- Short-run Cost Curves
- Fixed, variable, total, average, and marginal costs
- Fixed Cost
- Variable Cost
- 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
- Knowledge checkpoint: Explain, using a diagram, the shape of a short run average cost curve.
- Marginal Cost
- Knowledge checkpoint: Describe the factors which cause average costs to fall in the short run.
- Knowledge checkpoint: Describe, using a diagram, the relationship between marginal cost and average total cost.
- The relationship between costs, revenue and profit
- Here are some refreshers:
- Normal profit, supernormal profit and losses
- Short-run and long-run shut-down points
- Summary of short-down decisions
- Knowledge checkpoint: Describe reasons why a loss-making firm may continue to operate in the short run.
- Short vs Long run
- Short run
- Long run
- Understanding the long-run
- Understanding long-run costs curve
- Economies of Scale
- Diseconomies of Scale
- Economies of scale graphically
- Internal and External Economies of Scale
- Internal economies of scale
- External economies of scale
- Knowledge checkpoint: Describe internal and external economies of scale.
- Knowledge checkpoint: Describe internal economies of scale which may be achieved by firms operating in the drinks industry.
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‼️
Knowledge checkpoint: Describe the factors which cause average costs to fall in the short run.
Knowledge checkpoint: Describe, using a diagram, the relationship between marginal cost and average total cost.
The relationship between costs, revenue and profit
Here are some refreshers:
- Profit = TR - TC
What are the conditions for profit maximisation?
- Profit is maximised when the gap between TR and TC is the largest. This means the firm is earning much more in revenue than it is spending on costs, and therefore, profit is at its highest.
- Profit maximisation also occurs where Marginal Cost (MC) equals Marginal Revenue (MR).
- Marginal cost is the additional cost of producing one more unit of a good, while marginal revenue is the additional revenue from selling one more unit.
- If the marginal revenue of producing an additional unit is greater than the marginal cost (i.e., MR > MC), the firm makes a profit on that unit. Thus, it should continue producing until MR equals MC. Conversely, if the marginal cost exceeds marginal revenue, producing that additional unit would decrease profit, so production should stop.
- The point for profit maximisation is where the marginal cost curve is rising (sloping upwards) as it crosses the marginal revenue curve. This indicates that beyond this point, the cost of producing additional units would be higher than the revenue generated, thus reducing profit.
Normal profit, supernormal profit and losses
- In economic terms, costs are not just the explicit costs like wages and materials but also the implicit costs, which include the opportunity cost of the resources. Opportunity cost is the benefit that is foregone by not using resources in the next best alternative.
- When a business earns enough revenue to cover both its explicit and implicit costs, it is making normal profit. This means it is breaking even and covering all its expenses including opportunity costs.
- This is at the point where AC=AR or TC=TR: This means the business is not making any extra profit but is also not incurring losses.
Since normal profit is when AC = AR and AR=P we can conclude that normal profit occurs when AC=P
Supernormal profit:
- This occurs where AR>AC (or P>AC) or TR>TC.
- This means the business is generating excess profit above the normal profit level.
Losses:
- This happens when AR < AC (or P< AC) or when TR < TC, resulting in negative profit.
Short-run and long-run shut-down points
- This shutdown point occurs, most commonly when a firm continually incurs higher costs than the revenue generated if it were to continue production, as opposed to the reduced losses from ceasing production entirely.
- Simply, it is the point at which the profit from producing an additional unit is negative, hence making them worse off by producing more.
When a business is incurring losses, it isn't always the best decision to shut down immediately.
👉 The decision for a business to shut down depends on the average variable cost (AVC)
Short-run Decision
- If a firm's price is greater than or equal to the average variable cost in the short-run, they are likely to continue operating. This is because, in the short-run, fixed costs are considered sunk costs, and the firm only compares revenue to variable costs.
- Firms should continue production as each unit generates more revenue than its variable cost, helping cover fixed costs and reducing losses. They should only shut down when fixed costs increase (e.g., machinery replacement, lease renewal).
What are other reasons why a loss-making firm may continue to operate in the short run?
💰 Selling price/average revenue is greater than AVC: The revenue from selling products helps cover variable costs i.e P>AVC
🏠 Contribution towards fixed costs: Revenue minus variable costs helps pay fixed costs.
📉 Temporary downturn: The firm may predict that the downturn is temporary and profitability will recover, hoping that average revenue will equal average costs in the long run.
💼 Fulfilling orders/loyalty: Maintaining existing orders and customer loyalty.
💸 Reserves: The firm may have large reserves to cover losses.
⚙️ High shutdown/restart costs: The cost of shutting down and restarting capital equipment is high.
👷♂️ Workforce retention: Keeping the workforce to avoid high costs of replacing experienced or trained staff.
📉 Investor confidence: Avoiding loss of investor confidence by halting production or mothballing factories.
🌍 Strategic market presence: Maintaining a presence in certain markets for strategic purposes.
⏱️ Realisation delay: It may take time for the firm to realise they are making an operating loss.
🦠 Government restrictions (Covid-19): Decision-making may limit customers, but normal operations should resume later.
👩🍳 Staffing restrictions: Limitations on how many customers can be served in the hospitality sector due to restrictions.
😷 Consumer confidence: Loss of consumer confidence due to the increased risk of virus exposure.
💸 Anticipating support: Expectation of government financial support to help make normal profit in the future.
When should a business shut down immediently? 👇
- This would mean avoiding variable costs, but the firm would still be liable for its fixed costs, and likely have little to no incoming revenue – which would be considered in the decision.
- This would mean avoiding variable costs, but the firm would still be liable for its fixed costs, and likely have little to no incoming revenue – which would be considered in the decision.
Long-run and Short-run Shut-down Points
Long-run: Firms need to make at least normal profit to stay in the industry.
Summary of short-down decisions
Knowledge checkpoint: Describe reasons why a loss-making firm may continue to operate in the short run.
Short vs Long run
Short run
In the short run, firms can only influence prices by changing how much they produce. They have some fixed costs they can't change right away.
When thinking about the short run, firms try to maximise their profits with their given fixed costs and inputs. But this approach isn't sustainable over a long period.
Long run
In the long run, all inputs are variable, and there are no fixed costs. Over time, many producers can enter or leave the market, especially during times of profitability or loss.
In the long run, firms seek to find the best combination of all their inputs that maximises their output and profits.
The main difference between long-run and short-run costs is that in the long run, there are no fixed factors, so there are no fixed costs. All costs are variable. This means that in the long run, the total cost is the same as the total variable cost!
IBM, the computer software company, started by making things like time-keeping equipment, weighing scales, and coffee grinders.
- Over time, they moved to creating punch card systems, then typewriters, mainframes, computers, and now they focus on cloud-based information services.
- IBM's decisions and changes over time were based on maximising profits by considering the revenue from each product and the associated costs.
- The IBM of today is a result of continually finding the best mix of inputs to maximise profits.
Understanding the long-run
- Long-run Average Cost (LRAC)
- The Long-Run Average Cost (LRAC) curve shows the lowest cost per unit for a firm at each level of output when all production factors can be changed.
- This is the per-unit cost of producing different levels of output when all inputs can be varied.
- It assumes the firm has chosen the best combination of resources for any amount of production. So, the costs shown on the LRAC curve are the lowest possible costs for each level of output. It's like combining various short-run average cost (SRAC) curves to show the lowest average cost for any output level in the long run.
2. Long-Run Total Cost (LRTC)
- This shows the total cost of production for different output levels when all inputs are variable in the long run.
- The total cost curve shows the cost associated with every possible level of output. It tells us how much it costs to produce different amounts of goods.
3. Long-Run Marginal Cost (LRMC)
- This represents the extra cost of producing one more unit in the long run. It's calculated by dividing the Long-Run Total Cost (LRTC) by the quantity of output produced.
Understanding long-run costs curve
🧮 Cost-Minimising Choice
By calculating the most cost-effective choice of inputs for every level of output, we can find the cost of producing each level of output. This helps firms produce goods in the cheapest way possible.
Consider a restaurant that sells hot dogs:
🕰️ Short run
- In the short-run, your fixed costs will likely include any interests on any loans, property taxes, insurance etc – these are the costs that do not change depending on what your do in your restaurant.
- Your variable costs will include the electricity you use, the food used to make your hot dogs and the costs of the labour you hire.
- If you were to increase the number of hours your restaurant was open, then your decision would involve calculating the extra variable costs incurred against the increase in revenue this would generate.
- You would not account for a portion of the fixed costs.
⏳ long run
- In the long-run however, you must account for both your fixed costs and variable costs to calculate whether you will profitable over time.
- For example, if producing each hot dog costs £1 (accounting for the ingredients and labour) and you sell them for £2 each.
- If you were to sell 900 hot dogs, then you would generate revenue of £1800, of which £900 would be profit (total revenue minus cost of production).
- However, say your rent was £1000 per month, a fixed cost, then the profit generated from producing your hot dogs (£900) would be less than your total costs, hence, this is not a profitable decision.
Therefore, in the short run, this decision would be profitable, but it would not be in the long-run. 🌭
Economies of Scale
👉 Economies of scale occurs when the average cost of production falls as output increase i.e it gets cheaper to make each item when you make a lot of them.
💰 When this occurs, companies gain a cost advantage as production increases. This is because firms can make production more efficient by spreading costs over a larger amount of goods.
For example, in Costco where goods are bought in wholesale quantities, the price per unit or kg is likely lower than if you were to buy one of these items from a retailer store.
Diseconomies of Scale
As Walmart grew larger, it faced challenges such as inefficient management, difficulties in communication, and logistical problems. These issues led to higher costs and decreased efficiency, demonstrating how growing too big can sometimes result in higher costs per unit of output.
If we consider a bottle of tomato ketchup. People often questions why the same bottle might cost £2 in Asda but £3 in their local shop. This is the perfect example of economies of scale – the large supermarket sells more of the product therefore can spread the cost more, whereas the smaller local store sells less, therefore cannot spread the cost as much.
Economies of scale graphically
- The provision of water and its network is overseen by Scottish Water. To deliver water to all households, Scottish Water have invested in an extensive network of pipes and infrastructure.
- This investment is a fixed cost for Scottish Water in the short-run and is an extremely large cost for them.
- However, water is distributed to over 25 million households in Scotland, therefore the average cost of this investment is significantly lower as it is distributed across these households over the long-run.
- Therefore, if there was an addition of 1 million households in Scotland, then providing more water to households would spread the costs of doing so wider, therefore making it cheaper to produce more = economies of scale.
- One of the key limiting factors in Apple’s business model is that total human population has a limit, meaning the continued sales growth of Apple will decline eventually as more and more people purchase an iPhone.
- Often diseconomies of scale occurs when products are composed of multiple different parts, all of which are perhaps produced a slower or faster rates or quantities than others. This means that even if a good has increasing demand, the quantity demanded may not be feasibly produced given production time of components.
- In Apples case, they sell over 200 million iPhone’s every year, therefore every year they ultimately must produce over 200 million iPhones.
- This means that if a supplier of a component part cannot itself produce the equivalent number of parts, then Apple simply cannot use this part of supplier. Therefore, despite incredible demand, the additional cost of producing more iPhones may be higher if Apple must opt for a more expensive part and supplier who can help them meet demand.
- Henceforth, despite many seeing scale up as a positive, in Apple’s case, producing more iPhone’s ultimately makes their marginal cost more expensive than their average cost, and so they likely experience diseconomies of scale.
Internal and External Economies of Scale
There are two types of Economies of scale which are both Internal and External.
Internal economies of scale
🛒 Purchasing Economies:
- Definition: Cost savings achieved through bulk buying or negotiating discounts with suppliers.
- Example: A large supermarket chain like Asda can negotiate lower prices from food suppliers by purchasing in large quantities, reducing its per-unit cost of goods sold.
🔧 Technical Economies:
- Definition: Efficiency gains from using larger-scale machinery or specialised equipment.
- Example: An automobile manufacturer investing in robotic assembly lines can produce cars more efficiently and at lower costs per unit compared to smaller competitors using manual labor.
👨💼 Managerial Economies:
- Definition: Reductions in per-unit costs due to specialised managerial skills and efficient decision-making.
- Example: A multinational corporation employing experienced managers who streamline operations and improve productivity across multiple regions, thereby reducing administrative costs per unit of output.
💰 Financial Economies:
- Definition: Lower average costs of capital due to increased creditworthiness, leading to lower interest rates on loans.
- Example: A well-established technology company with a strong financial track record may secure lower interest rates on loans and bonds, reducing its overall cost of capital and improving profitability.
🌐 Risk-bearing Economies:
- Definition: Spreading risk across diversified products or markets, reducing the overall risk profile of the firm.
- Example: A diversified business operating in various sectors, such as energy, retail, and telecommunications, can mitigate sector-specific risks and economic downturns by balancing revenue streams from different industries.
External economies of scale
🏭 Ancillary Firms:
Definition: Support firms or suppliers that cluster near a larger industry to provide specialised goods or services, reducing costs and fostering collaboration.
Example: In Silicon Valley, numerous small companies provide specialised software and hardware components to tech giants like Apple and Google, benefiting from proximity and shared infrastructure.
🏙️ Agglomeration Economies:
Definition: Benefits gained from the concentration of related industries or firms in a specific geographic area, leading to synergies and efficiencies.
Example: The fashion district in New York City allows clothing designers, manufacturers, and retailers to share resources, attract skilled workers, and collaborate on trends, reducing costs and enhancing competitiveness.
🎓 Local Training Institutions:
Definition: Educational institutions located near an industry that offer specialised training programmes, reducing training costs and improving workforce skills.
Example: The presence of engineering colleges near automobile manufacturing hubs provides skilled engineers and technicians, reducing recruitment costs and enhancing industry-specific expertise.
🚗 Transportation Infrastructure:
Definition: Improved roads, ports, and public transport funded by local authorities, benefiting all businesses in an area by reducing transportation costs and improving logistics.
Example: The expansion of highways and rail networks near industrial parks in China facilitates the movement of goods, lowers distribution costs, and enhances supply chain efficiency.