average variable cost for the firm not to shut down in the
short run, the supply curve is the firm’s marginal cost curve only for prices greater than Average
Variable Cost. In the long-run a third condition for production is required, which is that the firm
earns a profit. This occurs where the price is greater than the Average Total Cost, or, the price
covers the fixed cost as well. There are therefore three conditions: (1) In the short run the firm may
supply produce along its marginal cost curve even when price does not cover Average Total Cost
till the point where price covers Average Variable Cost. Below this level of cost the firm shuts
down. (2) The supply curve of the firm is where price equals the marginal cost curve of the firm,
provided that the price is above Average Variable Cost. (3) For the firm to be earning profits, the
price must be greater than Average Total Cost.
Certificate course Macroeconomics for social negotiators
The global oil supply
In Figure 8 there is a line with steps of stairs. The first step on the left is at level $25 and it has a
width of 20. It indicates that about 20% of the world oil production capacity, that extracted in the
middle east (mainly Saudi Arabia, Iran and other countries of the gulf), can be produced, if it is
sold at a price equal or grater than $25 a barrel. For oil prices below $ 25 no producer can produce
in a sustainable way and the sustainable supply would be 0. For prices above $40 also the oil
extracted offshore on the shelf becomes viable. The second big step at level 40 represents that oil. It
is a further 20% of the total world production capacity. A 3% of the world extraction capacity is
represented by extra heavy oil, which is viable for prices above $48 per barrel. According to this
source, the onshore Russian production is sustainable at prices above $53 per barrel. For higher
prices other producers can extract. For prices above $ 62 North American shale becomes viable; and
for prices above $88 even oil sands can be produced and sold in an economically sustainable way.
Every time the price becomes higher, the total supply becomes larger, with the activation of some
more expensive production. The quantity which is actually supplied then depends not only on
global supply, but on the global oil demand. They will cross each other in one point. There we shall
have the actual supplied quantity and the world price.
Figure 8 The supply curve of the world oil industry in 2014. For higher prices, more producers can produce and
greater quantities are available on the market. Source: voxeu.org
Certificate course Macroeconomics for social negotiators
A special cost: The cost of using the market or Transaction Cost.
Using the market may be expensive. We not only have to pay those goods and services that we
want, we also have to spend money to inquire which goods may fit our needs, what is their price
and where we can find them.
Transaction costs are “the costs other than the money price that are incurred in trading goods or
services. Before a particular mutually beneficial trade can take place, at least one party must figure
out that there may be someone with which such a trade is potentially possible, search out one or
more such possible trade partners, inform him/them of the opportunity, and negotiate the terms of
the exchange. All of these activities involve costs in terms of time, energy and money [telephone
calls, internet searches, meetings, business dinners, due diligences-accounting advice, international
trips, legal advice among others]. If the terms of the trade are to be more complicated than simple
"cash on the barrelhead" (for example, if the agreement involves such complications as payment in
installments, prepayment for future delivery, warranties or guarantees for quality, provision for
future maintenance and service, options for additional future purchases at a guaranteed price, etc.),
negotiations for such a detailed contract may itself be prolonged and very costly. After a trade has
been agreed upon, there may also be significant costs involved in monitoring or policing the other
party to make sure he is honoring the terms of the agreement (and, if he is not, to take appropriate
legal or other actions to make him do so). These are the main sorts of transaction costs, then: search
and information costs, bargaining and decision costs, policing and enforcement costs.” If these
costs are very high we may decide not to buy a certain input on the market, but having a unit of our
company making it. In the trade of certain goods, transaction costs may be very high. For example
this is particularly true in the case of know how (non patented knowledge concerning production). If
you want to sell your know-how, you should explain what it is about; when you have fully
presented every detail about your know-how, your counterpart may have learnt about it and run
away, without paying you. For this reason, very often firms merge with or acquire companies with a
certain know how in order to obtain that. In other cases firms hire (bring into the firm) those
persons who have the key know-how of a certain company. In the past was most common for
pharmaceutical companies having R&D within the firm to reduce the problem of buying and selling
knowledge. Part of the transaction costs depends on the public authority. It is the public authority,
which decides the rules of the civil law, the limits to the compensation of solicitors, the litigation
duration and cost. In some countries public authorities or state owned companies provide
infrastructure (telephone lines, the internet, railways and airports) and create data bases, e.g.
telephone directories, which can considerably reduce the transaction costs of firms. In the
employment field, government sponsored employment agencies may play a key role in reducing the
time and the cost of hiring new staff. For these reasons employers organizations often asks
government to be active in providing a well working legal framework, infrastructure and other
services which may reduce corporate transaction costs.