Students should be able to: Illustrate and perform simple calculations using total cost; total fixed cost; total variable cost; average total cost; average fixed cost; average variable cost and marginal cost. Draw and interpret cost curves; distinguish between short run and long run costs; and explain the shape of the average cost curve in terms of diminishing marginal returns and economies of scale.

1. How can we calculate the costs of a firm?
Topic 3.3.4

2. How can we calculate the costs of a firm?
Topic 3.3.4
Students should be able to:
• Illustrate and perform simple calculations using total cost;
total fixed cost; total variable cost; average total cost;
average fixed cost; average variable cost and marginal cost.
• Draw and interpret cost curves; distinguish between short
run and long run costs; and explain the shape of the average
cost curve in terms of diminishing marginal returns and
economies of scale.

3. Key Concepts – Short Run Costs
Average Cost
Total cost per unit of output = Total cost /
output = TC/Q
Average Fixed Cost
Total fixed cost per unit of output =
TFC/Q
Average Variable Cost
Total variable cost per unit of output =
TVC/Q
Diminishing Returns
Addition of a variable factor to a fixed
factor results in a fall in marginal product
Fixed Cost
Business expense that does not vary
directly with the level of output
Marginal cost
The change in total costs from increasing
output by one extra unit

4. Google and Apple’s RevenueReminder of the Factors of Production
Factors of production are the inputs available to supply goods and
services in markets and industries.
Land Labour
Enterprise Capital
Natural resources
available for
production
The human input
into the production
process
Goods used in the
supply of other
products e.g. tech
Entrepreneurs
organise factors of
production and
take risks

5. Short Run
• At least one of the
factor inputs is fixed
(usually this is capital
but can also be land)
Long Run
• All factors of production
are variable and the
scale of production can
also change
The Short Run and the Long Run
The length of the short run will vary by industry

6. Consulting fees Rental Costs
Marketing Budgets Research Projects
Google and Apple’s RevenueFixed Costs

7. Fixed costs do not change as output
varies in the short run
Fixed cost has to be paid, whatever the
level of sales achieved
The higher the level of fixed costs in a
business, the higher must be the
achieved output in order to break-even
Google and Apple’s RevenueFixed Costs

8. Commission Bonuses Wage Costs
Component parts Basic raw materials
Google and Apple’s RevenueVariable Costs

9. Costs that relate directly to the production
or sale of a product
Increase in short run output (Q) will cause
total variable cost to rise (TVC)
Average variable cost = total variable cost /
output (TVC?Q)
Variable cost is determined by marginal cost
of extra units
Google and Apple’s RevenueVariable Costs

10. Output Total Fixed
Cost (£)
Total
Variable
Cost (£)
Total Cost
(£)
0 2000 0 2000
50 2000 500 2500
100 2000 700 2700
150 2000 850 2850
200 2000 1000 3000
250 2000 1250 3250
300 2000 1900 3900
350 2000 2550 4550
400 2000 3600 5600
Google and Apple’s RevenueCalculating Total Cost
Total cost = total fixed cost + total variable cost

11. Output Total Fixed
Cost (£)
Total
Variable
Cost (£)
Total Cost
(£)
Average
Total Cost
(£)
0 2000 0 2000
50 2000 500 2500 50
100 2000 700 2700 27
150 2000 850 2850 19
200 2000 1000 3000 15
250 2000 1250 3250 13
300 2000 1900 3900 13
350 2000 2550 4550 13
400 2000 3600 5600 14
Look at what is
happening to
average cost
Google and Apple’s RevenueCalculating Average Total Cost
Average cost = total cost / output

12. Output Total Cost
(£)
Average
Total Cost
(£)
Marginal
Cost (£)
0 2000
50 2500 50 10
100 2700 27 7
150 2850 19 3
200 3000 15 3
250 3250 13 5
300 3900 13 13
350 4550 13 13
400 5600 14 21
Google and Apple’s RevenueCalculating Marginal Cost
Marginal cost is the change in total cost from producing one extra unit of output

13. Output Total Cost
(£)
Average
Total Cost
(£)
Marginal
Cost (£)
0 2000
50 2500 50 10
100 2700 27 7
150 2850 19 3
200 3000 15 3
250 3250 13 5
300 3900 13 13
350 4550 13 13
400 5600 14 21
MC < AC; AC falling
MC < AC; AC falling
MC < AC; AC falling
MC < AC; AC falling
MC < AC; AC falling
MC = AC; AC constant
MC = AC; AC constant
MC > AC; AC rising
Google and Apple’s RevenueChanging Marginal Cost as Output Rises

14. Output Total Fixed
Cost (£)
Average
Fixed Cost
(£)
0 2000
50 2000 40
100 2000 20
150 2000
200 2000 10
250 2000
300 2000
350 2000
400 2000 5
Google and Apple’s RevenueTotal and Average Fixed Cost

15. Output Total Fixed
Cost (£)
Average
Fixed Cost
(£)
0 2000
50 2000 40
100 2000 20
150 2000
200 2000 10
250 2000
300 2000
350 2000
400 2000 5
Total fixed costs remain constant at each
level of output in the short run
Output (Q)
Cost
TFC
£2000
AFC
As output expands in the short run, the
overhead costs per unit will fall
Output
= 1 unit
Google and Apple’s RevenueAverage Fixed Cost Falls as Output Rises

16. Total, Average and Marginal Product
• Total product (total output). In manufacturing
industries such as motor vehicles, it is
straightforward to measure how much output is
being produced. In service or knowledge industries,
where output is less “tangible” it is harder to
measure productivity.
• Average product measures output per-worker-
employed or output-per-unit of capital.
• Marginal product is the change in output from
increasing the number of workers used by one
person, or by adding one more machines to the
production process in the short run

17. Short Run Production Function
• The short run is a time period where at least one
factor of production is in fixed supply
• A business has chosen its scale of production and
sticks with this in the short run time period
• We assume that the quantity of plant and
machinery is fixed and that production can be
altered by changing variable inputs such as
labour, raw materials and energy
• Hence in the short run we make a distinction
between fixed and variable costs of production

18. (Short Run) Law of Diminishing Returns
• In the short run at least one factor of production
is fixed (normally capital, but can also be land)
• The law of diminishing returns states that as
more units of a variable input are added to fixed
amounts of land and capital, the change in total
output will first rise and then fall
• Diminishing returns to labour occurs when
marginal product of labour starts to fall.
• This means that total output will be increasing at
a decreasing rate

19. MCCost
Output
Rising MC due to
diminishing returns in
the short run
Google and Apple’s RevenueThe Shape of Short Run Marginal Cost

20. MCCost
Output
AC
AC will fall
when
MC < AC
Average cost is at a
minimum when it is
intersected by the
MC curve
Google and Apple’s RevenueMarginal Cost and Average Total Cost

21. MCCost
Output
AC
AC will fall
when
MC < AC
Average cost is at a
minimum when it is
intersected by the
MC curve
AC will rise
when
MC > AC
Google and Apple’s RevenueMarginal Cost and Average Total Cost

22. MCCost
Output
AC
AVC
MC also cuts AVC
curve at min of AVC
Google and Apple’s RevenueMC, AC and Average Variable Cost (AVC)

23. MCCost
Output
AC
AVC
AFC
AFC will fall as
the level of
output
expands
MC also cuts AVC
curve at min of AVC
Google and Apple’s RevenueMC, AC and Average Fixed Cost (AFC)
Average fixed costs must fall continuously as output
increases because total fixed costs are being spread
over a higher level of production.

24. MCCost
Output
AC
AVC
Google and Apple’s RevenueThe Family of Short Run Cost Curves

25. MCCost
Output
AC1
AVC
AC2
Google and Apple’s RevenueShowing a Rise in Fixed Costs
A change in fixed costs has no effect on marginal
costs. Marginal costs relate only to variable costs!

26. MC1Cost
Output
AC1
MC2
AC2
Google and Apple’s RevenueShowing a Rise in Variable Costs
A rise in variable costs of production leads to an
upward shift both in marginal and average total cost

27. 1. Changes in the unit costs of production
– Lower unit costs mean that a business can supply more at each
price – for example higher productivity
– Higher unit costs cause an inward shift of supply e.g. a rise in
wage rates or an increase in energy prices / other raw materials
2. A fall (depreciation) in the exchange rate causes an increase in
prices of imported components and raw materials –
3. Advances in production technologies – outward shift of supply
4. The entry of new producers into the market – outward shift
5. Favourable weather conditions e.g. for agricultural products
6. Taxes, subsidies and government regulations
– Indirect taxes cause an inward shift of supply
– Subsidies cause an outward shift of supply
– Regulations increase costs – causing an inward shift of supply
Google and Apple’s RevenueKey Factors causing Supply Shifts

28. Source: DEFRA * data for May 2015
65.02
79.32 80.3
67.43
78.88
120.97
137.87
107.05
123.76
169.17
179.26 175.95
143.06
127.15
0
20
40
60
80
100
120
140
160
180
200
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015*
Pricepertonnein£s
Falling wheat prices will cause a reduction in the resource costs for food
manufacturers such as cereal producers. If other factors remain constant,
producers who use wheat will see an outward shift of supply
Google and Apple’s RevenueWheat prices – a variable cost for firms

29. Google and Apple’s RevenueCarbon Prices and Variable Costs
• The UK has a Carbon Price Floor
which applies to fossil fuels used
for electricity generation
• The minimum price for carbon
emissions is designed to provide
a stable carbon price signal as a
way of internalising externalities
• The minimum Carbon Price Floor
started at £16/tCO2 in 2013
• In 2014 the UK government
announced a cap of £18/tCO2
from 2016 until 2020
• Carbon prices within the EU
emissions trading system have
been highly volatile in recent
years and currently are very low
Arguments for a carbon price floor
• Reduces the risks, and thus costs, of
investing in low carbon projects
• Helps to reduce carbon price
volatility – sends signal to polluters
• Makes low carbon electricity more
competitive – boost to renewables
Arguments against a carbon price floor
• Restrict supply of carbon permits to
increase the free market price
• A carbon tax is a better alternative
and raises useful tax revenues
• Price floor set high might damage
international competitiveness

30. Google and Apple’s RevenueThe Living Wage and Business Costs
• Living Wage Foundation (LWF)
• The LWF living wage is an hourly
rate of pay set annually by reference
to the basic cost of living in the UK
and London.
• The current living wage is £7.85 per
hour outside London and £9.15 per
hour in London – employers can
voluntarily pay it – many do!
• Government National Living Wage
• The NLW applies to workers aged 25
and over and will be introduced at
an initial rate of £7.20 per hour
from April 2016. It effectively takes
the place of the National Minimum
Wage for workers aged 25 and over. 0
1
2
3
4
5
6
7
8
9
2011 2012 2013 2014 2015
Wageperhourin£s
Living wage Minimum wage

31. How can we calculate the costs of a firm?
Topic 3.3.4