Fixed and variable costs
Fixed costs do not alter with output. Fixed costs include:
- Indirect labour - admin, office staff etc. These must be employed whatever level of output.
Fixed costs are shown as a straight line on a graph.
Variable costs change with output. They include:
- Raw materials
- Overheads - electricity, heating etc.
- Direct labour - e.g. factory workers
Variable costs rise more slowly than output at low levels of output. As output gets bigger, diminishing returns set in and costs rise faster than output.
The law of diminishing return states that applying more of a factor of production gives a lower increase in output compared to previous increases. The law applies only in the short run when one or more factors is kept constant.
The total costs are simply the sum of the fixed and variable costs.
Average fixed costs
Average fixed costs always fall as output increases because the same cost is being spread over a larger output.
Average variable costs
Average variable costs may fall slightly for small levels of output due to increasing returns to scale. At larger outputs, AVC increases because of diminishing returns.
Average costs (aka average total costs) are U shaped. At lower levels of output, the effect of falling AFC (due to fixed costs being spread) causes AC to fall. At higher levels, the effect of increasing AVC (due to diminishing returns) is more important and causes AC to increase.
The minimum point on the AC curve is the output solution point. This is where productive efficiency is achieved. When a firm begins to produce quantities above the output solution point, its costs will increase (due to diminishing returns). In this case, the firm should move to new premises or get a new plant to overcome the problem of diminishing returns.
Marginal cost is the cost of the last item produced. It crosses AVC and AC at their minimum points. This is because when MC is lower than AC, the additional lower cost brings the average down, thus causing AC to fall. When MC is higher than AC, it will pull AC up.
When costs rise, MC is affected most quickly, because it is the last item produced. Averages take longer to reflect the full extent of the cost increase.