By Navneet and Gurpreet CSE
In
this note we consider production costs in the short run, in particular the
difference between fixed and variable costs and the relationships between
marginal and average costs.
In the short run, because at least one factor of production is fixed,
output can be increased only by adding more variable factors. Hence we consider both fixed and variable costs
Fixed
costs
Fixed
costs are business expenses that do not vary directly with the level of
output i.e. they are treated as independent of the level of
production.
Examples
of fixed costs include the rental costs of buildings; the costs of leasing or
purchasing capital equipment such as plant and machinery; the annual business
rate charged by local authorities; the costs of full-time contracted salaried
staff; the costs of meeting interest payments on loans; the depreciation of
fixed capital (due solely to age) and also the costs of business insurance.
Fixed
costs are the overhead costs of a business. They are important in
markets where the fixed costs are high but the variable costs associated with
making a small increase in output are relatively low. We will come back to
this when we consider economies of scale.
Average
fixed costs must fall continuously as output increases because total fixed
costs are being spread over a higher level of production. In industries where
the ratio of fixed to variable costs is extremely high, there is great scope
for a business to exploit lower fixed costs per unit if it can produce at a
big enough size. Consider the new Sony portable play station. The fixed
costs of developing the product are enormous, but these costs can be divided
by millions of individual units sold across the world.
A
change in fixed costs has no effect on marginal costs. Marginal costs
relate only to variable costs!
Variable
Costs
Variable
costs are costs that vary directly with output. Examples of variable
costs include the costs of intermediate raw materials and other
components, the wages of part-time staff or employees paid by the hour, the
costs of electricity and gas and the depreciation of capital inputs due to
wear and tear. Average variable cost (AVC) = total variable costs (TVC)
/output (Q)
 Variable costs are those associated with changes in short run production – what are the variable costs associated with an increase in the production of Californian wine shown in the picture above?
Average
Total Cost (ATC or AC)
Average total cost is simply the cost per unit produced Average total cost (ATC) = total cost (TC) / output (Q)
Marginal Cost
Marginal
cost is the change in total costs from increasing output by one extra unit.
The
marginal cost of supplying an extra unit of output is linked with the marginal
productivity of labour. The law of diminishing returns implies
that the marginal cost of production will rise as output increases.
Eventually, rising marginal cost will lead to a rise in average total cost.
This happens when the rise in AVC is greater than the fall in AFC as output
(Q) increases.
Worked
example of short run production costs
A
simple numerical example of short run costs is shown in the table below.
Fixed costs are assumed to be constant at £200. Variable costs increase as
more output is produced.
In
our example, average cost per unit is minimised at a range of output between
350 and 400 units. Thereafter, because the marginal cost of production
exceeds the previous average, so the average cost rises (for example the
marginal cost of each extra unit between 450 and 500 is 4.8 and this increase
in output has the effect of raising the cost per unit from 1.8 to 2.1).
Short
Run Cost Curves
When
diminishing returns set in (beyond output Q1) the marginal cost curve starts
to rise. Average total cost continues to fall until output Q2 where the rise
in average variable cost equates with the fall in average fixed cost. Output
Q2 is the lowest point of the ATC curve for this business in the short run.
This is known as the output of productive efficiency.
A
change in variable costs
A
rise in the variable costs of production leads to an upward shift both in
marginal and average total cost. The firm is not able to supply as much
output at the same price. The effect is that of an inward shift in the supply
curve of a business in a competitive market.
An
increase in fixed costs has no effect at all on variable costs of production.
This means that only the average total cost curve shifts. There is no change
at all on the marginal cost curve leading to no change in the profit
maximising price and output of a business. The effects of an increase in the
fixed or overhead costs of a business are shown in the diagram below.
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