This topic explores how firms measure and interpret their costs of production using key cost concepts and graphical analysis of cost curves.
Key cost definitions and calculations
Understanding the different types of costs and how they are calculated is essential for analysing the production decisions of firms. Costs can be classified in several ways depending on whether they change with output, how they behave over time, and how they influence pricing and profitability.
Total cost (TC)
Total cost represents the overall expenditure a firm incurs in the process of producing a given quantity of goods or services. It includes all fixed and variable components.
Definition: The complete cost of production for a specific level of output.
Formula:
Total Cost (TC) = Total Fixed Cost (TFC) + Total Variable Cost (TVC)
A firm must account for both fixed and variable expenses to calculate total cost. TC increases as output increases because variable costs rise with higher production.
Total fixed cost (TFC)
Total fixed cost refers to costs that do not vary with the level of output. These are the overhead costs that a firm must pay regardless of whether it produces anything.
Definition: Costs that remain constant irrespective of the firm’s level of output.
Examples: Office rent, insurance, salaries of permanent administrative staff, depreciation on machinery.
Even if output is zero, a firm still incurs fixed costs. This makes TFC particularly important in the short run.
Total variable cost (TVC)
Total variable cost represents the costs that vary directly with the level of output. As a firm increases production, it requires more inputs like raw materials and labour, which increases TVC.
Definition: Costs that change as output changes.
Examples: Costs of raw materials, wages of part-time or hourly workers, electricity used in manufacturing.
When no goods are produced, TVC is zero. As output rises, TVC increases steadily or sometimes at an increasing rate due to diminishing returns.
Average cost (AC)
Average cost helps firms assess the cost per unit of output, which is useful for pricing and profitability analysis.
Definition: The cost per unit of output produced.
Formula:
Average Cost (AC) = Total Cost (TC) divided by Quantity (Q)
AC = TC / Q
AC provides insight into efficiency. If a firm can reduce AC by producing more, it benefits from economies of scale.
Average fixed cost (AFC)
Average fixed cost represents how much of the fixed cost is allocated to each unit of output.
Definition: Fixed cost per unit of output.
Formula:
Average Fixed Cost (AFC) = Total Fixed Cost (TFC) divided by Quantity (Q)
AFC = TFC / Q
AFC always decreases as output increases, since the same fixed cost is spread over a larger number of units. This creates a curve that continually slopes downward and never touches the horizontal axis.
Average variable cost (AVC)
Average variable cost shows how much of the variable cost is assigned to each unit of output.
Definition: Variable cost per unit of output.
Formula:
Average Variable Cost (AVC) = Total Variable Cost (TVC) divided by Quantity (Q)
AVC = TVC / Q
AVC initially falls due to increasing marginal productivity, but it eventually rises due to diminishing marginal returns.
Marginal cost (MC)
Marginal cost is a critical concept for firms making production decisions. It indicates the cost of producing one additional unit of output.
Definition: The additional cost incurred from producing one extra unit.
Formula:
Marginal Cost (MC) = Change in Total Cost (ΔTC) divided by Change in Output (ΔQ)
MC = ΔTC / ΔQ
MC plays a key role in profit maximisation and determines whether producing an extra unit will increase or decrease profits.
Interpretation of short-run cost curves
Short-run cost curves illustrate how different types of costs behave when at least one factor of production is fixed. The short run is defined as a time period in which certain inputs, typically capital, cannot be changed.
Shape and behaviour of key cost curves
Marginal cost (MC):
U-shaped curve.
Falls at first due to increasing marginal returns.
Rises sharply due to diminishing marginal returns.
Average variable cost (AVC):
U-shaped like the MC curve but flatter.
Initially falls, then rises as marginal cost increases.
Lies below the AC curve.
Average fixed cost (AFC):
Continuously falls as output increases.
Curve is downward-sloping and asymptotic to the horizontal axis.
Average cost (AC):
U-shaped.
Combines AFC and AVC, so initially falls as both AFC and AVC fall.
Rises when AVC starts to rise and outweighs the falling AFC.
Intersections of curves
MC intersects AVC and AC at their minimum points.
This happens because when MC is less than AVC or AC, it pulls the average down.
When MC is greater than AVC or AC, it pushes the average up.
These intersections are critical for understanding optimal production points.
Real-world significance
Understanding these relationships allows firms to decide whether increasing output is cost-effective.
For example, a firm should continue increasing production if MC is below price, since each additional unit adds to profit.
The law of diminishing marginal productivity
The law of diminishing marginal productivity is the principle that explains the rising portion of the marginal and average cost curves.
Explanation of the law
As more units of a variable input (such as labour) are added to a fixed input (such as capital or land), the additional output produced by each new worker eventually starts to decrease.
Initially, additional workers may improve productivity due to specialisation and division of labour.
However, after a certain point, overcrowding or overuse of the fixed input causes efficiency to decline.
Effect on costs
The declining marginal productivity means that more inputs are required to produce each additional unit.
This causes marginal cost to rise, leading to the upward-sloping part of the MC curve.
It also causes AVC and AC to rise when the increase in marginal cost becomes significant.
Importance for production decisions
Firms must be aware of the output level at which diminishing returns set in.
Beyond this point, producing additional output becomes less efficient, raising costs and potentially reducing profits.
The long-run average cost (LRAC) curve
In the long run, all factors of production are variable. Firms can change the scale of all inputs, such as building larger factories, purchasing more machinery, or hiring more staff. The LRAC curve illustrates the cost behaviour when firms operate without any fixed constraints.
Characteristics of the LRAC curve
Definition: The LRAC curve shows the lowest possible average cost of production at each level of output when all inputs are variable.
Shape: Typically U-shaped due to economies and diseconomies of scale.
Unlike SRAC curves, LRAC does not reflect fixed costs since all inputs are adaptable.
Envelope curve formation
The LRAC is constructed as an envelope of multiple short-run average cost (SRAC) curves.
Each SRAC corresponds to a specific plant size or level of capital.
The LRAC curve touches each SRAC at its lowest point, representing the most efficient level of output for each short-run setup.
Firms operating in the long run can move along the LRAC by changing their scale of operations.
Economies and diseconomies of scale
The shape of the LRAC curve is influenced by changes in scale:
Economies of scale: As a firm increases production, it may benefit from cost savings due to factors like specialisation, bulk purchasing, and better use of capital. This causes the downward-sloping part of the LRAC curve.
Diseconomies of scale: At higher levels of output, the firm may face rising costs due to communication breakdowns, managerial inefficiencies, and decreased motivation. This leads to the upward-sloping part of the LRAC curve.
Minimum efficient scale (MES)
Definition: The lowest output level at which a firm can produce at the minimum point of the LRAC curve.
Beyond the MES, the firm operates at constant returns to scale.
Reaching MES allows firms to produce efficiently and compete effectively, especially in industries with high fixed costs.
Comparing short-run and long-run cost curves
Understanding the differences between short-run and long-run cost curves helps firms plan both tactical and strategic decisions.
Short-run average cost (SRAC)
In the short run, firms are restricted by fixed factors.
SRAC curves are U-shaped due to the influence of diminishing returns.
Firms operate on a single SRAC curve depending on their current plant size and fixed capital.
Long-run average cost (LRAC)
In the long run, firms can alter all inputs and change scale.
The LRAC curve reflects the lowest cost across all SRAC curves.
It allows firms to assess the best scale of production to minimise cost per unit.
Strategic applications
A firm currently operating on a SRAC that lies above the LRAC could benefit from expanding or contracting its scale of production.
Choosing the right point on the LRAC is crucial for long-term efficiency.
Large firms aim to produce at or just above the MES to stay competitive and reduce per-unit costs.
Diagrammatic understanding
The LRAC lies below the SRAC curves because it reflects the minimum cost attainable through optimal input combinations.
When plotted together, SRAC curves appear as small U-shaped curves that the LRAC tangentially touches.
Each tangency point on the LRAC corresponds to the most efficient level of output for a given plant size.
These distinctions between short-run and long-run cost behaviour are essential for making informed decisions about investment, scaling, and resource allocation. Understanding how and why costs behave in these different time frames enables firms to enhance their productive efficiency and maximise profitability.
FAQ
Marginal cost (MC) initially falls due to increasing marginal returns, where additional units of a variable input (like labour) contribute more to total output than the previous units. This happens because of improved specialisation, more efficient use of fixed inputs, and the benefits of teamwork. Workers can divide tasks, use machinery more effectively, and reduce idle time, which lowers the additional cost of producing each unit. However, this only continues up to a certain point. As more variable inputs are added to fixed factors, diminishing marginal returns set in. Fixed capital becomes overused, overcrowding occurs, and workers may get in each other’s way, leading to inefficiencies. At this stage, each additional unit of input adds less output than before, so more inputs are needed to produce the same increase in output. This drives marginal cost upwards, creating the U-shape in the MC curve. The turning point represents the output level at which marginal returns begin to diminish.
Average fixed cost (AFC) can become very small but never reaches zero. This is because total fixed cost (TFC) is a constant value that must be paid regardless of output. As output increases, AFC is calculated by dividing the same TFC by a larger quantity of output (Q). Mathematically, AFC = TFC / Q. So, while Q increases, AFC continues to decline, but it will never become exactly zero unless output becomes infinitely large, which is not practically possible. The AFC curve approaches the horizontal axis asymptotically — it gets closer and closer but never touches or crosses it. Even if a firm produces thousands or millions of units, there will still be a tiny fraction of fixed cost assigned to each unit. This declining AFC is one reason average cost (AC) initially falls in the short run. The behaviour of AFC is important when understanding cost structures, especially for firms producing at large scale.
Marginal cost (MC) and marginal product of labour (MPL) are inversely related in the short run. As marginal product increases, marginal cost decreases, and vice versa. This relationship is rooted in how much extra output is generated by adding an additional unit of labour, and how that affects the cost of producing extra output. If each new worker adds a large amount to total output (i.e. high MPL), the cost of producing one more unit falls (i.e. low MC), because the output gain outweighs the wage cost. This occurs in the phase of increasing returns. However, when diminishing marginal productivity sets in, each additional worker adds less output than the one before, so the firm has to employ more labour (and incur higher costs) to get the same additional output. This drives marginal cost up. Therefore, the point at which MPL starts to decline is the same point at which MC begins to rise, marking a critical threshold in production efficiency.
The long-run average cost (LRAC) curve is flatter than short-run average cost (SRAC) curves because firms have full flexibility to adjust all inputs in the long run. In the short run, at least one factor (typically capital) is fixed, which limits the firm’s ability to optimise its input mix, leading to steeper cost changes as output varies. The SRAC curves are more sensitive to output changes because they reflect fixed limitations that can cause inefficiencies. By contrast, the LRAC is formed by selecting the most efficient point from each SRAC curve, effectively “smoothing out” inefficiencies and fluctuations. Firms can build new plants, scale operations, and reorganise production entirely in the long run. This allows them to produce at lower average costs over a wider range of outputs. As a result, the LRAC tends to have a gentle U-shape that reflects gradual economies and diseconomies of scale, rather than the sharper changes seen in SRACs.
Cost curves are essential tools in business decision-making, helping firms assess efficiency, pricing strategies, output levels, and long-term planning. In the short run, marginal cost (MC) and average cost (AC) curves guide production decisions by showing the most efficient output level and where profits can be maximised. The point where marginal cost equals marginal revenue (MC = MR) indicates the profit-maximising output. Firms also monitor the relationship between MC and AC to avoid rising costs that erode profits. In the long run, the long-run average cost (LRAC) curve helps firms decide the optimal scale of production. By analysing where the LRAC is lowest, a firm can determine its minimum efficient scale (MES) and expand or contract its operations accordingly. Cost curves also influence pricing: understanding how costs change with output allows firms to forecast profits under different demand scenarios. Moreover, in competitive markets, efficient cost management shown by these curves is crucial for survival and growth.
Practice Questions
Explain, using a diagram, why the short-run average cost curve is typically U-shaped.
The short-run average cost (AC) curve is typically U-shaped due to the law of diminishing marginal productivity. Initially, as more variable inputs are added to fixed inputs, efficiency improves, lowering average costs. However, beyond a certain point, diminishing returns set in, increasing variable costs and pushing AC upward. The falling section reflects increasing returns to the variable factor, while the rising part shows decreasing returns. The curve reaches its minimum where marginal cost (MC) intersects AC from below. This point represents the most efficient level of output in the short run before diseconomies dominate.
Distinguish between the short-run average cost (SRAC) curve and the long-run average cost (LRAC) curve.
The SRAC curve reflects cost per unit when at least one input is fixed, typically capital. It is U-shaped due to diminishing marginal returns. Each SRAC represents a specific scale of production. In contrast, the LRAC curve is derived as an envelope of all possible SRACs, assuming all inputs are variable. It shows the lowest possible cost for any output level in the long run and is shaped by economies and diseconomies of scale. While SRAC curves are constrained by current capacity, the LRAC curve allows firms to adjust scale for optimal efficiency across time horizons.
