Costs in the short run
In the short run at least one input, such as a factory, is fixed. Fixed costs (FC) do not change with output, for example rent. Variable costs (VC) change with output, for example materials and hourly labour. Total cost (TC) = FC + VC.
Per-unit measures:
- Average fixed cost AFC = FC ÷ Q
- Average variable cost AVC = VC ÷ Q
- Average total cost ATC = TC ÷ Q = AFC + AVC
- Marginal cost MC = change in TC ÷ change in Q, the extra cost of one more unit.
Diminishing marginal returns
When more of a variable input (workers) is added to a fixed input (a kitchen), the marginal product of each extra worker eventually falls. This is the law of diminishing marginal returns, and it is why marginal cost eventually rises as output grows.
Worked example
A small print shop has fixed costs of 200 dollars per week. Producing 10 posters costs 150 dollars in variable costs.
- TC = 200 + 150 = 350
- AFC = 200 ÷ 10 = 20
- AVC = 150 ÷ 10 = 15
- ATC = 350 ÷ 10 = 35 (check: 20 + 15)
If the total cost of 4 posters is 100 and of 5 posters is 112, the marginal cost of the fifth is 112 − 100 = 12.
Marginal product example: a bakery's output with 1, 2, 3, 4 and 5 workers is 10, 22, 30, 36 and 40 loaves. The marginal products are 10, 12, 8, 6 and 4. The jump to 12 shows specialisation, but from the third worker the marginal product falls.
The MC and average curves
The MC curve crosses the ATC and AVC curves at their minimum points. When marginal cost is below the average, it pulls the average down. When above, it pulls the average up. A class-average analogy: a new student with a lower score than the current average lowers the average.
Profit
Economic profit = total revenue − total cost, where cost includes opportunity costs such as the owner's forgone salary. Accounting profit counts only explicit costs, so it is larger than economic profit. Normal profit is when economic profit is zero: the owner earns exactly as much as in the next-best use of the same resources.
Long run
In the long run all inputs can vary. Costs may fall as scale grows (economies of scale), stay flat (constant returns), or rise (diseconomies of scale).