Costs (Edexcel A Level Economics A): Revision Note

The Relationships Between Different Types of Costs

• Fixed costs are costs that do not change as the level of output changes

  • These have to be paid whether output is zero or 5000 

    • e.g. building rent, management salaries, insurance, bank loan repayments etc

• Variable costs are costs that vary directly with output

  • These increase as output increases and vice versa

    • E.g. raw material costs, wages of workers directly involved in production

• Marginal cost is the cost of producing an additional unit of output

Cost calculations

Based on the above definitions, we can calculate several different types of costs

1. $\mathrm{Total}\mathrm{costs}\left(\mathrm{TC}\right)=\mathrm{total}\mathrm{fixed}\mathrm{costs}\left(\mathrm{TFC}\right)+\mathrm{total}\mathrm{variable}\mathrm{costs}\left(\mathrm{TVC}\right)$
   

2. $\mathrm{Total}\mathrm{variable}\mathrm{cost}\left(\mathrm{TVC}\right)=\mathrm{variable}\mathrm{cost}\left(\mathrm{VC}\right)\times \mathrm{quantity}\left(\mathrm{Q}\right)$
   

3. $\mathrm{Average}\mathrm{total}\mathrm{cost}\left(\mathrm{AC}\right)=\frac{\mathrm{total}\mathrm{cost}\left(\mathrm{TC}\right)}{\mathrm{quantity}\left(\mathrm{Q}\right)}$
   

4. $\mathrm{Average}\mathrm{fixed}\mathrm{cost}\left(\mathrm{AFC}\right)=\frac{\mathrm{Total}\mathrm{fixed}\mathrm{costs}\left(\mathrm{TFC}\right)}{\mathrm{quantity}\left(\mathrm{Q}\right)}$
   

5. $\mathrm{Average}\mathrm{variable}\mathrm{cost}\left(\mathrm{AVC}\right)=\frac{\mathrm{Total}\mathrm{variable}\mathrm{costs}\left(\mathrm{TVC}\right)}{\mathrm{quantity}\left(\mathrm{Q}\right)}$
   

6. $\mathrm{Marginal}\mathrm{cost}\left(\mathrm{MC}\right)=\frac{∆\mathrm{in}\mathrm{total}\mathrm{cost}\left(\mathrm{TC}\right)}{∆\mathrm{in}\mathrm{quantity}\left(\mathrm{Q}\right)}$

Cost Calculations Using the Above Formulas

Short-run Cost Curves

Concepts That Help to Provide Understanding of How the Cost Curves Are Derived

• In the short-run, the shapes of the cost curves (AC, AVC and MC) are determined by the law of diminishing marginal productivity
  

Diagram analysis

• A small food van selling burgers (product) at a music festival increases productivity up to the addition of a third worker

• After that, workers get in each other's way and there is not enough grill space (capital) so MP no longer increases

• If more workers are hired, then the MP of each additional worker begins to fall

• Adding additional workers up to the 7th worker will keep increasing the total product

• With the hiring of the 7th worker, the MP turns negative, which will decrease the total product

Connection between diminishing marginal returns and the cost curves

• As the marginal product increases, marginal costs decrease

  • There is an inverse relationship

    • Increasing returns = decreasing costs

    • Decreasing returns = increasing costs

Diagram analysis

• The distance between the AVC and AC = the AFC

  • AVC converges towards AC as the AFC continuously decreases with an increase in output

  • AVC decreases as additional workers are added and each worker produces additional product

• Marginal costs (MC) decrease initially as additional workers are added and the marginal product is increasing

• Diminishing returns begin when the MC starts to increase

• MC will cross the AVC and AC curves at their lowest point

  • As long as the cost of producing the next unit (MC) is lower than the average, it will pull down the average

  • When the cost of producing the next unit (MC) is higher than the average, it will pull up the average

Short-run and Long-run Average Costs Curves

• Day-to-day operations of a firm occur in the short-run

• In the long-run, they are able to plan to increase the scale of production

  • E.g by increasing the size of the factory

  • Larger scale = more output and the firm moves onto a new SRAC curve in which the average unit costs are lower

• In the long-run, a growing firm is likely to keep repeating this process.

  • Each time a more efficient SRAC is generated

• The long-run average cost curve (LRAC) is the line of best fit between the lowest points of the short-run ATC curves