Fixed and Variable Costs

• Managing costs is a key business problem that economics addresses through the concepts of fixed and variable costs.

Learning Objectives: Types of Costs

• Study of costs requires understanding of short-run and long-run distinctions, fixed costs, variable costs, average costs, marginal costs, total costs including total revenue.
• Other elements to consider include the law of diminishing returns along with economies and diseconomies of scale.

Short-Run and Long-Run Production

• Short-run and long-run production involves fixed and variable inputs.
• The short run includes some fixed inputs.
• The long run has all inputs that are variable.
• Short-run production includes the law of diminishing returns.
• The law of diminishing returns dictates that with one or more fixed inputs, there is a point where additional units of a variable input lead to diminished extra output.

Costs and Inputs

• Costs relate to the productivity of labor factors and costs and the price of factors.
• Total cost = total fixed cost + total variable cost.

Fixed Cost Example

• The rent on the workshop is a fixed cost for a handmade furniture manufacturer.

Marginal Cost

• Marginal cost is how of much it costs to produce one extra unit of output.
• Marginal cost (MC) = Change in total cost (ATC) / Change in quantity (AQ).
• The idea of marginal cost is related to the law of diminishing returns.

Average Cost

• Average fixed cost (AFC) = Total fixed cost (TFC) / Quantity (Q).
• Average variable cost (AVC) = Total variable cost (TVC) / Quantity (Q).
• Average cost (AC) = Total cost (TC) / Quantity (Q) = AFC + AVC.

Average and Marginal Cost Relationship

• The shape of the average cost (AC) curve depends on the shape of the marginal cost (MC).
• Three rules to consider: If the marginal equals the average, the average will not change. If the marginal is above the average, the average will rise. If the marginal is below the average, the average will fall.
• When the marginal cost is below the average cost, then the average cost must be falling.

Long-Run Production and Scaling

• In the long run, all inputs are variable.
• Constant Returns to Scale means as you scale up, there is no cost advantage.
• Increasing Returns to Scale means as you scale up the inputs, the inputs being used become more productive.

Firms Scaling Up

• Firms scale up to achieve economies of scale.
• Economies of scale arise from specialization and division of labor, indivisibilities, greater efficiency of large machines, by-products, multi-stage production, organizational & administrative economies, and financial economies.
• Economies of scope example: A villa.
• Economies of scale is defined as large-scale production leading to lower costs per unit of production.

Diseconomies of Scale

• Diseconomies of scale can be: managerial diseconomies which mean disconnection with workers, the effects of workers and industrial relations, and the risks of interdependencies.
• The size of the whole industry can have external economies and diseconomies of scale.
• Economy and diseconomies of scale means economies of scale up to a certain output and diseconomies of scale once firms get very large.

Long-Run Average Cost

• The shape of the long-run average cost (LRAC) curve depends on whether there are economies or diseconomies of scale.
• Assumptions behind the LRAC curve include input prices are given, the state of technology and input quality are given, and firms operate efficiently.
• The minimum efficient scale is the point where LRAC levels off.

Revenue Calculations

• Total revenue (TR) = Price (P) x Quantity (Q).
• Average revenue (AR) = TR / Q.
• Marginal revenue (MR) = Change in TR / Change in Q.

Revenue Curves

• Revenue curves for firms are price takers with a horizontal demand curve, relating to average and marginal revenue.

Key Terms

• Total costs: Fixed costs + variable costs.
• The law of diminishing return impacts costs in the short run.
• Calculations for: average cost and marginal cost.
• Economies of scale impacts the long run.
• Diseconomies of scale needs to be understood.
• Total, average and marginal revenue calculations are relevant.

Price Elasticity

• Price elasticity of demand and a firm’s sales revenue (TR = P x Q).
• Effects of a price change on sales revenue may lead to elastic demand (TR changes in same direction as quantity) or inelastic demand (TR changes in opposite direction as quantity).
• Expenditure falls as price rises under an elastic demand
• Expenditure rises as price rises under an inelastic demand

Elasticity of Demand

• Income elasticity of demand includes measurement %∆Q/%∆Y, normal goods (positive elasticity), and inferior goods (negative elasticity- a rise in income leads to a fall in demand).
• Determinants include the degree of 'necessity' of the good, with applications to business being the importance of perceptions of the product and repositioning a product.
• Cross-price elasticity of demand has measurement: %∆QD/%∆PD for substitute goods (positive elasticity) and complementary goods (negative elasticity).
• Determinants include the closeness of complements or substitutes and the time period.
• Applications to business are effects of changes in competitors’ pricing strategy and strategies to make a product less cross elastic.

Price Elasticity of Supply

• Price elasticity of supply is measured by: %∆QS / %∆Ρ
• Determinants are the amount that costs rise as output increases and the time period (immediate, short run, and long run).
• When asked in which one of the following cases is good X likely to have a more price-elastic supply than good Y, the answer is when the cost of producing extra units increases more rapidly in the case of Y than in the case of X.