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1. Costs – FC, VC, AC, MC

2. Short-Run Costs and Output Decisions You have seen that firms in perfectly competitive industries make three specific decisions.

3. Costs in the Short Run fixed cost Any cost that does not depend on the firms level of output. These costs are incurred even if the firm is producing nothing. There are no fixed costs in the long run. variable cost A cost that depends on the level of production chosen. total cost (TC) Fixed costs plus variable costs TC = TFC + TVC

4. Costs in the Short Run Fixed Costs Total Fixed Cost (TFC) total fixed costs (TFC) or overheads The total of all costs that do not change with output even if output is zero. Short-Run Fixed Cost (Total and Average) of a Hypothetical Firm £ (1) Q (2) TFC (3) AFC (TFC/Q) 0 1 2 3 4 5 1,000 1,000 1,000 1,000 1,000 1,000 1,000 500 333 250 200

5. Costs in the Short Run Fixed Costs Total Fixed Cost (TFC) Average fixed cost is simply total fixed cost divided by the quantity of output. As output increases, average fixed cost declines because we are dividing a fixed number (£1,000) by a larger and larger quantity. £ £

6. Costs in the Short Run Fixed Costs Average Fixed Cost (AFC) average fixed cost (AFC) Total fixed cost divided by the number of units of output; a per- unit measure of fixed costs. spreading overhead The process of dividing total fixed costs by more units of output. Average fixed cost declines as quantity rises.

7. Costs in the Short Run Variable Costs Total Variable Cost (TVC) total variable cost (TVC) The total of all costs that vary with output in the short run. total variable cost curve A graph that shows the relationship between total variable cost and the level of a firm’s output.

8. Costs in the Short Run Variable Costs Total Variable Cost (TVC) (9 x £2) + (6 x £1) = £24 (6 x £2) + (14 x £1) = £26 6 14 9 6 A B 3 units of output (7 x £2) + (6 x £1) = £20 (4 x £2) + (10 x £1) = £18 6 10 7 4 A B 2 units of output 4 6 (4 x £2) + (4 x £1) = £12 (2 x £2) + (6 x £1) = £10 4 2 A B 1 unit of output Total Variable Cost Assuming PK = £2, PL = £1 TVC = (K x PK) + (L x PL) Using Technique Units of Input Required (Production Function) K L Produce Derivation of Total Variable Cost Schedule from Technology and Factor Prices £

9. Costs in the Short Run Variable Costs Total Variable Cost (TVC) Total variable cost is derived from production requirements and input prices. A total variable cost curve expresses the relationship between TVC and total output. £

10. Costs in the Short Run Variable Costs Marginal Cost (MC) marginal cost (MC) The increase in total cost that results from producing 1+ more unit of output. Marginal costs reflect changes in variable costs. Derivation of Marginal Cost from Total Variable Cost Units of Output Total Variable Costs (£) Marginal Costs (£) 0 1 2 3 0 10 18 24 10 8 6

11. Costs in the Short Run Variable Costs The Shape of the Marginal Cost Curve in the Short Run In the short run, every firm is constrained by some fixed factor of production. A fixed factor implies diminishing returns (declining marginal product) and a limited capacity to produce. As that limit is approached, marginal costs rise. £

12. Costs in the Short Run Variable Costs The Shape of the Marginal Cost Curve in the Short Run In the short run, every firm is constrained by some fixed input that (1) leads to diminishing returns to variable inputs and (2) limits its capacity to produce. As a firm approaches that capacity, it becomes increasingly costly to produce successively higher levels of output. Marginal costs ultimately increase with output in the short run.

13. Costs in the Short Run Variable Costs Graphing Total Variable Costs and Marginal Costs Total variable costs always increase with output. Marginal cost is the cost of producing each additional unit. Thus, the marginal cost curve shows how total variable cost changes with single- unit increases in total output. ££

14. Costs in the Short Run Variable Costs Average Variable Cost (AVC) average variable cost (AVC) Total variable cost divided by the number of units of output.

15. Costs in the Short Run Variable Costs Average Variable Cost (AVC) Short-Run Costs of a Hypothetical Firm £ (1) q (2) TVC (3) MC (ÄTVC) (4) AVC (TVC/q) (5) TFC (6) TC (TVC + TFC) (7) AFC (TFC/q) (8) ATC (TC/q or AFC + AVC) 0 0 1,000 1,000 1 10 10 10 1,000 1,010 1,000 1,010 2 18 8 9 1,000 1,018 500 509 3 24 6 8 1,000 1,024 333 341 4 32 8 8 1,000 1,032 250 258 5 42 10 8.4 1,000 1,042 200 208.4 500 8,000 20 16 1,000 9,000 2 18

16. Costs in the Short Run Variable Costs Graphing Average Variable Costs and Marginal Costs When marginal cost is below average cost, average cost is declining. When marginal cost is above average cost, average cost is increasing. Rising marginal cost intersects average variable cost at the minimum point of AVC. £

17. Costs in the Short Run Total Costs Adding TFC to TVC means adding the same amount of total fixed cost to every level of total variable cost. Thus, the total cost curve has the same shape as the total variable cost curve; it is simply higher by an amount equal to TFC. £

18. Costs in the Short Run Total Costs Average Total Cost (ATC) average total cost (ATC) Total cost divided by the number of units of output.

19. Costs in the Short Run Total Costs Average Total Cost (ATC) To get average total cost, we add average fixed and average variable costs at all levels of output. Because average fixed cost falls with output, an ever-declining amount is added to AVC. Thus, AVC and ATC get closer together as output increases, but the two lines never meet. ££ £10 £10 £2.50 £2.50

20. Costs in the Short Run Total Costs The Relationship Between Average Total Cost and Marginal Cost The relationship between average total cost and marginal cost is exactly the same as the relationship between average variable cost and marginal cost. If marginal cost is below average total cost, average total cost will decline toward marginal cost. If marginal cost is above average total cost, average total cost will increase. As a result, marginal cost intersects average total cost at ATC’s minimum point, for the same reason that it intersects the average variable cost curve at its minimum point.

21. Costs in the Short Run Short-Run Costs: A Review A Summary of Cost Concepts Term Definition Equation Accounting costs Out-of-pocket costs or costs as an accountant would define them. Sometimes referred to as explicit costs. Economic costs Costs that include the full opportunity costs of all inputs. These include what are often called implicit costs. Total fixed costs Costs that do not depend on the quantity of output produced. These must be paid even if output is zero. TFC Total variable costs Costs that vary with the level of output. TVC Total cost The total economic cost of all the inputs used by a firm in production. TC = TFC + TVC Average fixed costs Fixed costs per unit of output. AFC = TFC/q Average variable costs Variable costs per unit of output. AVC = TVC/q Average total costs Total costs per unit of output. ATC = TC/q ATC = AFC + AVC Marginal costs The increase in total cost that results from producing 1 additional unit of output. MC = ÄTC/Äq