Costs of productionFixed and variable costsFixed costs are those that do not vary with output and typically include rents, insurance, depreciation, set-up costs, and normal profit. They are also called overheads. Show
Variable costs are costs that do vary with output, and they are also called direct costs. Examples of typical variable costs include fuel, raw materials, and some labour costs. Try a quiz on costsAn exampleConsider the following hypothetical example of a boat building firm. The total fixed costs, TFC, include premises, machinery and equipment needed to construct boats, and are £100,000, irrespective of how many boats are produced. Total variable costs (TVC) will increase as output increases.
Plotting this gives us Total Cost, Total Variable Cost, and Total Fixed Cost. Total fixed costsGiven that total fixed costs (TFC) are constant as output increases, the curve is a horizontal line on the cost graph. Total variable costsThe total variable cost (TVC) curve slopes up at an accelerating rate, reflecting the law of diminishing marginal returns. Total costsThe total cost (TC) curve is found by adding total fixed and total variable costs. Its position reflects the amount of fixed costs, and its gradient reflects variable costs. Average fixed costsAverage fixed costs are found by dividing total fixed costs by output. As fixed cost is divided by an increasing output, average fixed costs will continue to fall.
The average fixed cost (AFC) curve will slope down continuously, from left to right. Average variable costsAverage variable costs are found by dividing total fixed variable costs by output.
The average variable cost (AVC) curve will at first slope down from left to right, then reach a minimum point, and rise again. AVC is ‘U’ shaped because of the principle of variable Proportions, which explains the three phases of the curve:
Average total costAverage total cost (ATC) is also called average cost or unit cost. Average total costs are a key cost in the theory of the firm because they indicate how efficiently scarce resources are being used. Average variable costs are found by dividing total fixed variable costs by output.
Average total cost (ATC) can be found by adding average fixed costs (AFC) and average variable costs (AVC). The ATC curve is also ‘U’ shaped because it takes its shape from the AVC curve, with the upturn reflecting the onset of diminishing returns to the variable factor. Areas for total costsTotal Fixed costs and Total Variable costs are the respective areas under the Average Fixed and Average Variable cost curves. Marginal costsMarginal cost is the cost of producing one extra unit of output. It can be found by calculating the change in total cost when output is increased by one unit.
It is important to note that marginal cost is derived solely from variable costs, and not fixed costs. The marginal cost curve falls briefly at first, then rises. Marginal costs are derived from variable costs and are subject to the principle of variable proportions. The significance of marginal costThe marginal cost curve is significant in the theory of the firm for two reasons:
ATC and MCAverage total cost and marginal cost are connected because they are derived from the same basic numerical cost data. The general rules governing the relationship are:
Total costs and marginal costsMarginal costs are derived exclusively from variable costs, and are unaffected by changes in fixed costs. The MC curve is the gradient of the TC curve, and the positive gradient of the total cost curve only exists because of a positive variable cost. This is shown below: Sunk costsSunk costs are those that cannot be recovered if a firm goes out of business. Examples of sunk costs include spending on advertising and marketing, specialist machines that have no scrap value, and stocks which cannot be sold off. Sunk costs are a considerable barrier to entry and exit. Test your knowledge with a quizPress Next to launch the quizYou are allowed two attempts – feedback is provided aftereach question is attempted. When average total cost is falling marginal cost must be?When marginal cost is less than average variable or average total cost, AVC or ATC must be decreasing. When marginal cost is greater than average variable or average total cost, AVC or ATC must be increasing.
When average cost is falling marginal cost curve the average cost curve?The marginal cost curve intersects both the average variable cost curve and (short-run) average total cost curve at their minimum points. When the marginal cost curve is above an average cost curve the average curve is rising. When the marginal costs curve is below an average curve the average curve is falling.
What is the relationship between marginal cost and average total cost curve?The relationship between the marginal cost and average cost is the same as that between any other marginal-average quantities. When marginal cost is less than average cost, average cost falls and when marginal cost is greater than average cost, average cost rises.
Can average costs fall when marginal cost is rising?Average cost will be neither decreasing nor increasing when marginal cost at a given quantity is equal to average cost at that quantity.
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