Costs
Syllabus
Candidates should be able to:
 Define 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
derive short-run cost curves from the assumption of
diminishing marginal productivity
 Explain the relationship between short-run and longrun average cost curves
Definitions – factors of production, economic cost versus imputed cost
Firms combine factors of production (_______________
____________________________________________)
in order to produce goods or services.
Economists differ in their use of the word “cost” and
“normal profit” from accountants, tax inspectors,
businesses and others.
The opportunity cost refers to the __________________
_____________________________________________
Jacob leaves his job as an accountant earning £30,000
to start his own business. What’s the opportunity cost?
Examples of imputed cost - Labour
A market trader working on her own may say that she
has made £50 profit on a day’s trading but this figure
may not include the value of her own time. If she could
earn £40 working in another job for the day then what is
her opportunity cost and hence her economic profit?
Definitions – variable versus fixed costs
Costs can be classified in two ways.
Variable costs vary in direct proportion to output e.g. if
Anna makes twice as many sandwiches she will need
twice as much ________
Fixed costs don’t change in relation to output. They
remain the same whether 500 or 501 sandwiches are
sold e.g. ________________
Fixed costs are often capital goods.
Variable costs are often raw materials
Short run versus long run
In the short run at least one factor of production cannot
be changed. For example the size of the factory is fixed
although more workers could be employed.
So in the short run, some costs are fixed whilst others
are ____________________
In the long run, all factor inputs can vary, so all costs
will be variable. For example, a new factory could be
built.
(Some textbooks refer to the very long run when
technology can change as well.)
Total, average and marginal costs
Total cost is found by adding total fixed cost and
total variable cost
Total cost =
TC =
Average cost =
AC =
Marginal cost is the cost of producing an _____
unit of output
MC =
Worksheet 3: plot TC, TFC and TVC
Worksheet 3: plot ATC, AFC, AVC and MC
You should find that the MC curve cuts the AC and AVC
at their ________ points respectively. If it doesn’t that is
because you’ve put the minimum in the wrong place!
Explanation why MC cuts ATC and AVC at minimum
If MC < ATC then ATC is
If MC > ATC then ATC is
Therefore if MC = ATC this must be the ________ point
The short run and diminishing marginal productivity (diminishing returns)
In the short run at least one factor is fixed.
Assume a firm has a factory with machines and 10
staff. What will happen as more staff are employed?
Initially output per worker should ____________ until it
reaches a maximum.
There is an optimum level of production which is
productively efficient; eventually output per worker will
start to __________
This is known as the law of diminishing marginal
returns (or the law of diminishing productivity).
£
Short run cost schedules – what can you say about the diagram?
Output
TVC
TFC
TC
TFC is a ________________ line showing that TFC is
_____________ whatever the output.
TC and TVC are _____________ because the vertical
distance between them is _______
The inflections in the TC and TVC are caused by the
change from increasing returns to diminishing returns.
Short run cost schedules – what can you say about the diagram?
AFC ____ as output increases because FC represent an
ever decreasing proportion of TC as output rises
ATC and AVC ___ and then ___ as diminishing average
returns set in, MC falls but then rises as diminishing
marginal returns set in. The vertical distance between
ATC and AVC is the value of _____
Key points with short run cost curves
1. MC,
ATC and AVC curves are U shaped because of
the law of diminishing returns. The lowest points on the
MC and AC curves show where diminishing marginal
returns and diminishing average returns set in
respectively.
2. MC cuts the ATC and AVC curves at their _____ points
3. ATC curve is ______ MC curve when ATC is falling
4. ATC curve is _______ MC curve when ATC is rising
5. ATC = MC when ATC is constant.
Hence MC = ATC at its lowest point.
6. Points (3 – 5) are also true for AVC and MC
Average costs and marginal costs
Complete the tables, what do you notice about TC, AC
and MC?
Quantity
TC (£)
1
20
2
28
3
35
4
41
Quantity
TC (£)
1
20
2
26
3
33
4
42
AC (£)
AC (£)
MC (£)
MC (£)
The long run



In the long run all factor inputs are __________
A producer can vary the amount of land, labour
and capital.
How might this happen?
Short or long run?



There is no standard length of time for the short or
long run.
In the chemical industry a plant may last 20 years
before it needs replacing and so the short run
might last 20 years.
In an industry with little or no permanent physical
capital, the short run may be measured in months
or even weeks.
What does the LRAC curve show?
The LRAC curve shows the minimum level of
average costs attainable at a given level of output.
It is a boundary between attainable and
unattainable costs.
If a firm is producing on
the LRAC curve, then it is
producing at long run
minimum cost.
If long run production is
inefficient, costs will be
within the boundary
(shaded)
Points on, above and below the LRAC curve
So, the curve shows the
minimum average costs at
any output.
If a firm was producing at
point __ this would be less
efficient than producing at
point __ (since the costs
are ____________).
Points above the LRAC
are not _____________
Points below the LRAC are
_________________
B
A
Movement along the LRAC curve
Sketch a LRAC diagram showing an increase in
output which leads to a fall in costs. Assume the
firm is originally producing at the minimum cost
Change in costs and LRAC curve
1.
2.
LRAC curves are drawn given a set of costs.
If the costs fell (e.g. a fall in the wage rate in the
whole industry) then the LRAC curve would shift
downwards.
Movements along the LRAC curve versus a shift
An increase in output which leads to a fall in costs
is shown by a ________________ the LRAC curve.
External economies of
scale will __________ the
LRAC curve downwards.
New technology, which is
more efficient, will shift the
LRAC _______________
If the government imposed
a tax on the industry then
the LRAC would shift ____
Short run average cost curve and LRAC curve
In the short run at least one factor is _______
SRAC fall at first and then begin to _________
because of diminishing returns.
In the long run all costs are ___________
LRAC change because of economies and
diseconomies of scale.
In the _________ run, a company will choose a scale
of production that will maximise its __________
fixed, long, profits, rise, variable
Short run average cost curve and LRAC curve
We can combine SRAC curves with the LRAC curve