Short run cost theory


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Short run cost theory

  1. 1. Short-run Cost Theory
  2. 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. 3. Total CostsThe 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+VCTo 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. 4. Fixed CostsCosts (£) 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 producesCosts (£) 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. 5. Variable and Marginal CostsOutput 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 asCosts (£) 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. 6. Average Total Costs Adding AFC to AVC to obtain the ATC curveRemember the rule: Costs (£)ATC = AFC + AVCThus the ATC curve is the total of the AFC and AVC curves. MC ATC AVCThe 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. 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 firms 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.