Fixed, Variable, and Marginal Costs

• Managing costs is addressed through the concepts of fixed and variable costs.
• Business cost and revenue will be discussed.

Learning Objectives/Types of Costs

• Short run and long run costs are to be covered.
• Fixed costs are part of the learning objectives
• Variable costs are to be covered
• Understanding average, marginal, and total costs is an objective.
• The Law of Diminishing Returns is a key concept
• Economies and diseconomies of scale are important
• Total revenue will be discussed

Production Costs in the Short Run

• Short-run and long-run production involves fixed and variable inputs
• In the short run, some inputs are fixed
• In the long run, all inputs are variable
• Short-run production is subject to the law of diminishing returns

Diminishing Returns

• With one or more inputs fixed, extra output from additional units of a variable input diminish beyond a certain point

Costs and Inputs

• Costs relate to the productivity of factors like labor, with more productive workers impacting costs
• Costs are affected by the price of factors; rising labor costs impact building companies.
• Total costs include total fixed costs (TFC), an example is a classroom
• Total variable costs are denoted as (TVC)
• TVC relates to the law of diminishing returns
• Total cost equation: TC = TFC + TVC, this is individual cost

Question

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

Marginal Cost

• Marginal cost defines how much it costs to produce one extra unit of output
• Marginal cost equation: MC = ΔTC / ΔQ
• Marginal cost relates to the law of diminishing returns

Average Cost

• Average fixed cost equation: AFC = TFC / Q
• Average variable cost equation: AVC = TVC / Q
• Average cost equation: AC = TC / Q = AFC + AVC

Average and Marginal Costs

• The shape of the average cost (AC) curve depends on the shape of the marginal cost (MC) curve

Key Rules

• If marginal cost equals average cost, the average cost will not change
• If marginal cost is above average cost, the average cost will rise
• If marginal cost is below average cost, the average cost will fall

Question

• If marginal cost is below average cost, then average cost is falling.

Production Costs in the Long Run

• All inputs are variable in the long run

Scale of Production

• Constant returns to scale mean scaling up does not provide a cost advantage
• Increasing returns to scale mean scaling up inputs increases productivity

Why Firms Scale Up

• Specialization and division of labor are reasons for scaling up
• Indivisibilities are factors
• Greater efficiency of large machines enable scale
• Multi-stage production enables scale
• Organizational and administrative economies are enabled by scaling up
• Financial economies are a factor for scaling up
• Economies of scope, such as in a villa, are a reason to scale

Question

• Economies of scale means large-scale production leads to lower costs per unit of production

Diseconomies of Scale

• Managerial diseconomies can cause disconnection with workers
• The Effects of workers and industrial relations
• Risks of interdependencies increase with scale
• External economies of scale affect the whole industry
• External diseconomies of scale also affect the whole industry
• Economies of scale occur up to a certain output
• Diseconomies of scale occur when firms become very large

Long-Run Average Cost

• The shape of the LRAC (long-run average cost) curve depends on economies or diseconomies of scale
• Assumptions behind the LRAC curve include: input prices are given, state of technology and input quality are given and firms operate efficiently.

Typical Long-Run Average Cost Curve

• Curve illustrates economies of scale, constant costs, and diseconomies of scale.

Question

• Minimum efficient scale is the point where LRAC levels off

Defining Revenue

• Total, average, and marginal revenue must be defined

Equations

• Total Revenue (TR) = Price (P) × Quantity (Q)
• Average Revenue (AR) = TR / Q
• Marginal Revenue (MR) = ΔTR / ΔQ
• Revenue curves for price takers are horizontal demand curves

Revenue

• Average revenue (AR) is relevant
• Marginal revenue (MR) is relevant

Learning Outcome Key Terms

• Total costs are the sum of fixed and variable costs
• The Law of Diminishing Returns applies in the short run
• Costs are different in the short run and long run.
• Average Cost (AC), Marginal Cost (MC) are important calculation
• Economies of scale are relevant in the long run
• Diseconomies of scale should be calculated
• Total Revenue (TR), Average Revenue (AR), and Marginal Revenue (MR) should be calculated.

Price Elasticity of Demand and Business

• Price elasticity of demand and a firm's sales revenue where revenue defined as TR = P x Q

Effects of Price Change on Sales Revenue

• With elastic demand, TR changes in the same direction as quantity
• With inelastic demand, TR changes in the opposite direction as quantity

Elastic Demand

• Elastic demand means expenditure falls as price rises

Inelastic Demand

• Inelastic demand means expenditure rises as price rises

Income Elasticity of Demand

• Income elasticity of demand is (YεD)
• Measurement: %ΔQ / %ΔY

Measurement: %∆Q/%∆Y

• Normal goods have positive elasticity.
• Inferior goods have negative elasticity; a rise in income leads to a fall in demand

Determinants

• The Degree of 'necessity' of the good
• Applications to business involves importance of perceptions of the product
• Repositioning a product

Cross-Price Elasticity of Demand

• Measurement: %ΔQDa / %ΔPb

Measurements

• Substitute goods have positive elasticity
• Complementary goods have negative elasticity
• Closeness of complements or substitutes
• The time period is relevant
• Effects of changes in competitors’ pricing strategy impacts business
• Strategies to make a product less cross-elastic will improve business

Price Elasticity of Supply

• Measured as (%∆Qs/ %∆Ρ)
• Determinants depend on how much costs rise as output increases
• Time period depends on the immediate term, short run, and long run

Different Price Elasticity of Supply

• Inelastic supply is shown as S1
• Elastic Supply is shown as S2

Question

• Good X is likely to have a more price-elastic supply than good Y if the cost of producing extra units increases more rapidly in the case of Y than in the case of X.

Next Lecture

• Perfect competition is the next lecture topic.