3.3.2 Costs Flashcards
Total cost (TC)
The cost of producing a given level of output: fixed + variable costs
Total fixed cost (TFC)
Costs that do not change with output and remain constant
Total variable cost (TVC)
Costs that change directly with output e.g. materials
Average (total) cost (ATC)
Total cost / Output
Average fixed cost (AFC)
Total fixed cost / Output
Average variable cost (AVC)
Total variable cost / Output
Marginal cost (MC)
The extra cost of producing one more unit of a good
Change in total cost / Change in output
Short-run cost curves
The short run is the length of time when at least one factor of production is fixed and cannot be changed; this varies massively with different types of production. The long run is when all factors of production become variable.
Diminishing marginal productivity
If a factor of production is fixed, this will affect the business if it decides to expand. More workers can be added relatively easily and this will see an increase in production as machinery is used more efficiently. However, it will take a long time for the factory to expand and adding more labour will mean that they will have less and less impact on the amount produced as they get in the way and have no machines to use. This is called the Law of Diminishing Returns or diminishing marginal productivity.
- Diminishing marginal productivity means that if a variable factor is increased when another factor is fixed, there will come a point when each extra unit of the variable factor will produce less extra output than the previous unit.
- Marginal output will decrease as more inputs are added in the short run. This will mean that the marginal cost of production will rise.
Costs and Revenues diagram
• The average fixed cost curve (AFC) starts high because the whole fixed costs are being divided by a small output. As output is increased, AFC falls as the same amount is divided by a larger number.
• The average total cost curve (AC/ATC) is U-Shaped due to the law of diminishing marginal productivity. Costs initially fall as machinery is used more efficiently but as production continues to expand, efficiency falls as machinery is overused.
• The average variable cost curve (AVC) is also U-Shaped, but it gets closer to ATC as output increases since AFC gets smaller.
• The marginal cost (MC) will also be U-Shaped due to the law of diminishing marginal productivity. It will initially fall as the machines are used more efficiently but will rise as production continues to rise.
MC = AC
The marginal cost line will always cut the AC line at the lowest point on the AC curve: if MC is below AC, then AC will continue to fall since producing one more costs less than the average so the average falls; but if MC is above AC, then AC will rise. Marginal costs can be rising whilst AC is still falling, as long as MC is still below AC.
Total/Average Cost curve
Each firm will have a different total cost curve. If average costs are constant, the line would be a straight diagonal line beginning at the origin. When output is 0, fixed costs are equal to total costs since there are no variable costs. Average costs can be worked out from the total cost curve: at point A, average costs are C/D whilst at point B, average costs are E/F.
Average costs at B are lower than at A, since the gradient of A is steeper than B. The tangent to the total cost curve is marginal cost.
Relationship between short-run and long-run average cost curves
Short run average cost (SRAC) curves are U-Shaped because of the law of diminishing returns whilst long run average cost.
Long run average cost (LRAC) curves are U-Shaped because of economies and diseconomies of scale.
SRAC and LRAC diagram
The LRAC is an ‘envelope’ for all associated SRAC curves because the LRAC is either equal to or below the relevant SRAC as shown in the diagram. The firm may initially be set up to produce a certain amount a day and have enough machinery to do so effectively. They may become popular and need to produce more than that this amount and in the short run this will cause a rise in SRAC due to the law of diminishing returns as some factors of production are fixed. In the long run, all factors become variable and so the SRAC curve can be shifted. The new SRAC curve will be lower since the firm is able to enjoy economies of scale. This will continue to occur until the firm begins to experience constant returns to scale and eventually diseconomies of scale.
• Up until output Q1, the firm experiences economies of scale and so sees falling
LRAC.
• From output Q1 until output Q2, the firm has constant returns to scale where their
LRAC are constant
• Any output above Q2 means the firm experiences diseconomies of scale and their
LRAC rises.
Shifts and movement of LRAC curve
• The long run average cost curve is a boundary representing the minimum level of average costs attainable at any given level of output. Points below the LRAC are unattainable and producing above the LRAC is inefficient.
- Movement along the LRAC is due to a change in output which changes the average cost of production due to internal economies/diseconomies of scale.
- A shift can occur due to external economies/diseconomies, taxes or technology, which affects the cost of production for a given level of output.
