2. All inputs have a cost
Premises must be Fixed factors of
rented or purchased, production have fixed
often using a mortgage costs. In other words, the
which has to be paid cost does not vary in the
back. short-term as output
changes.
Variable factors of
Equipment must also be
production have variable
rented or purchased. It
costs. In other words, the
also costs money to
cost changes as output
maintain the equipment
changes.
and power to run it.
Which of the factors on
the left are fixed and
Workers must be which are variable?
paid a wage..
3. Total Costs
The total cost of production at a particular level of output can be
calculated by working out the total fixed costs and adding the
total variable cost of production.
Total Cost = Total Fixed Cost + Total Variable Cost
TC=FC+VC
To understand the effect of changing levels of output on the
productivity of the firm we often look at the average cost per
unit. This can be calculated by dividing the cost by the number
of units produced.
Average Total Cost = Average Fixed Cost + Average Variable Cost
ATC=AFC+AVC
4. Fixed Costs
Costs (£)
Fixed costs, such as rent payments,
are incurred even if a firm
TFC
produces nothing. As production
increases, in the short-run these
costs remain the same. Shown on
a graph (left) the TFC line is
horizontal.
0
Output If we consider a firm which produces
Costs (£) only one unit in a period of time,
this single unit would bear the full
fixed cost. As production
increases, the fixed costs are
shared amongst more units and
the AFC falls rapidly at first,
AFC
reaching and sustaining a very
low level at higher levels of
0
Output output (as shown in the lower left-
hand graph).
5. Variable and Marginal Costs
Output Variable costs include factors such as
Average and marginal product
labour which vary as production levels
change. However, the change is not
directly proportional to output.
As production levels rise, increasing
marginal returns occur due to the
division of labour. Eventually,
MP AP
0
diminishing marginal returns occur as
Costs (£)
Workers
the variable factor of production (e.g.
Average and marginal cost labour) increases in relation to the
fixed factor (e.g. capital). Therefore,
MC the average and marginal costs
AVC
incurred as output levels increase
falls to begin with, before rising as
marginal returns diminish.
The average and marginal cost curves
0 Q1 Q2
Output therefore mirror the average and
6. Average Total Costs
Adding AFC to AVC to obtain the ATC curve
Remember the rule:
Costs (£)
ATC = AFC + AVC
Thus the ATC curve is the total of the
AFC and AVC curves. MC ATC
AVC
The ATC curve is U-shaped. At first,
ATC falls due to two effects;
●
Falling average fixed costs as
these are shared between more AFC
units 0 Q1 Q2
Output
●
Falling marginal costs due to
division of labour Note that the MC curve
intersects the AVC and ATC
●
The ATC curve begins to rise as curves at their lowest points.
diminishing marginal returns
outweighs the effects of continued
falls in AFC.
7. Summary
A simplified cost diagram for a firm.
●
TC = TFC + TVC
Costs (£)
●
ATC = AFC + AVC
●
AFC falls as fixed costs are shared MC
between more units of output ATC
●
Variable, and therefore marginal,
costs fall due to increasing
marginal returns then rise due to
increasing marginal returns
AFC
●
The U-shaped ATC curve is the 0 Q1 Q2
sum of the AFC and AVC curves Output
It is usual to show only the ATC
●
ATC falls due to falling AFC and and MC curves when constructing
AVC, then rises as diminishing models of firm's revenues and
marginal returns 'pulls up' costs costs. However, it is important to
despite continued decreases in know how the ATC curve is
AFC derived.
