Short-run Cost Curves
These costs include:
- Wage costs
- typically considered variable costs
- Operating costs
- often have both fixed and variable components
👉 This will help show why companies might change their prices or production levels, and how they plan for the future.
Fixed, variable, total, average, and marginal costs
Fixed Cost
What is a fixed cost?
What are examples of fixed costs?
What is the average fixed cost (AFC)?
Since the cost is consistent regardless of the level of output produced, AFC decreases as more is produced. This leads to a downward-sloping AFC.
Output | Fixed cost | Average fixed cost |
0 | 50 | – |
1 | 50 | 50 |
2 | 50 | 25 |
3 | 50 | 16.7 |
4 | 50 | 12.5 |
5 | 50 | 10 |
6 | 50 | 8.3 |
7 | 50 | 7.1 |
8 | 50 | 6.3 |
9 | 50 | 5.6 |
10 | 50 | 5 |
Fixed cost
- Regardless of weather a firm produces 2 outputs or 10 outputs, they will still incur a cost of £50 hence why the fixed cost line is a horizontal line.
Average fixed cost (AFC)
- Say a firm produces 2 outputs, the AFC will be 50/2=25
- if a firm produces 10 outputs, the AFC will be 50/10 =5
- Therefore, the AFC decreases as a firm produces more because fixed costs are spread over a larger number of units of output
- AFC therefore falls rapidly at first but can never quite reach the x-axis because fixed costs are always positive and never completely vanish.
Variable Cost
What is a variable cost?
Example:
Output | Fixed cost | Variable cost |
0 | 50 | 0 |
1 | 50 | 40 |
2 | 50 | 70 |
3 | 50 | 90 |
4 | 50 | 100 |
5 | 50 | 120 |
6 | 50 | 150 |
7 | 50 | 190 |
8 | 50 | 240 |
9 | 50 | 300 |
10 | 50 | 370 |
- We can see that regardless of a firm’s output, the fixed cost stays the same at 50 throughout
- However, if we go to the the variable cost column, we see that as a firm produces more, the variable costs increases
What are examples of variable costs?
Labour: Wages paid to workers that vary with production levels, such as paying hourly workers in a factory.
Utilities: Costs like electricity and water that go up or down depending on how much is used, similar to how your family's electric bill changes each month
What is the Average variable cost (AVC)?
Let’s add in the AVC column:
Output | Variable cost | Average variable cost (AVC) |
0 | 0 | – |
1 | 40 | 40 |
2 | 70 | 35 |
3 | 90 | 30 |
4 | 100 | 25 |
5 | 120 | 24 |
6 | 150 | 25 |
7 | 190 | 27.1 |
8 | 240 | 30 |
9 | 300 | 33.3 |
10 | 370 | 37 |
- At Output 2, the variable cost is 70. To calculate the AVC: 70/2 = 35
- At Output 6, the variable cost is 150. To calculate the AVC: 150/6 = 25
- Notice in the Average variable cost column, AVC decreases till output reaches 4 units, and then starts to increase afterwards when output increases over 6 units. Why is this the case? 👇
The law of diminishing marginal returns states that as one factor of production (like labour) is increased while others are held constant, the additional output or returns will eventually diminish.
Key point to note:
👉 Returns are the payments or income earned by the owners of the factors of production, like land, labour, and capital.
👉 Increasing Returns: At first, when production increases, each additional unit costs less to make because resources are used more efficiently → AVC goes down with increased production → business starts experiencing increasing returns, earning more because they are spending less per unit.
👉 Diminishing Returns: After a certain point (like 6 units) making even more units becomes harder and more expensive → AVC starts to go up because the business needs more resources, like additional workers or equipment, to produce more units → business spends more on each unit and starts experiencing decreasing returns, reducing the income or returns because they are now spending more per unit.
Let’s imagine a new energy supplier that has committed to an office space for a 5-year lease. The company is having great success and has doubled their number of staff in the first 3 years.
🏢 Since the amount of space – and therefore desk space – is fixed, once there is enough staff for each desk, each worker hired adds an element of friction. More time is spent coordinating between employees and less time is spent billing customers and taking calls.
- So there is an overworking of the fixed factors (e.g captial, land, entrepreneurship) leading to declining productivity of extra labour
Critically, there are increasing and diminishing returns to variable costs. This leads to a U-shaped average variable cost curve:
Knowledge checkpoint: Explain, using a diagram, the shapes of average fixed and average variable cost curves.
Knowledge checkpoint: Explain the law of diminishing marginal returns.
Total cost
What is total cost?
- Total cost is a critical metric for understanding the profitability of a firm in the short- and long-run.
Output | Fixed cost | Variable cost | Total cost |
0 | 50 | 0 | 50 |
1 | 50 | 40 | 90 |
2 | 50 | 70 | 120 |
3 | 50 | 90 | 140 |
4 | 50 | 100 | 150 |
5 | 50 | 120 | 170 |
6 | 50 | 150 | 200 |
7 | 50 | 190 | 240 |
8 | 50 | 240 | 290 |
9 | 50 | 300 | 350 |
10 | 50 | 370 | 420 |
What is average total cost?
Output | Total cost | Average total cost |
0 | 50 | – |
1 | 90 | 90 |
2 | 120 | 60 |
3 | 140 | 46.7 |
4 | 150 | 37.5 |
5 | 170 | 34 |
6 | 200 | 33.3 |
7 | 240 | 34.3 |
8 | 290 | 36.3 |
9 | 350 | 38.9 |
10 | 420 | 42 |
ATC = SRAC = AC
- Spreading Effect: We are seeing the spreading effect take place as fixed cost is spread over more units of output. This causes the average total cost (ATC) to decrease initially.
- Point of Maximum Efficiency: The lowest point on the ATC curve represents the point of maximum efficiency, where costs are at their lowest per unit (at output 6 units)
- The curve falls initially due to several factors:
- Increasing Returns: Output increases more than costs initially due to efficient use of resources.
- Specialisation Benefits: Workers and processes become more specialised, increasing productivity and reducing costs.
- Fixed Cost Distribution: Fixed costs are spread over a larger number of units, reducing the fixed cost per unit.
- Output vs. Cost Growth: Output rises faster than costs, leading to a lower ATC.
When the ATC is Upward Sloping:
- Diminishing Returns: As production increases further, the ATC starts to rise due to diminishing returns. More units of input are required to produce each additional unit of output.
- Curve Rise Factors: The curve begins to rise due to:
- Diminishing Returns/Law of Diminishing Marginal Returns: Additional inputs contribute less to output, increasing costs.
- Erosion of Specialisation Benefits: The advantages of specialisation decrease, and the fixed factor becomes overworked.
- Cost vs. Output Growth: Costs begin to rise faster than output, increasing the ATC.
Knowledge checkpoint: Explain, using a diagram, the shape of a short run average cost curve.
Marginal Cost
What is marginal cost?
Output | Total cost | Marginal cost |
0 | 50 | – |
1 | 90 | 40 |
2 | 120 | 30 |
3 | 140 | 20 |
4 | 150 | 10 |
5 | 170 | 20 |
6 | 200 | 30 |
7 | 240 | 40 |
8 | 290 | 50 |
9 | 350 | 60 |
10 | 420 | 70 |
- For example, to produce 4 output units instead of 3 output units, total costs rose from 140 to 150 which is an increase of 10 which is the additional/marginal cost to produce 4 output units
- If the marginal (next) person to enter a room is taller than the average height, average height increases, however if they are smaller than the average height, average height decreases.
Therefore
- if MC>AC, MC will push AC up‼️
- if MC<AC, MC will pull AC down‼️