- Define and explain Costs of Production in your own words
- Use key terms such as marginal cost accurately
- Apply what you have learned to new examples and questions
- Avoid the common mistakes learners make with this topic
This lesson focuses on Costs of Production: explore fixed, variable and marginal costs for firms.
Explore fixed, variable and marginal costs for firms.
Key ideas
Elasticity shapes pricing
Demand for luxuries with many substitutes, like restaurant meals, tends to be price elastic: a small price rise causes a big fall in quantity. Necessities like bread are inelastic. Firms use this insight: raising prices increases revenue only when demand is inelastic.
Equilibrium and shifts
Where the demand and supply curves cross is the equilibrium: the market clears. If demand rises — say a heatwave boosts ice-cream demand — the curve shifts right, pushing price and quantity up to a new equilibrium. Surpluses push prices down; shortages push them up.
Key term — marginal cost: The extra cost of producing one more unit. Firms compare it with marginal revenue when deciding how much to produce.
A rail firm raises off-peak fares from £10 to £12 and passenger numbers fall from 1,000 to 700. Calculate PED and advise the firm.
Percentage change in price: (£12 − £10) ÷ £10 = +20%. Percentage change in quantity: (700 − 1,000) ÷ 1,000 = −30%. PED = −30 ÷ 20 = −1.5. The absolute value (1.5) exceeds 1, so demand is elastic. Revenue before: £10 × 1,000 = £10,000. Revenue after: £12 × 700 = £8,400 — revenue fell.
Answer: PED = −1.5 (elastic). The price rise cut total revenue from £10,000 to £8,400, so the firm should reverse the increase.
- Saying demand 'shifts' when price changes A price change causes a movement along the curve; only other factors, like income or tastes, shift the whole curve.
- Dropping the minus sign on PED PED is normally negative because price and quantity move in opposite directions — keep the sign, or compare the absolute value with 1.
Practice
They are equal — the market clears with no shortage or surplus.
Inelastic.
PED = −25 ÷ 10 = −2.5 (elastic).
Any one of: factory air pollution, traffic congestion, noise from building work, cigarette smoke.
Quick check
Which of these best defines "marginal cost"?
A tax is placed on sugary drinks. Using demand and supply, what happens to price and quantity?
Why might a firm with inelastic demand raise its prices?
- Costs of Production: explore fixed, variable and marginal costs for firms.
- Elasticity shapes pricing: Demand for luxuries with many substitutes, like restaurant meals, tends to be price elastic: a small price rise causes a big fall in quantity.
- externality: A side effect of production or consumption on third parties, such as pollution from a factory — a leading cause of market failure.
- Watch out for: saying demand 'shifts' when price changes