• 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 & 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

Cost Calculations Using the Above Formulas

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 & MC) are determined by the?law of diminishing marginal productivity

In the short run, marginal product (MP) increases with the addition of three workers before diminishing returns for each additional worker begin

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 & there is not enough?grill space (capital)?& 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 & 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 & AC = the AFC
  • AVC converges towards AC as the?AFC continuously decreases?with an increase in output
  • AVC decreases as?additional workers are added?& each worker produces additional product
• Marginal costs (MC)?decrease initially as additional workers are added & 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

• 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?& 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

The LRAC curve is generated by the addition of successive SRAC as the firm expands its scale of production