When analysing costs, the first thing to know is that there are fixed and variable costs:
- Fixed costs: fixed costs cannot be altered in short run. They mainly include things like rent, repayments on technology, etc… which require time to change, and are often associated with indirect production costs (all that which is not a direct input). They do not depend on the level of production and cannot be adjusted accordingly.
- Variable costs: variable costs depend on the level of production, and can include things such as direct inputs (raw materials) and contracted labour hours (not fixed salaries).
As seen in the graph, fixed costs are represented by a straight horizontal line, independent of quantity. Variable costs follow a curve as they grow slower than production at first (phase I) before reaching a point of inflection (II) and beginning to grow exponentially (phase III). Total costs are simply the sum of fixed and variable costs, as can be seen on the graph.
The way in which fixed and variable costs affect production is related with returns to scale. In phase I, where the elasticity of scale is greater than 1, there are increasing returns to scale, while phase III corresponds to decreasing returns to scale. In point II, the elasticity of scale equals 1, which represents constant returns to scale.